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Goals of Financial Management - Wealth Maximization

1. Definition

Wealth Maximization is the modern and universally accepted goal of financial management that focuses on maximizing the market value of equity shares, thereby creating long-term value for shareholders while considering risk, timing, and quality of earnings.

Formula Representation:

Formula

Wealth = Present Value of Expected Future Cash Flows

Wealth = Σ [CFt / (1 + r)^t]

Where:

  • CFt = Cash flow in period t
  • r = Required rate of return
  • t = Time period

2. Meaning and Concept

Focus: Maximizing market price per share (shareholder wealth)

Measurement: Stock market value of equity shares

Example:

Company A:
Share price today: ₹100
Share price after 1 year: ₹120
Wealth created: ₹20 per share (20% increase)

Company B:
Share price today: ₹100  
Share price after 1 year: ₹110
Wealth created: ₹10 per share (10% increase)

Company A achieved better wealth maximization

3. Why Wealth Maximization is Superior

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4. Features of Wealth Maximization

4.1 Cash Flow Focus

Why Cash Flows?

  • Profit can be manipulated (accounting policies)
  • Cash flows are factual and measurable
  • Cash is needed for dividends, investments, debt repayment

Example:

Company shows ₹10 lakh profit but:
- ₹5 lakh is credit sales (not yet received)
- ₹2 lakh is paper profit (revaluation)
- Actual cash generated: Only ₹3 lakh

Wealth maximization focuses on ₹3 lakh actual cash, not ₹10 lakh accounting profit

4.2 Time Value Consideration

Uses discounting to find present value of future cash flows.

Example Problem:

Question: Which project creates more wealth?

Project X: ₹10 lakh after 1 year
Project Y: ₹11 lakh after 3 years
Discount rate: 10%

Solution:

Project X:
PV = ₹10,00,000 / (1.10)^1
PV = ₹9,09,091

Project Y:
PV = ₹11,00,000 / (1.10)^3
PV = ₹11,00,000 / 1.331
PV = ₹8,26,446

Answer: Project X creates more wealth (higher PV)

4.3 Risk Consideration

Higher risk = Higher discount rate = Lower present value

Example:

Same cash flow: ₹10 lakh after 1 year

Low-risk project (10% discount):
PV = ₹10,00,000 / 1.10 = ₹9,09,091

High-risk project (20% discount):
PV = ₹10,00,000 / 1.20 = ₹8,33,333

Risk reduces wealth created

5. Measuring Wealth Maximization

Primary Measure: Market Price Per Share (MPS)

Formula:

Formula

Wealth = Number of Shares × Market Price Per Share

Or

Wealth Per Share = Market Price - Book Value

Example:

Company Data:
- Number of shares: 10 lakh
- Market price per share: ₹150
- Book value per share: ₹100

Total Wealth Created:
= 10,00,000 × ₹150
= ₹15 crores (Market Capitalization)

Wealth per share:
= ₹150 - ₹100
= ₹50 per share

Shareholders gained ₹50 per share over book value

6. Advantages of Wealth Maximization

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7. Practical Application - TCS Example

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Exam Pattern Questions and Answers

Question 1: "Explain wealth maximization as a goal of financial management." (6 Marks)

Answer:

Definition (2 marks): Wealth maximization is the primary goal of financial management focusing on maximizing market value of equity shares, thereby creating long-term value for shareholders. It is measured by market price per share and aims to maximize present value of expected future cash flows considering time value of money and risk.

Focus on Cash Flows (1 mark): Unlike profit maximization which uses accounting profits, wealth maximization focuses on actual cash flows which are factual, measurable, and cannot be manipulated through accounting policies. Cash is required for dividends, investments, and debt service.

Time Value Consideration (1mark): Wealth maximization recognizes that money available today is worth more than same amount in future. It uses discounting to calculate present value of future cash flows, thus considering timing of returns which profit maximization ignores.

Risk Consideration (1 mark): Different projects have different risk levels. Wealth maximization incorporates risk through risk-adjusted discount rates - higher risk projects use higher discount rates, resulting in lower present values, thus properly reflecting risk-return trade-off.

Measurement (1 mark): Measured through market price per share in stock market. Increase in share price indicates wealth creation for shareholders. Formula: Wealth = Number of Shares × Market Price Per Share.

Question 2: "Why is wealth maximization superior to profit maximization?" (6 Marks)

Answer:

Time Value of Money (1.5 marks): Profit maximization ignores timing of profits - it treats ₹10 lakh today same as ₹10 lakh after 3 years. Wealth maximization considers time value by discounting future cash flows to present value, recognizing that earlier returns are more valuable than later returns due to earning capacity and inflation.

Risk Factor (1.5 marks): Profit maximization does not differentiate between high-risk and low-risk projects earning same profit. Wealth maximization incorporates risk through risk-adjusted discount rates - higher risk requires higher return, and risky future cash flows are discounted at higher rates, properly reflecting risk-return relationship.

Cash vs Accounting Profit (1.5 marks): Accounting profit can be manipulated through depreciation methods, stock valuation, and credit policies. Wealth maximization focuses on actual cash flows which are factual and measurable. Cash is ultimate requirement for dividends, investments, and operations.

Long-term Orientation (1.5 marks): Profit maximization may encourage short-term decisions that boost immediate profits but harm long-term value like cutting R&D, reducing quality, or delaying maintenance. Wealth maximization emphasizes sustainable long-term value creation measured through market price which reflects investor expectations of future performance and growth.

Summary

Key Points for Revision:

  1. Definition: Maximize market value of shares (shareholder wealth)
  2. Measurement: Market Price Per Share
  3. Formula: PV of future cash flows
  4. Three Pillars:
    • Cash flow focus (not accounting profit)
    • Time value consideration (discounting)
    • Risk adjustment (risk-adjusted rates)
  5. Superiority: Considers time, risk, cash flows, long-term
  6. Example: TCS share price growth from ₹850 to ₹4000+
Exam Tip

Always contrast wealth maximization with profit maximization showing three key differences: time value, risk, and cash focus. Use numerical example showing PV calculation to demonstrate time value consideration. Mention real company (TCS, Infosys) for share price growth illustration.

Quiz Time! 🎯

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