Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The concept requires a company’s management team to continually search for the highest possible returns on funds invested in the business, while mitigating any associated risk of loss. This calls for a detailed analysis of the cash flows associated with each prospective investment, as well as constant attention to the strategic direction of the organization.
The most direct evidence of wealth maximization is changes in the price of a company’s shares. For example, if a company spends funds to develop valuable new intellectual property, the investment community is likely to recognize the future positive cash flows associated with this new property by bidding up the price of the company’s shares. Similar reactions may occur if a business reports continuing increases in cash flow or profits.
Role of Business Managers
People often think that the managers of a firm are the owners. That may be true in the case of a small business or partnership. In a larger business, however, there may be many levels of management, and they do not necessarily own the firm. Aside from their salaries and benefits, they only profit from the business if they own shares of stock in the company.
When employees are also shareholders, they tend to have a greater sense of responsibility to the firm. Consequently, many companies encourage employees to become shareholders. In fact, some businesses offer shares of stock to their employees at a discount through an Employee Stock Options Plan (ESOP).
Increase in Wealth = Present Value of cash inflows – Cost
- Profits are more manipulative, but cash flows are not. Thus, wealth maximization is less prone to manipulation than profit maximization, which relies on profit.
- It is more related to cash flows than profits. Cash flows are more certain and regular, and there is a lack of uncertainty that otherwise is associated with profit.
- They consider risk and uncertainty factors while considering the discounting rate, which reflects both the time and risk.
- It is more long-term-focused than profit maximization, which has a short-term focus. Profit maximization is easy to attain because managers may adopt unethical ways to bring short-term profits based on long-term sustainability.
- May go against public interest: As in the case of the Great Recession of 2008, prioritizing wealth above all other goals can have detrimental and unintended consequences.
- Other business goals can suffer: By nature, a primary goal means all other goals must be secondary. An unrelenting focus on increasing stock price can block the advancement of a business’s other goals.
- Can conflict with manager goals: A business’s managers may see a stronger incentive to put their own welfare and job security ahead of increasing the company’s stock price. These conflicting priorities can make it difficult to maximize shareholder wealth.