WEALTH MAXIMIZATION

Shareholder’s wealth maximization (SWM) means maximizing the present value of a course of
action to shareholders. Net present value (NPV) or wealth of a course of action is the difference between
the present value of its benefits and the present value of its costs. A financial action that has a positive
NPV creates wealth for share holders and, therefore, is desirable. A financial action resulting in negative
NPV should be rejected since it would destroy shareholders wealth. Between mutually exclusive projects
the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature.
Therefore the wealth will be maximized if NPV criterion is followed in making financial decisions.

The objective of SWM is an appropriate and operationally feasible criterion to choose among the
alternative financial actions. It provides an unambiguous measure of what financial management should
seek to maximize in making investment and financing decisions on behalf of shareholders. From the
shareholders’ point of view, the wealth created by a company through its actions is reflected in the market
value of the company’s shares. Therefore the wealth maximization principle implies that the fundamental
objective of a firm is to maximize the market value of its shares. The value of the company’s shares is
represented by their market price that, in turn, is a reflection of shareholders’ perception about quality of
the firm’s financial decisions. The market price serves as the firm’s performance indicator. That is
Wealth maximization means maximizing the net wealth of the company’s share holders. Wealth
maximization is possible only when the company pursues policies that would increase the market value of
shares of the company.

The efficiency of Financial Management of any firm is judged by the success in achieving the
firm’s goal. The shareholder wealth maximization goal states that management should endeavor to
maximize the net present value of the future expected cash flows to the shareholder of the firm. Net
present value refers to the discounted value of future cash flows at the expected rate of return. Wealth
maximization can be achieved only with the most efficient use of society’s economic resource.

Shareholders’ wealth maximization is theoretically logical and operationally feasible normative

goal for guiding the financial decision making. Shareholders’ wealth maximization means maximizing the
net present value of a course of action to shareholders. The goal of maximization of shareholders wealth
as reflected in the market price of the share makes the interest of the shareholders compatible with that of
the management. With this objective in sight, the management will allocate the available economic
resources in the best possible way within the given constraints of risk. This goal directly affects the policy
decision of a firm about what to invest in and how to finance these investments. Further, the goal of
maximization of shareholders wealth implies a long term perspective of the goal. The market price of a
share reflect all expected future benefits flowing from the firm to its shareholders, and therefore the
management cannot emphasize the short term profits at the cost of long term perspective.

Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their
consumption over time. With their wealth maximized, shareholders can adjust their cash flows in such a
way as to optimize their consumption. From the shareholders’ point of view, the wealth created by a
company through its actions is reflected in the market value of the company’s shares. Therefore, the
wealth maximization principle implies that the fundamental objective of a firm is to maximize the market
value of its shares. The value of the company’s shares is represented by their market price that, in turn, is
a reflection of shareholders’ perception about quality of the firm’s performance decisions.
 In the light of above mentioned view let us examine the case of firm Reliance Industries Limited.

Reliance Industries Limited.

Reliance Industries Limited has a wide range of products from petroleum

products, petrochemicals, to garments (under the brand name of Vimal), Reliance Retail has entered into
the fresh foods market as Reliance Fresh and launched a new chain called Delight Reliance Retail
and NOVA Chemicals have signed a letter of intent to make energy-efficient structures. The primary
business of the company is petroleum refining and petrochemicals. It operates a 33 million tone refinery
at Jamnagar in the Indian state of Gujarat. Reliance has also completed a second refinery of 29 million
tons at the same site which started operations in December 2008. The company is also involved in oil &
gas exploration and production.

Particulars 2008-09 2007-08 2006-07 2005-06

Net worth 114520.39 80577.34 61255.02 45154.07

Capital Employed 188494.12 117057.02 89140.89 67019.68

Market capitalization (Rs. In crores) 309984.75 331541.82 186067.02 142492.51

Net Sales (Rs. In crores) 141959 133805.78 111699.03 80877.79

PBIDT 25373.75 28934.64 20524.51 14982.01
PAT(Rs. In crores) 15309.32 19458.29 11943.4 9069.34

Earning Per Share(Rs.) 95.24 131.97 84.28 63.7

Market Per Share(Rs.) 2132.46 2280.8 1280.6 980.24
Payout (%) 12.66 8.5 12.27 14.7
Retention (%) 87.34 91.5 87.73 85.3

Dividend (annual) % 130 130 110 100

dividend (Rs.) 13 13 11 10

Return on investment (%) 13.66 19.3 23.59 23.18

Prof James E. Walter considers dividend as one of the important factors determining the market
valuation. According to Walter, in the long run, share prices reflect the present value of future stream of
dividends. Retained earnings influence stock prices only through their effect on further dividends.
 Particulars 2009 2008 2007 2006
EPS 95.24 131.97 84.28 63.7
Rate of ROI (%) ( r ) 13.66 19.3 23.59 23.18
retention rate (b) 87.34 91.5 87.73 85.3
cost of capital( k ) 4.46 5.78 6.56 6.49
Dividend 13 13 11 10
Walter Model (p)
(E-D)r/k 251.88 397.25 263.52 191.80
P 5939.08 7097.80 4184.72 3109.36

According to this model if the ROI from retained earnings is higher than the market capitalization
rate then the value of its shares would be high even if the dividends are low. As given in the case of RIL
the dividends are very less and retention rate is very high , nearly 90% of the profits but still the
company’s share price is increasing which is due to their difference in returns rate and market
capitalization rate as given in above table the difference is around 10-15% on positive side.

From last 4 years, the sale of RIL has been increased by huge amounts and the profit of the
company is also increasing in huge amounts and dividend paid by RIL is also increasing year by
year.

As the trend is given there, 100% of the face value had been declared as dividend in 2005-06(
previous to this, in 2004-05 that was 75% i.e. Rs. 7.5/.share) and then RIL is declaring more
dividends in the further years, like 110%, 130% for two years.

This shows the company’s strong prospects for their future profits as they are declaring more
dividends year by year. It also provides a sense of benchmark for the dividends to the
shareholders of Reliance Industries.

Earnings per share of three years, i.e. 2006,07,08 are increasing from Rs. 63 to Rs. 131 and in
response to this company had given dividend @ 100%, 110% & 130%, at increasing rates. This
shows that company is giving much return to their shareholders as their part of profits.

But if we take a look at the Earning Per Share of 2009 i.e. Rs. 95, which is less than the previous
year’s EPS and the company had not increased its dividend as it was doing from last 3 years, but
still they maintained to gave them the same dividend as to the related previous year i.e. 130%.

This shows about the relationship between EPS & dividends as company generally tries to trace
the EPS and move towards giving the increased value to the shareholders and also provides the
good indication of the profitability & cash position of the company to the market.

In this manner Reliance is the company which is providing maximum values to their shareholders,
the form could be different as it has already been mentioned that company’s dividend payout ratio is very
low( less than 15%) but still shareholders are having benefits in one way or other. Shareholders are
receiving Rs. 10, 11, 13, 13 as dividends in last 4 years, but their capital gain from the increase in value of
shares was remarkable which had created much wealth for their shareholders. Their retention of profits
generally provide a positive effect to the market because market prospects of this company is very wide
and that is the thing which affect its share price and directly attain the main goal of the company i.e.
wealth maximization.

Reference :-

1) http://mbaassignment.blogspot.com/2009/06/wealth-maximization-functions-of.html (Wealth
Maximization & Functions of Finance)
2) http://www.learningwhatworks.com/papers/Max_Value.pdf (Maximizing Shareholder Value
And The Greater Good)
3) http://www.valuebasedmanagement.net/articles_cima_maximizing_shareholder_value.pdf
(Maximising Shareholder Value Achieving clarity in decision-making)
4) http://www.law.harvard.edu/programs/olin_center/corporate_governance/papers/No339.01.R
oe.pdf (THE SHAREHOLDER WEALTH MAXIMIZATION NORM AND INDUSTRIAL ORGANIZATION)
5) http://investor.harley-davidson.com/StatementsBalanceSheets.cfm
6) http://moneycentral.msn.com/investor/research/printrep.asp?symbol=HOG
7) http://www.slideshare.net/Akshay69Bhatia/dividend-decisions-by-reliance-industries
8) http://cfaphoenixlearning-financesimplified.blogspot.com/2010/10/wealth-maximization-
leading-to.html
9) Financial Management-I M Pandey- Ninth Edition Vikas Publishing House Pvt. Ltd.