Value Maximization

Wealth maximization objective was developed as an alternative objective due to above mentioned limitations of profit maximization. Alternative, profit maximization objective had led to an alternative objective to guide resource allocation decisions of the firm, viz.; shareholder’s wealth maximization or maximization the value of the firm.
Before considering what is value maximizing or wealth maximization, the meaning of value should be clarified. There are many concepts of value in economics and business such as- book value, market value, liquidity value, going concern value etc. The value of the firm is defined as the present value of the firm’s expected future net cash flows. If cash flows are equated to profits for simplicity, the value of the firm today, or its present value, is the value of expected future profit or cash flows discounted back to the present at an appropriate interest rate.
Where, PV is the present value of all expected future profits of the firms i is the appropriate interest or discount rate, ? stands for sum up.
Assume the values from 1 up to the n years are considered. Because profits (p) are equal to total revenues (TR) minus total costs (TC), Equation (2) can be rewritten as:
This equation (3) can be used to examine how the expected value maximization model relates to a firm’s various functional departments and activities. The marketing department of a firm has a major responsibility for sales (TR); the production department has a major responsibility for costs (TC), and the finance department has a major responsibility for acquiring the capital needed to support the firms investment and operating activities and, hence, for the discount factor (i), there are many important overlaps among these functional areas. For instance, marketing department can help to reduce the costs associated with a given level of output by influencing customer size and timing. The production department can stimulate sales by improving quality and reducing delivery lags. Other department like accounting, personnel, transportation, and engineering- provide information and service vital to both sales growth and cost control. Therefore, the determination of TR and TC is a complex job that requires recognizing important interrelations among the various areas of firm’s activity. All of these activities affect the firm’s risks and thus the discount rate used to determine present values. An important concept in managerial economics is that managerial decisions throughout the firm should be analyzed in terms of their effects on the various determinants of value as expressed in equations (2) and (3).
Thus, the value maximization or wealth maximization model of the firm removes two major defects of the profit maximization objectives, viz.
? Profit maximization objective is failure- to incorporate the time dimension in the decision process.
? Profit maximization objectives is failure to deal explicitly with the risk and uncertainty in decision-making.
For these reason’s profit maximization has become a static objective. The value maximizing equation gives both the requirements, viz.
? It considers time dimensions by incorporating in the equation net discounted earnings during the future periods at a certain required rate of return.
? It also perceives and considers the element of differential risk associated with alternative projects by adjusting the required rate of return. Both, financial conditions and the level of inflation are taken into account while determining such a rate of return.
The above merits make the objective of-value or wealth maximization as a dynamic objective of the firm.