Unit I

Introduction to Financial Management

Meaning of Business Finance
According to the Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversion of capital funds in meeting financial needs and overall objectives
of a business enterprise”.
According to the Guthumann and Dougall, “Business finance can broadly be defined as the
activity concerned with planning, raising, controlling, administering of the funds used in the
business”.
In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in nonfinancial
fields of industry”.
Corporate finance is concerned with budgeting, financial forecasting, cash management, credit
administration, investment analysis and fund procurement of the business needs to adopt
modern technology and application suitable to the dynamic global environment.
Meaning and Definitions of Financial Management
Financial management is that managerial activity which is concerned with planning and
controlling of the firm’s financial resources. In other words, it is concerned with acquiring,
financing and managing assets to accomplish the overall goal of a business enterprise (mainly
to maximise the shareholder’s wealth).

In today’s world where positive cash flow is more important than book profit, Financial
Management can also be defined as planning for the future of a business enterprise to ensure a
positive cash flow. Some experts also refer to financial management as the science of money
management. It can be defined as
“Financial Management comprises of forecasting, planning, organizing, directing,
coordinating and controlling of all activities relating to acquisition and application of the
financial resources of an undertaking in keeping with its financial objective.”

“It is concerned with the efficient use of an important economic resource namely, capital
funds”. – Solomon Ezra & J. John Pringle.
Financial management “as an application of general managerial principles to the area of
financial decision-making. – Howard and Upton
Financial management “is an area of financial decision-making, harmonizing individual
motives and enterprise goals”. – Weston and Brigham
Financial management “is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations. – Joseph and Massie
Another very elaborate definition given by Phillippatus is
“Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short term and long term credits for the firm.”
As such it deals with the situations that require selection of specific assets (or combination of
assets), the selection of specific problem of size and growth of an enterprise. The analysis of
these decisions is based on the expected inflows and outflows of funds and their effect on
managerial objectives.

There are two basic aspects of financial management viz., procurement of funds and an
effective use of these funds to achieve business objectives.

Procurement of
Funds/ Sources of
Aspects of Funds
Financial
Management Utilization of
Funds/ Application
of Funds

Procurement of Funds
Since funds can be obtained from different sources therefore their procurement is always
considered as a complex problem by business concerns. Some of the sources for funds for a
business enterprise are: -
 Debent
ures
and
Bonds
Hire
Owners Purchas
Equity es &
Leasing

Commercial
Banks (Short ,
Angel
Medium and Investor
Long term
Loans) s

Venture
Capital

In a global competitive scenario, it is not enough to depend on the available ways of raising
finance but resource mobilization has to be undertaken through innovative ways or financial
products which may meet the needs of investors. We are constantly seeing new and creative
sources of funds which are helping the modern businesses to grow faster. For example trading
in Carbon Credits is turning out to be another source of funding.

Funds procured from different sources have different characteristics in terms of risk, cost and
control. The cost of funds should be at the minimum level for that a proper balancing of risk
and control factors must be carried out.

Another key consideration in choosing the source of new business finance is to strike a balance
between equity and debt to ensure the funding structure suits the business. Let us discuss some
of the sources of funds:

(a) Equity: The funds raised by the issue of equity shares are the best from the risk point of
view for the firm, since there is no question of repayment of equity capital except when the
firm is under liquidation. From the cost point of view, however, equity capital is usually the
most expensive source of funds. This is because the dividend expectations of shareholders are
normally higher than prevalent interest rate and also because dividends are an appropriation of
profit, not allowed as an expense under the Income Tax Act. Also the issue of new shares to
public may dilute the control of the existing shareholders.
(b) Debentures: Debentures as a source of funds are comparatively cheaper than the shares
because of their tax advantage. The interest the company pays on a debenture is free of tax,
unlike a dividend payment which is made from the taxed profits. However, even when times
are hard, interest on debenture loans must be paid whereas dividends need not be. However,
debentures entail a high degree of risk since they have to be repaid as per the terms of
agreement. Also, the interest payment has to be made whether or not the company makes
profits.

(c) Funding from Banks: Commercial Banks play an important role in funding of the business
enterprises. Apart from supporting businesses in their routine activities (deposits, payments
etc) they play an important role in meeting the long term and short term needs of a business
enterprise. Different lending services provided by Commercial Banks are depicted as follows:
-

Lending
Services

Non Fund
Fund Based
Based

Bills
Working Letter of
Cash Credit Overdraft Term Loans Purchase/Di Guarantee
Capital Credit
scounting

(d) International Funding: Funding today is not limited to domestic market. With
liberalization and globalization, a business enterprise has options to raise capital from
international markets also. Foreign Direct Investment (FDI) and Foreign Institutional Investors
(FII) are two major routes for raising funds from foreign sources besides ADR’s (American
depository receipts) and GDR’s (Global depository receipts). Obviously, the mechanism of
procurement of funds has to be modified in the light of the requirements of foreign investors.

Effective Utilisation of Funds

The finance manager is also responsible for effective utilisation of funds. He has to point out
situations where the funds are being kept idle or where proper use of funds is not being made.
All the funds are procured at a certain cost and after entailing a certain amount of risk. If these
funds are not utilised in the manner so that they generate an income higher than the cost of
procuring them, there is no point in running the business. Hence, it is crucial to employ the
funds properly and profitably. Some of the aspects of funds utilization are: -

(a) Utilization for Fixed Assets: The funds are to be invested in the manner so that the
company can produce at its optimum level without endangering its financial solvency. For this,
the finance manager would be required to possess sound knowledge of techniques of capital
budgeting. Capital budgeting (or investment appraisal) is the planning process used to
determine whether a firm’s long term investments such as new machinery, replacement
machinery, new plants, new products, and research development projects would provide the
desired return (profit).

(b) Utilization for Working Capital: The finance manager must also keep in view the need
for adequate working capital and ensure that while the firms enjoy an optimum level of working
capital, they do not keep too much funds blocked in inventories, book debts, cash etc.

Finance Functions/ Finance Decisions

Value of a firm will depend on various finance functions/decisions. It can be expressed as :

V = f (I,F,D)

The finance functions are divided into long term and short-term functions/decisions

Long Term Finance Function Decisions:

(a) Investment decisions (I): These decisions relate to the selection of assets in which funds
will be invested by a firm. Funds procured from different sources have to be invested in various
kinds of assets. Long term funds are used in a project for various fixed assets and also for
current assets. The investment of funds in a project has to be made after careful assessment of
the various projects through capital budgeting. A part of long-term funds is also to be kept for
financing the working capital requirements. Asset management policies are to be laid down
regarding various items of current assets. The inventory policy would be determined by the
production manager and the finance manager keeping in view the requirement of production
and the future price estimates of raw materials and the availability of funds.

(b) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet
financial objectives and seeing that fixed and working capital are effectively managed. The
financial manager needs to possess a good knowledge of the sources of available funds and
their respective costs and needs to ensure that the company has a sound capital structure, i.e.,
a proper balance between equity capital and debt. Such managers also need to have a very clear
understanding as to the difference between profit and cash flow, bearing in mind that profit is
of little avail unless the organisation is adequately supported by cash to pay for assets and
sustain the working capital cycle. Financing decisions also call for a good knowledge of
evaluation of risk, e.g., excessive debt carried high risk for an organization’s equity because of
the priority rights of the lenders. A major area for risk-related decisions is in overseas trading,
where an organisation is vulnerable to currency fluctuations, and the manager must be well
aware of the various protective procedures such as hedging (it is a strategy designed to
minimize, reduce or cancel out the risk in another investment) available to him. For example,
someone who has a shop, takes care of the risk of the goods being destroyed by fire by hedging
it via a fire insurance contract.

(c) Dividend decisions(D): These decisions relate to the determination as to how much and
how frequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders. The owner of any profit-making organization looks for reward for his
investment in two ways, the growth of the capital invested and the cash paid out as income; for
a sole trader this income would be termed as drawings and for a limited liability company the
term is dividends.

The dividend decision thus has two elements – the amount to be paid out and the amount to be
retained to support the growth of the organisation, the latter being also a financing decision;
the level and regular growth of dividends represent a significant factor in determining a profit-
making company’s market value, i.e., the value placed on its shares by the stock market.

All three types of decisions are interrelated, the first two pertaining to any kind of organisation
while the third relates only to profit-making organisations, thus it can be seen that financial
management is of vital importance at every level of business activity, from a sole trader to the
largest multinational corporation.

Short- term Finance Decisions/Function.

Working capital Management (WCM): Generally short-term decision is reduced to

management of current asset and current liability (i.e., working capital Management)
Nature, Significance and Scope of Financial Management

In modern times, we cannot imagine a world without the use of money. In fact, money is the
life-blood of business in the present-day world because all our economic activities are carried
out through the use of money. For carrying on business, we need resources which are pooled
in terms of money. It is used for obtaining physical and material resources for carrying out
productive activities and business operations which affect sales and pay compensation to
suppliers of resources, physical as well as monetary. Hence financial management is
considered as an organic function of a business and has rightly become an important one.

A group of experts defines Financial Management as simply the task of providing funds needed
by the business or enterprise on terms that are most favourable in the light of its objectives.
The approach, thus, is concerned almost exclusively with the procurement of funds and could
be widened to include instruments, institutions and practices through which to raise funds. It
also covers the legal and accounting relationship between a company and its sources of funds.
Financial Management is certainly broader than procurement of funds and there are other
functions and decisions too.

Other set of experts assume that finance is concerned with cash. Since every business
transaction involves cash directly or indirectly, finance may be assumed to be concerned with
everything that takes place in the conduct of a business. Obviously, it is too broad.

The third set of people whose point of view has been widely accepted considers Financial
Management as procurement of funds and their effective utilisations in the business; though
there are other organisations like schools, associations, government agencies etc., where funds
are procured and used. So, Financial Management has not only to see that funds can be raised
for installing plant and machinery at a cost; but it has also to see that additional profits
adequately compensate for the costs and risks borne by the business while setting up the
project.

Thus, from the point of view of a corporate unit, financial management is related not only to
‘fund-raising’ but encompasses wider perspective of managing the finances for the company
efficiently. In the developed state of a capital market, raising funds is not a problem; the real
problem is to put the capital resources to efficient use through effective financial planning,
financial organisation and financial control and to deal with tasks like ensuring the availability
of funds, allocating them for different uses, managing them, investing funds, controlling costs,
forecasting financial requirements, doing profit planning and estimating rate of return on
investment and assessment of working capital etc.

Financial Management, to be more precise, is, thus concerned with investment, financing and
dividend decisions in relation to objectives of the company. Such decisions have to take care
of the interests of the shareholders. They are upheld by maximisation of shareholders’ wealth
which depends upon increase in the net worth of capital invested in the business plus ploughed
back profits for growth and prosperity of the company. It is for such reasons that the market is
prepared to pay a lower or higher price for the shares of some company or the other. Nature of
Financial Management therefore can be judged by the study of the nature of investment,
financing and dividend decisions.

Financial
Decisions

Investment Financing Dividend

Decisions Decisions Decisions

Working
Capital Cost of Capital
Capital
Budgeting Capital Structure
Management

Types of Financial Decisions

Investment Decisions

Investment ordinarily means utilisation of money for profits or returns. This could be done by
creating physical assets with the money and carrying on business or purchasing shares or
debentures of a company or sometimes, though erroneously, purchasing a consumer durable
like building. In an economy, money flows from one type of business to another depending
upon profits expected or in a capital market securities of a concern are purchased or sold in the
expectation of higher or lower profits or gains. However, within a firm, a finance manager
decides that in which activity resources of the firm are to be channelised, and more important
who should be entrusted with the financing decisions. A marketing manager may like to have
a new show room, a production manager a new lathe and a personnel manager higher wages
for labour, which may lead to regular and efficient production. Over and above, the top
management may like to enter an entirely new area of production like a textile company
entering electronics. All these are the ventures which are likely to increase profits. But
resources are limited. Hence, the problem of accepting one proposal and leaving other persists.

Capital budgeting is a major aspect of investment decision making process. Investment

decisions and capital budgeting are considered as synonymous in the business world.
Investment decisions are concerned with the question whether adding to capital assets today
will increase the revenue of tomorrow to cover costs. Thus investment decisions are
commitments of monetary resources at different times in expectation of economic returns in
future. Choice is required to be made amongst available resources and avenues for investment.
As such investment decisions are concerned with the choice of acquiring real assets, over the
time period, in a productive process. In making such a choice consideration of certain aspects
is essential viz., need for investment, factors affecting decisions, criteria for evaluating
investment decisions and selection of a particular alternative from amongst the various options
available.

Investment decisions have, thus, become the most important area in the decision making
process of a company. Such decisions are essentially made after evaluating the different
proposals with reference to growth and profitability projections of the company. The choice
helps achieve the long term objectives of the company i.e., survival and growth, preserving
market share of its products and retaining leadership in its production activity. The company
likes to avail of the economic opportunity for which investment decisions are taken viz.,

(1) expansion of the productive process to meet the existing excessive demand in local market,
exploit the global market, and to avail of the advantages and economies of the expanded scale
of production.

(2) replacement of an existing asset, plant and machinery or building, necessary for taking
advantages of technological innovations, minimising cost of production by replacing obsolete
and worn out plants, increasing efficiency of labour, etc.

(3) The choice of equipment establishes the need for investment decisions based on the
question of quality and latest technology.
(4) Re-allocation of capital is another area of investment, to ensure asset allocation in tune with
the production policy.

(5) Mergers, acquisitions, re-organisations and rehabilitation are all concerned with economic
and financial involvement and are governed by investment decisions.

Thus, investment decisions encompass wide and complex matters involving the following
areas:

– capital budgeting

– cost of capital

– measuring risk

– management of liquidity and current assets

– expansion and contraction involving business failure and re-organisations

– buy or hire or lease an asset.

Factors affecting investment decisions are essentially the ingredients of investment decisions.
Capital is a scarce resource and its supply cost is very high. Optimal investment decisions need
to be made taking into consideration such factors as are given below viz.

(1) Estimation of capital outlays and the future earnings of the proposed project focusing on
the task of value engineering and market forecasting;

(2) availability of capital and considerations of cost of capital focusing attention on financial
analysis; and

(3) a set of standards by which to select a project for implementation and maximising returns
therefrom focusing attention on logic and arithmetic.

Financing Decisions

Financing decision is the next step in financial management for executing the investment
decision once taken. A look at the balance-sheet of a sample company indicates that it obtains
finances from shareholders, ordinary or preference, debenture holders on long-term basis,
financial institutions as long-term loans, banks and others as short-term loans and the like.
There are variations in the provisions governing the issue of preference shares, debentures, loan
papers, etc. Financing decisions are concerned with the determination of how much funds to
procure from amongst the various avenues available i.e. the financing mix or capital structure.
Efforts are made to obtain an optimal financing mix for a particular company. This necessitates
study of the capital structure as also the short and intermediate term financing plans of the
company.

In more advanced companies, financing decision today, has become fully integrated with top-
management policy formulation via capital budgeting, long-range planning, evaluation of
alternate uses of funds, and establishment of measurable standards of performance in financial
terms.

Financial decision making is concerned more and more with the questions as to how cost of
funds be measured, proposals for capital using projects be evaluated, or how far the financing
policy influences cost of capital or should corporate funds be committed to or withheld from
certain purposes and how the expected returns on projects be measured.

Optimal use of funds has become a new concern of financing decisions and top managements
in corporate sector are more concerned with planning the sources and uses of funds and
measuring performance. New measurement techniques, utilising computers, have facilitated
efficient capital allocation through financing decisions. Both Investment decision and financial
decisions are jointly made as an effective way of financial management in corporate units. No
doubt, the purview of these decisions is separate, but they affect each other. Financial decisions,
as discussed earlier, encompass determination of the proportion of equity capital to debt to
achieve an optimal capital structure, and to balance the fixed and working capital requirements
in the financial structure of the company. This important area of financing decision making,
aims at maximising returns on investment and minimising the risk. The risk and return analysis
is a common tool for investment and financing decisions for designing an optimal capital
structure of a corporate unit. It may be mentioned that debt adds to the riskiness of the capital
structure of a firm. This part of financial management is the analysis of company through
earnings before interest and taxes, variable costs, contribution. It is called a study of operating
leverages. Further, the earnings per share to be given to shareholders is analysed through the
technique of financial leverage. When study of both these aspects is made it is known as
combined leverage.

Dividend Decisions

The dividend decision is another major area of financial management. The financial manager
must decide whether the firm should distribute all profits or retain them or distribute a portion
and retain the balance. Theoretically, this decision should depend on whether the company or
its shareholders are in the position to better utilise the funds, and to earn a higher rate of return
on funds. However, in practice, a number of other factors like the market price of shares, the
trend of earning, the tax position of the shareholders, cash flow position, requirement of funds
for future growth, and restrictions under the Companies Act etc. play an important role in the
determination of dividend policy of business enterprise. The finance manager has to take a
decision regarding optimum dividend payout ratio, he also has to take decisions relating to
bonus issue and interim dividend.

Scope of Financial Management

As an integral part of the overall management, financial management is mainly concerned with
acquisition and use of funds by an organization. Based on financial management guru Ezra
Solomon’s concept of financial management, following aspects are taken up in detail under the
study of financial management:
(a) Determination of size of the enterprise and determination of rate of growth.
(b) Determining the composition of assets of the enterprise.
(c) Determining the mix of enterprise’s financing i.e. consideration of level of debt to equity,
etc.
(d) Analysis, planning and control of financial affairs of the enterprise.
The scope of financial management has undergone changes over the years. Until the middle of
this century, its scope was limited to procurement of funds under major events in the life of the
enterprise such as promotion, expansion, merger, etc. In the modern times, the financial
management includes besides procurement of funds, the three different kinds of decisions as
well namely investment, financing and dividend.
Financial Management today covers the entire gamut of activities and functions given below.
The head of finance is considered to be importantly of the CEO in most organizations and
performs a strategic role. His responsibilities include:
1. Estimating the total requirements of funds for a given period.
2. Raising funds through various sources, both national and international, keeping in mind
the cost effectiveness;
3. Investing the funds in both long term as well as short term capital needs;
4. Funding day-to-day working capital requirements of business;
5. Collecting on time from debtors and paying to creditors on time;
6. Managing funds and treasury operations;
 7. Ensuring a satisfactory return to all the stake holders;
8. Paying interest on borrowings;
9. Repaying lenders on due dates;
10. Maximizing the wealth of the shareholders over the long term;
11. Interfacing with the capital markets;
12. Awareness to all the latest developments in the financial markets;
13. Increasing the firm’s competitive financial strength in the market; and
14. Adhering to the requirements of corporate governance.

Organisation of Financial Management Functions

The responsibilities for financial management are spread throughout the organisation in the
sense that financial management is, to an extent, an integral part of the job for the managers
involved in planning, allocation of resources and control. For instance, the production manager
(engineer) shapes the investment policy (proposal of a new plant); the marketing
manager/analyst provides inputs in forecasting and planning; the purchase manager influences
the level of investment in inventories; and the sales manager has a say in the determination of
receivables policy.

Nevertheless, financial management is highly specialised in nature and is handled by

specialists. Financial decisions are of crucial importance. It is, therefore, essential to set up an
efficient organisation for financial management functions.

Since finance is a major/critical functional area, the ultimate responsibility for carrying out
financial management functions lies with the top management, that is, board of
directors/managing director/ chief executive or the committee of the board. However, the exact
nature of the organisation of the financial management function differs from firm to firm
depending upon factors such as size of the firm, nature of its business, type of financing
operations, ability of financial officers and the financial philosophy, and so on. Similarly, the
designation of the chief executive of the finance department also differs widely in case of
different firms. In some cases, they are known as finance managers while in others as vice-
president (finance), director (finance), and financial controller and so on. He reports directly to
the top management. Various sections within the financial management area are headed by
managers such as controller and treasurer.

The figure depicts the organisation of the financial management function in a large typical firm.
 Board of Directors

Managing Director/Chairman

Vice President/Director
(Finance) / Chief Finance
Officer (CFO)

Treasurer Controller

Capital Fund Financial Cost Data

Cash Credit Portfolio Tax Internal
Budegting Raising Accounting Accounting Processing
Manager Manager Manager Manager Auditor
Manager Manager Manager Manager Manager

Responsibilities/Role of Finance Executive/ Managers

The job of the chief financial executive does not cover only routine aspects of finance and
accounting. As a member of top management, he is closely associated with the formulation of
policies as well as decision making. Under him are controllers and treasurers, although they
may be known by different designations in different firms. The tasks of financial management
and allied areas like accounting are distributed between these two key financial officers. Their
functions are described below.

The main concern of the treasurer is with the financing activities of the firm. Included in the
range of his functions are: (i) obtaining finance, (ii) banking relationship, (iii) investor
relationship, (iv) short-term financing, (v) cash management, (vi) credit administration, (vii)
investments, and (viii) insurance. The functions of the controller are related mainly to
accounting and control. The typical functions performed by him include: (i) financial
accounting, (ii) internal audit, (iii) taxation, (iv) management accounting and control, (v)
budgeting, planning and control, and (vi) economic appraisal and so on.
Modern financial management has come a long way from the traditional corporate finance. As
the economy is opening up and global resources are being tapped, the opportunities available
to finance managers virtually have no limits.

A new era has ushered during the recent years for chief financial officers in different
organisation to finance executive is known in different name, however their role and functions
are similar. His role assumes significance in the present day context of liberalization,
deregulation and globalisation.

The finance executive of an organisation plays an important role in the company’s goals,
policies, and financial success. His responsibilities include:

1. Financial analysis and planning: Determining the proper amount of funds to employ
in the firm, i.e., designating the size of the firm and its rate of growth.
2. Investment decisions: The efficient allocation of funds to specific assets.
3. Financing and capital structure decisions: Raising funds on favourable terms as
possible i.e., determining the composition of liabilities.
4. Management of financial resources (such as working capital).
5. Risk management: Protecting assets.
6. Budgeting
7. Forecasting
8. Managing M&As
9. Treasury (cash management)
10. Profitability analysis (for example, by customer or product)
11. Preparing internal financial reports for management.
12. Pricing analysis
13. Preparing quarterly, annual filings for investors.
14. Decisions about outsourcing
15. Tax filing
16. Overseeing the IT function.
17. Tracking accounts payable and accounts receivable.
18. Overseeing the HR function.
19. Travel and entertainment expense management.
20. Strategic planning (sometimes overseeing this function).
21. Regulatory compliance
Goals and Objectives of Financial Management

Financial Management as the name suggests is management of finance. It deals with

planning and mobilization of funds required by the firm. There is only one thing which
matters for everyone right from the owners to the promoters and that is money. Managing
of finance is nothing but managing of money. Every activity of an organization is reflected
in its financial statements. Financial Management deals with activities which have financial
implications.

The very objective of Financial Management is to maximize the wealth of the shareholders
by maximizing the value of the firm. This prime objective of Financial Management is
reflected in the EPS (Earning per Share) and the market price of its shares.

The earlier objective of profit maximization is now replaced by wealth maximization. Since
profit maximization is a limited one it cannot be the sole objective of a firm. The term profit
is a vague phenomenon and if given undue importance problems may arise whereas wealth
maximization on the other hand overcomes the drawbacks of profit maximization. Thus the
objective of Financial Management is to trade off between risk and return. The objective
of Financial Management is to make efficient use of economic resources mainly capital.

The functions of Financial Management involves acquiring funds for meeting short term
and long term requirements of the firm, deployment of funds, control over the use of funds
and to trade-off between risk and return.

Efficient financial management requires the existence of some objectives or goals because
judgment as to whether or not a financial decision is efficient must be made in the light of
some objective. Although various objectives are possible but we assume two objectives of
financial management for elaborate discussion. These are:

Profit Maximisation

It has traditionally been argued that the primary objective of a company is to earn profit;
hence the objective of financial management is also profit maximisation. This implies that
the finance manager has to make his decisions in a manner so that the profits of the concern
are maximised. Each alternative, therefore, is to be seen as to whether or not it gives
maximum profit. However, profit maximisation cannot be the sole objective of a company.
It is at best a limited objective. If profit is given undue importance, a number of problems
can arise. Some of these have been discussed below:
(i) The term profit is vague. It does not clarify what exactly it means. It conveys a
different meaning to different people. For example, profit may be in short term or long term
period; it may be total profit or rate of profit etc.

(ii) Profit maximisation has to be attempted with a realisation of risks involved. There
is a direct relationship between risk and profit. Many risky propositions yield high profit.
Higher the risk, higher is the possibility of profits. If profit maximisation is the only goal,
then risk factor is altogether ignored. This implies that finance manager will accept highly
risky proposals also, if they give high profits. In practice, however, risk is very important
consideration and has to be balanced with the profit objective.

(iii) Profit maximisation as an objective does not take into account the time pattern of
returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if
the returns of proposal A begin to flow say 10 years later, proposal B may be preferred
which may have lower overall profit but the returns flow is more early and quick.

(iv) Profit maximisation as an objective is too narrow. It fails to take into account the
social considerations as also the obligations to various interests of workers, consumers,
society, as well as ethical trade practices. If these factors are ignored, a company cannot
survive for long. Profit maximization at the cost of social and moral obligations is a short
sighted policy.
Wealth / Value Maximisation
Shareholders wealth are the result of cost benefit analysis adjusted with their timing and
risk i.e. time value of money.
So,
Wealth = Present value of benefits – Present Value of Costs
It is important that benefits measured by the finance manager are in terms of cash flow.
Finance manager should emphasis on Cash flow for investment or financing decisions not
on Accounting profit. The shareholder value maximization model holds that the primary
goal of the firm is to maximize its market value and implies that business decisions should
seek to increase the net present value of the economic profits of the firm. So for measuring
and maximising shareholders wealth finance manager should follow:
 Cash Flow approach not Accounting Profit
 Cost benefit analysis
 Application of time value of money.
The management of an organisation tries to maximises the present value not only for
shareholders but for all including employees, customers, suppliers and community at large.
This goal for the maximum present value is generally justified on the following grounds:
(i) It is consistent with the object of maximising owners economic welfare.
(ii) It focuses on the long run picture.
(iii) It considers risk.
(iv) It recognises the value of regular dividend payments.
(v) It takes into account time value of money.
(vi) It maintains market price of its shares.
(vii) It seeks growth in sales and earnings.

However, profit maximisation can be part of a wealth maximisation strategy. Quite often
two objectives can be pursued simultaneously but the maximisation of profit should never
be permitted to overshadow the objectives of wealth maximisation.

The objective of the firm provides a framework for optimal decision making in the area of
business management. The term ‘objective’ should be used in the sense of ‘decision
criteria’ for taking decisions involved in financial management. It means that what is
relevant is not the overall objective of the business but operationally useful criterion against
which the investment, financing and dividend policy decisions are to be judged. The
objective of shareholder wealth maximisation 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 maximise in making investment and
financing decisions on behalf of shareholders. Another point to note in this context is that
objective provide a ‘normative’ framework. In other words, it implies that the focus is on
what a firm should try to achieve and on policies that it should follow if the objectives are
to be achieved.
Other goals a business enterprise may have. Some of the other goals a business
enterprise may follow are:-

• Achieving a higher growth rate

• Attaining a larger market share
• Gaining leadership in the market in terms of products and technology
• Promoting employee welfare
• Increasing customer satisfaction
• Improving community life, supporting education and research, solving societal problems,
etc.
Though, the above goals are important but the primary goal remains to be wealth
maximization, as it is critical for the very existence of the business enterprise. If this goal
is not met, public/institutions would lose confidence in the enterprise and will not invest
further in the growth of the organization. If the growth of the organization is restricted than
the other goals like community welfare will not get fulfilled.
The table below highlights some of the advantages and disadvantages of both profit
maximization and wealth maximization goals:-
Goal Objective Advantages Disadvantages
(i) Emphasizes the
(i) Easy to calculate short term gains
profits (ii) Ignores risk or
Profit Large amount of (ii) Easy to determine uncertainty
Maximization profits the link between (iii) Ignores the timing
financial decisions of returns
and profits. (iv)Requires
immediate resources.
(i) Emphasizes the
long term gains (i) Offers no clear
(ii) Recognises risk relationship between
Shareholders or uncertainty financial decisions
Highest market
Wealth (iii) Recognises the and share price.
value of shares
Maximisation timing of returns (ii) Can lead to
(iv)Considers management anxiety
shareholders’ and frustration.
return.