Wealth maximization

Wealth maximization is a modern approach to financial management. Maximization of profit used to be the main aim of a business and financial management till the concept of wealth maximization came into being. It is a superior goal compared to profit maximization as it takes broader arena into consideration. Wealth or Value of a business is defined as the market price of the capital invested by shareholders. Wealth maximization simply means maximization of shareholders wealth. It is combination of two words viz. wealth and maximization. Wealth of a shareholder maximize when the net worth of a company maximizes. To be even more meticulous, a shareholder holds share in the company /business and his wealth will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization. Finance managers are the agents of shareholders and their job is to look after the interest of the shareholders. The objective of any shareholder or investor would be good return on their capital and safety of their capital. Both these objectives are well served by wealth maximization as a decision criterion to business. How to calculate wealth? Wealth is said to be generated by any financial decision if the present value of future cash flows relevant to that decision is greater than the costs incurred to undertake that activity. Wealth is equal to the present value of all future cash flows less the cost. In essence, wealth is the net present value of a financial decision. Wealth = Present Value of cash inflows Cost. Where,
Present Value of cash = inflows CF1 (1 + K) + CF1 (1 + K)
2

+.+

CFn (1 + K) n

Why wealth maximization model is superior to profit maximization? Wealth maximization model is a superior goal because it obviates all the drawbacks of profit maximization as a goal to financial decision. y Firstly, the wealth maximization is based on cash flows and not profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with accounting profits.

Secondly, profit maximization presents a shorter term view as compared to wealth maximization. Short term profit maximization can be achieved by the managers at the cost of long term sustainability of the business. y Thirdly, wealth maximization considers the time value of money. It is important as we all know that a dollar today and a dollar one year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. y Fourthly, the wealth maximization criterion considers the risk and uncertainty factor while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

In the light of modern and improved approach of wealth maximization, a new initiative called Economic Value Added (EVA) is implemented and presented in the annual reports of the companies. Positive and higher EVA would increase the wealth of the shareholders and thereby create value. Economic Value Added = Net Profits after tax Cost of Capital. In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders achieve their objectives and therefore is superior to profit maximization. For financial managers, it is a decision criterion being used for all the decisions.

Examples

Reliance Industries (RIL)

Private sector oil behemoth Reliance Industries (RIL) has outshone its public sector peers ONGC to emerge as the biggest wealth creator on the Indian bourses in the past one year of the bull run. RIL could achieve the distinction on the back of a 4.3% spurt in its share price to Rs 1,079 on Thursday, when the ONGC scrip actually fell 0.4% to end at Rs 1,326. RIL and ONGC have added Rs 74,992 crore and Rs 69,728 crore, respectively to investor wealth since May 4, '05. According to analysts, RIL has witnessed a significant re-rating of its valuation, especially after the company demerged four companies - Reliance Communication Ventures, Reliance Energy Ventures, Reliance Capital Ventures and Reliance Natural Resources - from itself. RIL shares began trading on an ex-split basis from January 18,

'06, since then the scrip has shot up 56% to end at a new closing high of Rs 1,079 on Thursday. The sensex rose 34% to end at a new high of 12348 during the period. A flow of positive developments such as announcement of better-than-expected Q4 numbers, successful IPO of its subsidiary Reliance Petroleum (RPL) and Chevron's acquisition of a 5% stake in RPL also helped boost market sentiments towards RIL, said analysts. Till Wednesday, ONGC was the topper in terms of wealth generated on a yearly-basis. However, the ranking of the top wealth creators has seen a change with RIL's smart performance on Thursday. Though RIL has recorded the highest absolute growth in market cap in one year, ONGC still remains the market cap topper with a figure of Rs 1,89,014 crore as on Thursday. RIL is the second-largest market cap company with a figure of Rs 1,50,381 crore.

Tata Motors
As the market picked up the pieces from the global meltdown and inched back to its glorious milestones, the Tata group has leapt ahead of the bourses this year. Thirty-one companies from the salt-to software conglomerate saw their combined market capitalisation soar by more than Rs 2 lakh crore, or by over 150%, in 2009 (up to December 24, 2009). The jewel in the Tata crown, Tata Consultancy Services, had a rocking year, with its M-cap trebling, by 213%. Together, the wealth of Indias top 25 industrial housesranked according to turnover and measured by M-caprose by 113% to Rs 15.22 lakh crore, from Rs 7.15 lakh crore at the end of last year. In the same period, the benchmark 30-scrip Sensex gained nearly 80% to reach 17,360.61 points, while the broader 50-scrip Nifty moved up by 75%. Among the larger business houses, Anil Dhirubhai Ambani Group saw its M-cap rising by just 15.6% this year. The highest percentage increase, of over 350%, was recorded by the Om Prakash Jindal group; M-cap of group firm Jindal Steel & Power soared 366%. Power companies have been on steroids as such; the M-cap of Torrent Power moved up 326%. Another sector that gave investors big returns was automobiles. After being battered towards the end of 2008, in the wake of the economic slowdown, companies such as Bajaj Auto, Tata Motors and Mahindra & Mahindra rebounded smartly, as consumer demand picked up. The Indian stock market has been among the top five performers in Asia, ahead of China, this year. Foreign institutional investors have shown a good appetite for Indian stocks, buying equities worth over $16 billion, with the bulk of the money coming in after the Lok Sabha election results were announced on May 16, 2009.

With the outlook for the economy improving, India Inc is expected to turn in fairly good profit numbers in 2010-11. However, given the sharp run-up in stocks in 2009 and the fairly rich valuations, market watchers believe it would be unreasonable to expect similar returns this year.

APPLE
The value of Apple stock hit a record high Thursday before suddenly diving of a cliff. By the time the Apple flash crash stabilized, the Apple stock price had fallen $10 in four minutes. Analysts guessed that either rumors about Steve Jobs health or gaming by short-sellers triggered the flash crash of Apple stock. Apple stock value is expected to only go upward, which makes the Apple flash crash a mystery. Apple stock was cruising along at nearly $360 a share until it started trending down about 1 p.m. Thursday. At 1:39 p.m., Apple stock collapsed from $355 to $349 a share. In four minutes Apple, a company worth more than $300 billion, lost $10 billion in market capitalization. Trading volume of Apple stock spiked upward as hard as the value of Apple shares dove. At the bell, Apple stock was at $354.54, down $3.62, or 1.01 percent from Wednesdays close of $358.16. Trading volume for Apple stock Thursday was 33.1 million shares, about twice the volume of Apple shares than other day this month. The reasons for the Apple flash crash floated by analysts dont make sense. When Steve Jobs took a break, the public expected the worst. But he was seen on Apples Cupertino, Calif., campus last week and spotted having lunch at an Indian restaurant in Mountain View Tuesday. Concerns about the Verizon iPhone dont seem credible. The iPhone set a sales record for Verizon the first three hours it was on sale. Analysts also expect Apple could sell between 30 million and 40 million iPads in 2011 for $18 billion to $20 billion in revenue. The most likely reason for the Apple flash crash is sleazy: short-sellers floating rumors for a quick windfall.