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Assignment Of Business Economics ON WEALTH MAXIMIZATION

Submitted To: Prof. Kinjal Shah

Submitted By: Sancheeta Tendulkar

Wealth maximization means maximizing the net present value (or wealth) of a course of action. The neat present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive net present value creates wealth and therefore it is desirable. Wealth maximization objective is a widely recognized criterion with which the performance a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth maximization is also stated as net present worth. Net present worth is difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present worth represents the present value of expected cash benefits discounted at a rate, which reflects their certainty or uncertainty. Thus, wealth maximization objective as decisional criterion suggests that any financial action, which creates wealth or which, has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected.

Scope of financing to the Business Organization:

According to the modern approach, the function of finance is concerned with the following three types of decisions - Financing decisions, Investment decisions, and Dividend policy decisions. The core objective of stockholder wealth maximization is highest market value of common stock which emphasizes the long-term, recognizes risk or uncertainty, recognizes the timing of returns, and considers stockholdersreturn.

Normative dimensions:
According to (Boatright, 2010) the descriptive, instrumental and normative dimensions of shareholder wealth maximization are mutually supporting. The descriptive dimension concerns a particular empirical view of laws, markets, motives and behaviors. The view posits relatively efficient markets, marketoriented institutions, and self interested economic rationality. Descriptively, the

view that management (i.e, officers and directors) has strong fiduciary duties on behalf of shareholders, which are established by law and enforced by the market for corporate control. The instrumental dimension concerns the prescriptively best approach to managing a public corporation on behalf of the shareholders and handling the interests of multiple stakeholders in the corporation and its activities. The prescription is that shareholder wealth maximization will most efficiently and effectively advance the interests of shareholders and stakeholders and thus social welfare in a market economy.

Companys common stock:

Shareholders wealth is represented in the market price of the companys common stock, which, in turn, is the function of the companys investment; financing and dividend decision3.Managements' primary goal is shareholders' wealth maximization, which translates into maximizing the value of the company as measured by the price of the companys common stock. Shareholders like cash dividends, but they also like the growth in EPS that results from ploughing earning back into the busines5s. The optimal dividend policy is the one that maximizes the company's stock price which leads to maximization of shareholders' wealth and thereby ensures more rapid economic growth. (International Research Journal of Finance and Economic, 2008)

Time value of money:

The wealth maximization objective considers time value of money. It recognizes that cash benefits emerging from a project in different years are not identical in value. This is why annual cash benefits of a project are discounted at a discount rate to calculate total value of these cash benefits. At the same time, it also gives due weightage to risk factor by making necessary adjustments in the discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at a higher discount rate (cost of capital), while lower discount rate applied to discount expected cash benefits of a less risky project. In this way, discount rate used to

determine present value of future streams of cash earning reflects both the time and risk.

How to calculate wealth?

Wealth is said to be generated by any financial decision if the present value of future cash flows relevant to that decision is greater than the costs incurred to undertake that activity. Wealth is equal to the present value of all future cash flows less the cost. In essence, wealth is the net present value of a financial decision. Wealth = Present Value of cash inflows Cost. Where,
Present Value of cash inflows = (1 + K) CF1 + (1 + K)

CF1 +.+

CFn (1 + K) n

Why wealth maximization model is superior to profit maximization? / Wealth Maximization vs. Profit Maximization
Wealth maximization model is a superior goal because it obviates all the drawbacks of profit maximization as a goal to financial decision. Firstly, the wealth maximization is based on cash flows and not profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits. Secondly, profit maximization presents a shorter term view as compared to wealth maximization. Short term profit maximization can be achieved by the managers at the cost of long term sustainability of the business.

Thirdly, wealth maximization considers the time value of money. It is important as we all know that a dollar today and a dollar one year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. Fourthly, the wealth maximization criterion considers the risk and uncertainty factor while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

In the light of modern and improved approach of wealth maximization, a new initiative called Economic Value Added (EVA) is implemented and presented in the annual reports of the companies. Positive and higher EVA would increase the wealth of the shareholders and thereby create value. Economic Value Added = Net Profits after tax Cost of Capital.

Cost :
The value of an asset is judged not in terms of its cost but in terms of the benefit it produces. Similarly the value of a course of action is judged in terms of benefits it produces less the cost of undertaking it. The benefits can be measured in terms of stream of future expected cash flows, but they must take into consideration not only their magnitude but also the extent of uncertainty. Investing in wealth maximization approaches may experience losses in the short-run but yield substantial profit in the long-run. Also, a firm that wants to show a short-term profit may, for example, postpone major repairs or replacement, although such postponement is likely to hurt its long-term profitability. (Putra, 2010).

Financial decision making:

Effective financial decision making requires an understanding of the goal(s) of the firm. What objectives should guide business decision makingthat is what should management t try achieve for the owners of the firm? The most widely accepted objective of the firm is to maximize the value of the firm for its owners that is to maximize shareholder wealth. Shareholder wealth is represented by the market price of the firms common stock. According to (Ellsworth, 2002) in this time of great paradox the allegiance of maximization of shareholder wealth is stronger than ever before; yet the importance of shareholders contribution to competitive advantage has never been smaller. Capital is readily available and has given way to knowledgeto the ingenuity and dedication of peopleas the key to competitive advantage and wealth creation.

Much has been spoken about wealth maximization but there is a school of thought with a view that wealth maximization does not necessary lead to economic development. Wealth maximization excludes distributional considerations in that many people in the public sphere especially the poor may be excluded and therefore it may lead to unfairness especially in an economy controlled by forces of demand and supply. Another critique is that even though wealth maximization tries to predict the future, future economic performances can be volatile and unpredictable the best example being the world financial crisis otherwise known as the credit crunch.

It is now accepted that the objective of the business should be to maximize its wealth and value of shares of the company. The object can also be stated as maximization of the value.