Difference Between Profit Maximisation and Wealth Maximisation in Financial Management

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).