WEALTH MAXIMIZATION - Accounts and Finance for Managers

The next important set of objectives taken for discussion is Wealth maximization

Only in order to replace bottlenecks which were associated with the profit maximization.

Wealth maximization means that value / net worth maximization.

The Worth of Action normally happens only at when the Value of benefits are more than the Cost of its undertaking. In other words, the wealth maximization is defined in the angle of the concept of cash flows. The Cash flows are clearly dealt only in accordance with the "CASH SYSTEM"-Definite Connotation

  • It eliminates the ambiguity associated with accounting profits
  • Second feature - timing of benefits and quality of benefits are jointly considered
  • Operational implications of timing of benefits and quality of benefits

The timing and quality of benefits are given greater importance under the wealth maximization through the incorporation of capitalization rate which is applied to the tune of risk and timing of benefits associated with the project.

The discounting component mainly depends upon the time and risk preferences of theowners of the capital

The importance of the wealth maximization is explained through the discount rate component
Higher the discount Rate reveals that Higher Risk and Higher uncertainty
Lower the discount Rate portrays that Lower Risk and Lower uncertainty
The Decision Criterion is based on the comparison in between the Value and Cost
The Creation of Value takes place only at when the economic benefits are more than Cost
The Reduction of wealth just contrary to the earlier which normally produces lesser Economic Benefits than Cost
The decision of either acceptance or rejection is subject to the net present value
It is imperative to refer the words of Ezra's Solomon to illustrate the importance of the wealth maximization

"The gross present worth of a course of action is equal to the capitalised value of the flow future expected benefit, discounted at a rate which reflects their certainty/uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which rates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive, then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth"

  • W = V-C
  • W = Net present worth
  • V = Gross present worth
  • C = Investment required to acquire the asset/purchase the course of action
  • V = E/K
  • E = Size of the benefits available to the suppliers of capital
  • K = capitalization rate reflecting quality and
  • Timing of benefits attached to E
  • E = G–(M+I+T)
  • G = Average future flow of gross earnings expected from the course of action, before the maintenance charges, taxation, expected flow of interest, preference dividend
  • M = Average annual required investment to maintain G
  • I =Expected flow of annual payments of Interest, Preference Dividend and other prior charges
  • l T=Expected annual outflow of taxes
  • Alternate method:
  • Expected annual outflow of taxes

A1, A2, A3--------depicts the flow of cash resources from a course of action over the period of time
K=is an appropriate discount rate
C=Initial outlay to acquire the asset

If the out come is positive means that net present worth is positive i.e., more than the initial investment, considered to be fruitful for the investment and vice versa

Wealth of the investors= market value of the shareholding of the investors

If net worth is positive then the wealth of the investors will go up; it means that the market value of the share holding of the investors will pile up.

It is called in other words as Maximization of market value of the shares.

All rights reserved © 2020 Wisdom IT Services India Pvt. Ltd DMCA.com Protection Status

Accounts and Finance for Managers Topics