Difference Between Profit Maximisation and Wealth Maximisation in Financial Management

This article discusses the difference between profit maximisation and wealth maximisation in financial management. It explores the implications of these approaches in terms of planning, risk management, and capacity building.

FINANCIAL MANAGEMENT
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FINANCIAL MANAGEMENT
Question 1
It is imperative for financial managers and top management to differentiate between profit
maximisation and wealth maximisation. This is because there is difference in focus in the two
approaches. Profit maximisation tends to focus on profit maximisation in the short run unlike
wealth maximisation which focuses on maximisation of firm value over long term. The above
difference indicated in purview of the two approaches tends to have implications for the
financial management (Brealey & Myers, 2014).
A key aspect where this difference is exhibited is planning. Short term planning dominates in
case of profit maximisation as the focus is to maximise short term profits. As a result, it is
possible that the managers would assume risky projects with high amount of debt in the short
run so as to maximise profit in the short term without worrying about the long term
implications such as debt repayment. On the contrary, wealth maximisation would require
long term planning. As a result, the projects chosen would be those which would create
wealth over the long term despite being underperforming in the short run (Damodaran, 2015).
Further, this difference in the approaches would also be manifested in the case of risk
management. Since profit maximisation focus in aimed at maximised short term profit, hence
it is less likely for these managers to deploy risk management tools such as hedges as the
profits would be reduced. On the contrary, wealth maximisation driven managers tend to
manage risk so that there is generation of wealth from the business even if there is some
adverse event. As a result, the risk management is given high importance in this perspective
(Parrino & Kidwell, 2014).
Yet another aspect of financial management where the difference between wealth
maximisation and profit maximisation has relevance is with regards to capacity building.
Managers driven by profit maximisation do not tend to expand capacity by considering the
future demands and seek to maximise the profits today. Assuming incremental debt for
capacity expansion would lower the profit margins in the near term, profit maximisation
approach would not prefer this. However, wealth maximisation based management would
consider the future demand and engage in capacity expansion so that the business can fulfil
the higher demand in future years (Petty et. al., 2016).

FINANCIAL MANAGEMENT
Question 2
An ordinary annuity may be defined as a stream of annual payments occurring at the end of
the each year for a defined time. An annuity due is defined as a stream of annual payments
which occur at the beginning of the year for a defined time. As a result, the essential
difference between the two instruments is the timing of cash flow. However, this tends to
impact the decision made by investor on account of time value of money concept. As per this
concept, given a choice, a rational person would prefer to receive a particular amount of
money today rather than at a future date (Brealey, Myers & Allen, 2014). This is because the
concerned person can invest the money today in various instruments and can obtain some
return. If the money is obtained at a future date, then the potential return which the investor
could have earned is lost which becomes the opportunity cost. As a result, investment is
worth more in case of annuity due in comparison to ordinary annuity (Parrino & Kidwell,
2014).
The above conclusion can be mathematically illustrated. Consider an investment which
would fetch an annual annuity of $ 1,000 for a period of five years. For the given investment,
the fair value that the investor should pay is the present value of future investments. Assume
that the interest rate for this annuity is 10 percent.
Present value of ordinary annuity = (1000/1.11) + (1000/1.12) + (1000/1.13) + (1000/1.14) +
(1000/1.15) = $3,790.79
Now consider an annuity due with the same cash inflow of $ 1,000 for a period of five years.
Also, to facilitate comparison between the two instruments, the interest rate for this annuity
has been assumed as 10 percent only.
Present value of annuity due = (1000/1.10) + (1000/1.11) + (1000/1.12) + (1000/1.13) +
(1000/1.14) = $4,169.87
From the above illustration, it is apparent that annuity due is more valuable. This is not
surprising since in case of annuity due, the payment is received at the starting of the year
unlike the ordinary annuity when payment is received at the year end. As a result, in case of
discounting cash flows from annuity due, the first cash flow is not discounted as it is received
in the present time only (Petty et. al., 2016).

FINANCIAL MANAGEMENT
References
Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 6thed. New
York: McGraw-Hill Publications
Damodaran, A. (2015), Applied corporate finance: A user’s manual, 3rd ed., New
York:Wiley, John & Sons
Parrino, R. & Kidwell, D. (2014) ,Fundamentals of Corporate Finance,4th ed., London:
Wiley Publications
Petty, JW, Titman, S, Keown, A, Martin, JD, Martin, P, Burrow, M & Nguyen, H (2016),
Financial Management, Principles and Applications, 3rd ed., Sydney: Pearson Education
& French Forest Australia