Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal to a financial decision.
- 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 Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability of the business.
- 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 In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value.
- 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.