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Subject

Paper No and Title Paper No 8: Financial Management

Module No and Title Module No 2: Goals of financial management – profit

maximization vs. wealth maximization
Module Tag COM_P8_M2

TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Profit Maximization
3.1.Meaning
3.2.Arguments in Favour
3.3.Limitations
4. Shareholder’s Wealth Maximization(SWM)
4.1.Meaning

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4.2. Arguments in Favour

4.3.Criticism
4.4. Profit Maximizationvs. Shareholder’s Wealth Maximization
5. Other objectives of Financial Management
5.1. Stakeholder’sWelfare Maximization
5.2.Maximization of Economic Value Added(EVA)
5.3.Maximization of Earnings Per Share (EPS)
5.4.Maximization of Sales
5.5.Maximization of Market Share
6. Summary

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1. Learning Outcomes

After studying this module, you will be able to

· Understand Profit Maximization as the objective of Financial Management

· Appreciate Shareholder’s Wealth Maximization as objective of Financial
Management
· Show that Shareholder’s Wealth Maximization is superior to Profit
Maximization.
· Know other possible objectives of Financial Management

2. Introduction: Objective of Financial Management

The term 'objective' in context of financial management is used to describe a goal or

decision criterion for financial management decisions. For financial management, an
operationally useful criterion is required which would serve as a yardstick for
financial decisions viz., capital budgeting, capital structure, dividend policy and
working capital management. The objective would provide a framework within which
optimal financial decisions can be taken. The objective of financial management
should be derived from wider corporate vision, mission, goals and objectives. Thus,
objective of financial management would be the financial part of overall corporate
objectives and would therefore be in harmony with wider organizational goals. It will
provide a basis to attain financial targets which are required to achieve corporate
goals.
Hence, the chief financial officer of the organization or financial manager must
clearly determine the basic objective of financial management and communicate the
same to entire finance team.
Hereunder, we discuss some of the main objectives of financial management.

3. Profit Maximization as Objective of Financial Management

3.1. Meaning

In the traditional phase, profit maximization was pointed out to be the important objective
of financial management. Main motive of business concern is to earn profit. It can be said
that most businesses function mainly for the purpose of earning profits. Profit is the
yardstick by which efficiency of business operations can be measured. Profit
maximization as objective of financial management means that all financial decisions in a
firm are guided by the criteria of amount of profits that the financial decision generates or
saves. Unprofitable projects and investment alternatives would be rejected. If sufficient
funds are not available to finance all profitable investment projects then those with
highest profits would be selected.

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3.2. Arguments in Favor

Profit maximization as objective of financial management is justified on the following

grounds:
(i) Main purpose of most businesses is to earn profits.
(ii) Profit can be a suitable criterion for measuring success of business operations.
(iii) Profit maximization ensures efficient utilization of scarce financial resources as these
resources are allocated to uses which generate maximum profits.
(iv) Profit maximization may lead to maximization of economic welfare of society. Since
each individual component of society would seek maximum profitability, the
economic welfare of society as a whole would be maximized.

3.3. Limitations

However,profit maximization as objective of financial management is severely criticised

on following basis:
(i) It is a vague and ambiguous objective. The term profit is not specifically defined.
It
can mean Profit after tax or profit before tax, total profit or incremental profits.
(ii) It does not consider the time value of money: Timing of receipt of benefits (cash
inflows) is not considered. It does not make any difference between cash inflows
occurring at different points of time.
(iii) It ignores risk: Quality of benefits is also ignored. Profit maximization does not
consider risk of not receiving or receiving less than expected cash inflows.
(iv) The objective of a business enterprise is not just to maximize profit but also to
create
value for its owners.
(v) Based on Accounting Profit: Accounting profits can be easily affected by
management through altering of accounting policies underlying the calculation of
accounting profits.

Due to above drawbacks, profit maximization is regarded as an unrealistic and

inappropriate objective of financial management.

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4. Shareholder’s Wealth Maximization (SWM) as Objective of Financial

Management

4.1. Meaning

In the modern phase, the objective of financial management is considered to be

Shareholder’s Wealth Maximization. Since it is based on the concept of cash flows
and considers timing of benefits, it overcomes the limitations of Profit Maximization
objective and provides a realistic objective.
Shareholders’ wealth includes market value of company’s shares, reserves and surplus,
accumulated profits. However, the main component is market value of shares.
Market Value of Shares or Market Capitalization = Market price per Share x No. of
Shares. Therefore, the finance manager should take all financial decisions in such a way
that market value of firm’s shares is maximized. Now since the no. of shares remain fixed
over a given period of time. The focus of finance manager should be on maximization of
market price per share so that shareholder’s wealth is maximized. Finance manager may
achieve higher share price quickly by selecting high risk-high return projects. But this
may backfire which could result in a significant fall in share prices. If shareholders are
not satisfied with the functioning of management or progress of the organization, they
can communicate their displeasure by selling company’s share which would end in a fall
in share prices.
Other popular names for Wealth maximization are net present worth maximization or
value maximization. This objective maximizes the net present value of a course of action
to shareholders. This is based on the presumption that finance managers will seek to
maximize the worth of shareholder’s total investments. In this regard, finance managers
would want to maximize the value of all investment projects which the firm selects and
undertakes. For this, the net present value of a project is obtained based on its projected
cash inflows and outflows and the cost of capital to the firm (discount rate). Net Present
Value (NPV) can be obtained by subtracting present value of all cash outflows of the
project from present value of all cash inflows received during the lifetime of the project.

é C C2 C3 Cn ù
NPV = ê 1 + + +L+ - C0
ë (1 + k ) (1 + k ) (1 + k )
2 3
(1 + k ) n úû
n
Ct
NPV = å - C0
t =1 (1 + k )
t

Where:
n = life of the project in years.
C1, C2, C3, ….. Cn are cash inflows of years 1,2,3, … n.

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C0 is the initial cash outflow of the project.

k is the discount rate. It is the opportunity rate of return of investors or cost of capital of
the firm.

Decision Rule:

When the projects are not mutually exclusive:

All projects with positive NPV i.e., NPV > 0 would be accepted because a positive NPV
means that the project would increase shareholder’s wealth. For example, if NPV of a
project is + Rs.50,000 it implies that undertaking the project would increase shareholder’s
wealth by Rs.50,000.

When the projects are mutually exclusive:

When the projects are mutually exclusive then the project with highest NPV should be
selected.Further, in case there are several projects with positive NPV and there is a
constraint of fundsthe projects may be ranked from highest NPV to lowest NPV and
selected in that order so as to maximise shareholder’s wealth.

4.2. Arguments in Favour

(i) Wealth maximization aims to maximise the value of investments or wealth of the
shareholders. Hence is considered superior to profit maximization.
(ii) It is based on the concept of Cash Flows, which is precise and unambiguous
unlike
profit. Here cash inflow is treated as benefit and cash outflow as cost associated
with
a particular decision.
(iii) Wealth maximization considers the timing of occurrence of benefits (cash
inflows)
and costs (cash outflows). It thus takes into account the time value of money.
(iv) Wealth maximization also considers the risk associated with occurrence of cash
flows.
(v) Wealth maximization ensures that funds of a company are allocated to those uses
which generate maximum value or worth to the shareholders.
(vi) Shareholder’s wealth maximization also upholds the economic welfare of the
society
as a whole by ensuring efficient allocation of society’s scarce capital
resources.
4.3. Criticism

(i) It is difficult to incorporate shareholder’s wealth maximization as objective of

financial management in day to day functioning of a modern business enterprise.
(ii) Wealth maximization creates owners-management conflict and gives rise to

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agency problem.
(iii) Wealth maximization is criticised on the grounds that it seeks to maximise only
shareholder’s wealth and is not concerned about welfare of other important
stakeholders of the business such as management, creditors, employees, suppliers,
distributors, customers.

(iv) The criteria of wealth maximization is maximization of market price of a firm’s

shares. But in real life, share prices are affected by a large no. of reasons on which
business has no control.
(v) Some argue that Wealth maximization is not much different than profit maximization.
It is profit maximization in another form.

4.4.Profit Maximization vs. Shareholder’s Wealth Maximization

S.No. Basis Profit Maximization Shareholder’s Wealth Maximization

1. Meaning Goal of financial management Goal of financial management is to
is to maximise profits of the maximise wealth of the
business organization. shareholders or owners of the
business organization.
2. Vagueness Objective is not clear and hence Objective is clear and precise
is vague and ambiguous. having no scope for vagueness and
ambiguity.
3. Criteria Maximization of Accounting Maximization of Market Price per
Profits. Share.
4. Time Value Ignores Time Value of Money. Considers Time Value of Money.
of Money
5. Risk Does not consider risk Takes into account, the riskiness of
associated with cash flows. cash flows.
6. Basis of Accounting Profits Cash Flows
Computation
7. Acceptability It is not widely accepted as It is widely accepted as objective of
objective of financial financial management.
management.
8. Imperfect Makes assumption of perfect Makes no such assumption and so
Markets competition and hence is not can be universally applied to all
applicable in imperfect markets. market forms.
9. Manipulation Can be easily manipulated by Cannot be easily manipulated.
changing accounting policies.

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5. OtherObjectives of Financial Management

5.1.Stakeholder’s Welfare Maximization

Stakeholder in a company is anyone who has an interest in the company, can influence
the fortunes of the company or is itself influenced by the happenings related to the
company. Shareholders, management, creditors, employees and employee unions,
suppliers, distributors, consumers and consumer groups, government and its agencies,
local people living in close proximity to the business, environment groups and society at
large are the main stakeholders of a company. Each of these groups are important for the
functioning of the business. Thus, a finance manager cannot seek to maximise the
interests of any one group and ignore the needs of others. Because the financial resources
at the disposal of finance manager are limited he/she cannot maximise the benefits to
every stakeholders. Also even if he/she had enough financial resources then also it would
not have been possible because often the interests of various stakeholders are in conflict
with each other.
For example: (1) While shareholders would want more percentage of after tax profits to
be distributed as dividends, the managers would want to retain more percentage of after
tax profits in the business to meet future growth needs.
(2) Creditors would want firm to undertake lower risk projects so that their claims can be
met but shareholders would want firm to undertake more risky projects so that they can
earn more returns.
(3) Suppliers, distributors and employees would want higher payments, margins and
salary respectively which would increase cost and hence price of the product but
customers would want lower prices.

Thus, a finance manager has to indulge in a satisficing behaviour whereby the

minimum requirements of all stakeholders are fulfilled. The extent to which a
stakeholder’s expectations are met will depend upon the degree of influence which
that stakeholder possesses on the business in relation to other stakeholders. The
shareholders wealth Maximization as the primary goal notwithstanding, there is a
broader focus in financial management to include the interest of other stakeholders
along with that of the shareholders. The goal should be to preserve the well-being of
all stakeholders and not to maximise welfare of few of them.

However, it should not be inferred that stakeholder’s welfare maximization is in conflict

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with the shareholder’s wealth maximization objective.

Protection of interest of various stakeholders and
enhancement of their welfare is a corporation’s responsibility. It in fact maximizesvalue
to the shareholders in the long run by enabling a favorablerelationship with various
stakeholders and in turn minimizing stakeholder turnovers, clashesand lawsuits.

5.2. Maximization of Economic Value Added (EVA)

The EVA can be obtained by deducting cost of funds used to finance an investment
project from after-tax operating profits generated by the project.
EVA = Net Operating Profit after Tax – {Firm’s Weighted Average Cost of Capital (%) *
Total Capital Invested}.
If after tax operating profits are greater than cost of funds used for financing then EVA
would be positive. If cost of funds are greater than after tax profits then EVA would be
negative. A positive EVA would mean addition to shareholder’s wealth by the amount of
positive EVA and a negative EVA would cause shareholder’s wealth to decline by the
amount of negative EVA. Hence, only those investment projects whichhave positive
EVA should be undertaken.
EVA is praised as objective of financial management because it is relatively simplerthan
other approaches and easy to understand; is theoretically sound;and exhibits correlation
with share prices, i.e., positive EVA can cause share prices to increase and vice versa.
However, NPV is preferred over EVA as EVA does not account for size differences
across projects, relies on financial accounting methods of revenue realization and expense
recognition for computation and does not consider future cash flows by not computing
their present value.

5.3. Maximization of Earning Per Share (EPS)

EPS is obtained by deducting Preference share dividend from Net Income after tax and
dividing by average outstanding equity shares. It gives earning per equity share.
Earning Per Share (EPS) = Net Income after Tax – Dividend On Preference Shares
Average Outstanding Equity Shares
In this approach,finance manager takes all actions with an aim to maximize earnings per
share. Impact of all decision alternatives on EPS is seen. Only those investment projects
are selected which increase EPS. All alternative courses of action which decrease EPS are
not undertaken.This objective of financial management implies that all financial
management decisions, viz.,capital budgeting, capital structure, dividend and working
capital management policy decisions of a firm are concerned withmaximization of EPS.
Maximizing EPS does not imply maximization of shareholder’s wealth. The two concepts
are different. Maximization of EPS ignores time value of money and risk associated with
expected benefits. Also, market price of a company’s share is not directly related to EPS.
EPS can be one of the several factors influencing the market price of a company’s share.

5.4.Maximization of Sales

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In pursuance of this objective, the finance manager aims

to maximise sales volume through cutting of prices, adding additional features and
improving quality of the products, undertaking aggressive advertising and sales
promotion campaigns, widening
distribution networks and adding more intermediaries to penetrate deep in the market.
However, this is not generally regarded as the objective of financial management because
higher sales volume does not necessarily mean equal proportionate increase in profits of
the enterprise or wealth of the shareholders or welfare of the stakeholders.

5.5. Maximization of Market Share

In this objective, focus is on establishing the firm as market leader by acquiring

maximum percentage share of the overall market. Firm seeks to be the No.1 among
companies operating in the market and wishes to create a brand, goodwill or image of the
company to which everyone relates. It involves undertaking aggressive strategies to reach
that position. But again like sales maximization, maximization of market share is also not
considered as the objective of financial management because there does notexist a perfect
correlation between higher market share and increased wealth of the shareholders or
profitability of the business.

6. Summary

Ø For financial management, objective is an operationally useful criterion which

would serve as a yardstick for decisions of financial management viz., capital
budgeting, capital structure, dividend policy and working capital management.
Ø Profit maximization as objective of financial management means that all financial
decisions in a firm are guided by the criteria of amount of profits that the financial
decision generates or saves.
Ø Profit maximization is criticized because it is vague and ambiguous, does not
consider the time value of money, ignores risk and is based on accounting profit.
Ø In the modern phase, the objective of financial management is considered to be
Shareholder’s wealth maximization. The focus of finance manager is on
maximization of market price per share so that shareholder’s wealth is
maximized.
Ø Shareholder’s Wealth maximization is considered superior to profit maximization
because it aims to maximise the value of investments or wealth of the
shareholders, is based on cash flows, considers the timing of occurrence of cash
flows and risk associated with occurrence of cash flows.
Ø Stakeholder’s Welfare Maximization, Maximization of Economic Value Added
(EVA), Maximization of Earnings Per Share (EPS), Maximization of Sales and

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Maximization of Market Share are other possible

objectives of financial management.

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