The Concept of Wealth Maximization - Case Study Example

Introduction: The concepts of profit and wealth maximization normally differ with one another. Profit maximization involves the use of the resources of the company, for purposes of getting profits within a short run. This is as opposed to the concept of wealth maximization which involves laying out strategies that the business organization would use, with the intention of making profits over a long period of time. Wealth maximization process normally goes hand in hand with the concept of capital budgeting process. Furthermore, wealth maximization process involves the creation of policies aimed at building a positive brand name for the organization. Wealth Maximization: Wealth maximization refers to a financial management technique which emphasizes on an increase in the net worth of a given firm, or company. The wealth maximization approach normally contrasts and contradicts with a traditional method of management, which seeks to increase profits, above all other considerations (Aksoy, 2007). This includes customer satisfaction. Furthermore, business organizations or managers who pursue this concept normally concern themselves with the earnings that shareholders would receive per share, the cash flow of the business organization, and the social values or implications of any financial initiative. Through the inclusion of all these aspects of the business operations, then this approach of management will take a considerable period of time to achieve its objectives (Bottom of Form Dullum). It is important to focus the financial management system of a company by use of different factors, and this is for purposes of acquiring a maximum amount of capital, for the owners of the company. Capital acquisition is an important element for any business organization that seeks to expand its territories. This is because they will manage to finance their various expansion strategies, and therefore increase the level of their profits. Some of the methods of acquiring capital include the use of the stock exchange, and loans from financial and banking institutions. In the process of carrying out the business operations of the organization, it is important that the management should initiate policies aimed at acquiring a large percentage of profits, through cost reduction strategies. Cost reduction strategies normally aim at reducing the various operational and administrative costs of the business organization, with the intention of maximizing on profits. This might include reduction of labor wages, or other less important costs that the business organization faces. Wal-Mart is a company that has managed to achieve efficiency in the cost reduction strategies. The company is known for selling cheap retailing products, and this has been made possible by its cost reduction strategies. However, the major disadvantage of this type of a policy is that it may lead to a high labor turnover. Take for instance Wal-Mart. Because of poor pay, the company is unable to retain 50% of its employees. This is on an annual perspective. Top of Form Bottom of Form Marcinko (2004) therefore explains that it is more expensive for the company to use cost reduction measures as a strategy. This is because in the long run, the company would use more resources to recruit and train new employees. Aksoy (2007) explains that at other times, the search for a profit can be difficult, or problematic to the shareholders of the business organization. For instance, a certain business idea might help in making the organization to achieve a high degree of profitability; however, implementing such kind of an idea might cause some environmental problems. This may make the company to have a negative brand name. Every reputable company normally wishes to have a positive brand name. A positive brand name will help a company to achieve a competitive advantage over its rivals. Companies such as Apples, Samsung, Microsoft, have managed to do well in their business operations because of their capability of building a positive brand name. Top of Form Bottom of Form Marcinko (2004) explains that profits are normally transitory in character, and it is because of this fact that they are unable to accurately represent the financial strength of a business organization. Because of this fact, the concept of wealth maximization is becoming a popular goal for business and financial managers. When business leaders pursue this strategy, they normally seek to help the shareholders of the organization to get a higher income per share that they hold. Most shareholders of an organization are concerned with how much revenue they will get from their shares. Continuous payment of dividends is advantageous to a company, because it is a symbol that the company under consideration is stable (Chandra, 2002). It is a reflection of the worth of a company, and this is mainly because its shareholders are able to acquire revenue through this periodic payment of dividends. Continuous payment of dividends would attract other investors, and this is with the belief that the company is stable, and it is a good organization to conduct business with. Furthermore, issuance of dividends is an indication that the business organization has a stable cash flow (Top of Form Bottom of Form Marcinko, 2004). This is an essential requirement, for any organization to qualify for loans. Shareholders of an organization are deeply concerned with how other people view the organization. This is more important than acquisition of profits and issuance of dividends. Under the concept of wealth maximization, a company that is socially responsible has more value, in comparison to a company that is not socially responsible. This is irrespective of the profits that both businesses make. The major difference that exists between profit and wealth maximization narrows down to the question of time. For example, the business investors who are looking for profits are concerned with an immediate return of their various investments (Chandra, 2002). This is without looking at the future. On the other hand, wealth maximization requires a long term approach for the financial managers of the business organization to strategize on how they would acquire profits, in the long run. These managers are of the opinion that the ups and downs of a current profit seeking should be under the subordinate of the long term initiatives of the organization, in seeking wealth. Profit Maximization: Profit maximization refers to a process whereby a business organization seeks to determine the output level and price of its products, for purposes of achieving profits. These processes are always undertaken over a long or short period of time (Greuning and Bratanovic, 2000). There are a variety of approaches that organizations would seek to use for purposes of maximizing their profits. A good example is the total revenue minus total cost strategy. Under this concept, the profit an organization makes, is equated to its revenue, and the various costs incurred by the same organization (Aksoy, 2007). On this basis, an organization would seek to maximize on this difference. Furthermore, the concept of marginal revenue minus marginal cost is always based on the notion that the total profit of an organization would reach its maximum point, at a point whereby the marginal revenue of an organization would be subtracted to its marginal cost. Any costs that an organization incurs is normally divided into two major groups, variable costs and fixed costs. Fixed costs are always incurred in the short run, and at any level of output. This includes zero output. Fixed costs normally include rent, wages, maintenance of equipment, general upkeep of the business, etc. Variable costs normally change with the level of output that an organization places. Top of Form Bottom of Form Marcinko (2004) explains that variable costs normally increase, when the business organization increases the level of products it generates. Materials that are consumed during the time of production have a large impact on this category. This impact includes an increase in the wages of employees, who can be laid off or hired within a short or long run. When variable and fixed costs are combines, then the total cost of the organization emerges. Roe and Law (2001) explains that revenue refers to the amount of money that emanates from the daily business activities of an organization. On a specific perspective, this is money that comes from the sale of the products of the organization (Vallabhaneni, 2008). This is as opposed to the kind of revenue that an organization gets or incurs, which emanates from the sale of securities, debt issuances, and equity shares. Furthermore, identifying marginal cost depends on whether the organization takes a calculus approach in identifying the costs. Marginal cost is therefore defined as a change in revenue or cost, when the additional units are produced (Aksoy, 2007). Marginal cost can also be defined as a derivative of revenue or costs, in respect to the volume or amount of output that the business organization manages to incur. Take for example, when explaining the first definition. For instance, it would take an organization 400 US dollars, to make some 5 units of a product. It may also take the same organization some 480 US dollars to make six units of a product. The marginal cost of producing the sixth unit would amount to 80 dollars. Earnings per Share and Wealth Maximization: On a frequent basis, maximization of profits is viewed as a good objective of a business organization. However, it is not an inclusive objective of maximizing the wealth of a shareholder. It is important to understand that the total profits of an organization are not important when compared to the earnings per share (Aksoy, 2007). This is mainly because the amounts of dividend a shareholder receives, reflects the value of the shares under consideration. Investors are always attracted to companies that have a high share value. This is because they are convinced that the business operations of the company are stable. This makes it easier for the organization to receive and attract capital. It is important to explain that a business organization has the capability of making profits, by issuing stocks, and investing in treasury bills. However, there is no substitute for the payment of dividends. A business organization has to pay, or fail to pay the dividends under consideration. Asplund (2007) explains that the maximization of earnings per share are not appropriate, and this is mainly because they do not specify the duration or timing of expected returns. For example, we can ask the question if the investment projects that produces a return of 100,000 dollars in the next five years is valuable than an investment that produces 15,000 dollars annually for the next five years. Giving an accurate answer to this question greatly depends on the time value of money that the firm and investors have. Very few shareholders would prefer a project or investment that brings its return in a period of 100 years. On this basis, while analyzing wealth maximization, there is a need of taking into account the time pattern of the expected returns in this analysis. Another disadvantage of this concept of maximizing earnings per share emanates because it does not put into consideration the uncertainty or risks of a prospective earnings stream (Asplund, 2007). This is because investing in some investments is very risk when compared to other investments. Based on this fact, the potential stream of earning per share is uncertain, in case these projects are not undertaken. Furthermore, a company will become more risky or less, depending on the amount of debts, in relation to its equity, that exists in the capital structure (Chandra, 2002). This risk is referred to as the financial risk, and it makes a contribution to the uncertainty of future stream of the earnings per share. For example, two companies may have a similar expectation of future earnings per share. However, if the earning stream of one company is subjected to a considerable uncertainty over the earning stream of another company, then the share prices of the company may increase or fall, depending on the uncertainty under consideration. Because of these reasons, the objectives of maximizing an earnings per share, is not similar as maximizing the price of the shares under consideration (Ananthan and Appannaiah, 2010). The market price or value of the shares of a stock gives a representation of the focal judgment of all the participants of the company’s economic agents. The share value of a stock is an indication of the financial strengths of a business organization. For example, when the share prices of a company are low, then chances are high that the financial performance of the business under consideration is poor. This is the reason investors, or injectors of capital are able to ignore the shares of these companies, and the effect of this, is a reduction of the share prices under consideration. Furthermore, it is not only the speculations and demand of investors that may lead to an increase or decrease of the share prices or value of an organization (Chandra, 2002). Other factors that are considered includes the future and current share price earnings, duration, timing, and the risks associated with the earnings that emanate from these shares, and any other factor or issue that bears on the market price of the shares under consideration. There are a variety of factors or issues that can influence the value of shares or stock, apart from the interference of the government (Vallabhaneni, 2008). These issues include internal problems with the company, political instability, and intensity of competition. Internal problems may include poor management, or administrative policies. Poor managerial practices normally result to the failure of the business organization to achieve its own objectives. This is because employees would leave, and the capital that the business organization has, would not be spent effectively (Greuning and Bratanovic, 2000). This would most definitely affect the perception that investors have towards the company, and it would result to a decrease in the values and prices of the stock. Political stability normally affects the share prices of all the industries that is found within an economy (Aksoy, 2007). However, it is important to denote that even If a country is politically stable, this does not mean that the share prices of the company will be high. This is because there are a variety of factors that determine the share value and prices. On the other hand, political instability will negatively affect the share prices of a business organization (Ananthan and Appannaiah, 2010). This is because the company will not be conducting business; hence its financial position will be low. Investors will not invest in the given country; hence there will be a downward spiral of the share values of companies operating in a country that is politically unstable. The government therefore plays a great role in ensuring that the share prices or values of all companies operating within it, are high and stable. This is because the market share price of an organization, acts as a report card or performance index of the progress of a business organization. It is an indication on how well the management of an organization is managing the business, on behalf of all its shareholders. Asplund (2007) explains that the government plays an important role in the tendencies of an organization to maximize wealth and profits. This is because the government provides an environment where business organizations can carry out their activities. Furthermore, the policies that the government normally enacts have the capability of determining whether the company would follow the principles of wealth or profit maximization. Capital Budgeting and Wealth Maximization: The process of capital budgeting has a direct relation with this concept of wealth maximization. Any capital investment, that has an internal rate of return of more than 1, normally has the capability of creating value for the business organization. These projects or investments normally bring in more than the required or expected rates of return, for the business organization (Sen, 2008). In short, capital investments that bring an internal rate of return of more than 1 help in maximizing the wealth that shareholders have. This is because they are able to earn more than what they expect to get, if they could have invested the money, by themselves. It is therefore prudent to denote that the capital budgeting process has a direct relationship with the concept of wealth maximization (Vallabhaneni, 2008). By analyzing and examining projects through the process of capital budgeting, it is possible to know whether the wealth under consideration will be created, or not. However, the question to ask is what is the real source of wealth? What are the characteristics of a project that has the capability of generating wealth to the business organization? Capital budgeting refers to a long term plan, on how to replace inefficient equipments or physical plants, during the process of carrying out the operations of the business organization (Sen, 2008). Capital budgeting has the capability of determining the time when an organization has the capability of purchasing a given equipment or tool. Wealth maximization concerns itself with a long time period in which a company involves itself in acquiring or accumulating wealth for the shareholders. This also includes heavily investing in capital projects, such as machineries, business premises, acquisition of other companies, etc. It is based on these facts, that the process of capital budgeting is directly related to the process of wealth maximization (Ananthan and Appannaiah, 2010). Capital budgeting process is therefore an important process that all business organizations need to follow (Greuning and Bratanovic, 2000). This is because it helps to compare the present operations of a business organization, with a project that is proposed, or the various alternatives that exists, for effective implementation of the operations of the business organization. In carrying out these comparisons, the capital budgeting process normally uses the revenues and costs of each and every option that is available (Chandra, 2002). Furthermore, the financial measurement tools normally help to determine the relative values of each policy pursued by the company. This is for purposes of ensuring whether the policy under consideration will manage to bring value to the company, in the long run. Conclusion: Wealth and profit maximization process are two different issues. Wealth maximization involves a process whereby the company will initiate a series of policies aimed at ensuring the generation of wealth, over a long period of time. On the other hand, profit maximization concerns itself with the current operations of the business organization. Shareholders of a company are always concerned with a stable company that has the capability of bringing revenue to them, on a constant basis. However, they are more concerned with the social implications of the various policies of the business organization. References: Roe, M., & Law, E. (2001). The shareholder wealth maximization norm and industrial organization. Cambridge, MA: Harvard Law School, John M. Olin Center for Law, Economics, and Business. Top of Form Bottom of Form Dullum, K. (n.d.). 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