Financial Management 2

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Module 2: Nature of Financial Management

Profit Maximization, Wealth Maximization - Traditional and Modern


approach
The objective of the firm

It is necessary to be clear about the purpose of the organisation; to be


clear about what objective is set for management to achieve.

A multitude of small decisions is made every day; more importantly, every


now and then major strategic commitments of resources are made.

It is imperative that the management teams are aware of, respect


and contribute to the fundamental objective of the firm in all these
large and small decisions.

So, before we can make decisions in the field of finance we need to


establish what it is we are trying to achieve.

Arnold ,G., Lewis, Deborah , Corporate financial management


The objective of the firm……..

‘In whose interests is the firm run?’

This is a political and philosophical as well as an economic question and the


answer to this debate is of central importance to making choices in
finance.
A company has responsibilities to a number of stakeholders
The objective of the firm……..

Sound financial management is necessary for the survival of the firm and for
its growth. Therefore all of these stakeholders, to some extent, have an interest
in seeing sensible financial decisions being taken.

However, there are occasions when someone has to decide which claimants
are to have their objectives maximised, and which are merely to be satisficed.

The pro-capitalist economists believe that making shareholders’ interests the


paramount objective will benefit both the firm and society at large.
Caveat: This must include obeying the laws and conventions of society, and
behaving ethically and honestly.
The objective of the firm……..

At the opposite end of the political or philosophical spectrum are the advocates
of the primacy of workers’ rights and rewards. The belief here is that labour
should have its rewards maximised.

Standing somewhere in the middle are those keen on a balanced stakeholder


approach. Here the (often conflicting) interests of each of the claimants are
somehow maximised but within the constraints set by the necessity to
compromise in order to provide a fair return to the other stakeholders.
Few of the possible objectives:

• Achieving a target market share

• Keeping employee agitation to a minimum

• Creating an ever-expanding empire

• Maximisation of profit

• Maximization of long-term shareholder wealth


Goal and Objectives of financial Decision making
A goal of the firm may be defined as a target against which the firm’s operating
performance can be measured.

A good objective of financial management should have the following


characteristics :
➢ It should be clear and unambiguous.
➢ It comes with a clear and timely measure that can be used to evaluate
the success or failure of a decision.
➢ It should be consistent with the long-term existence of the firm.
Goal and Objectives of financial Decision making….
Several goals of financial management have been cited e.g., maximization of
sales revenue, net profit, return of investment, size of the firm, percentage
market share, etc.

The following two are often considered as the objectives of the financial
management :
1. Maximization of the profits of the firm, and
2. Maximization of the shareholders’ wealth.
1. Maximization of the Profits of the Firm : For any business firm,
the maximization of the profits is often considered as the implied objective, and
therefore, it is natural to retain the maximization of profit as the goal of the
financial management also.

The profit maximization as objective of financial management will result in


efficient allocation of resources not only from the point of view of the firm but
also for the society as such.

However, the profit maximization as the objective of financial management


fails to deliver the goods in its operational terms. As already stated that
various parties have stake in the firm. Though the stake of the shareholders is
of prime relevance, yet the interest of other parties such as lenders,
creditors, society, etc., cannot be ignored.
There are various problems with the profit maximization as the objective of
financial management. Some of these are as follows :

It ignores the risk. The profit maximization does not take into account the
amount of risk which the firm undertakes in attempting to increase the profits.

The profit maximization concentrates on the profitability only and ignores


the financing aspect of that decision and the risk associated with that
financing.

It ignores the timings of costs and returns and thereby ignores the time
value of money.

The profit maximization as an objective is vague and ambiguous. Does it


refer to maximization of short term profit or long term profit; after tax profit or
profit before tax
The profit maximization may widen the gap between the perception of the
management and that of the shareholders

The profit maximization borrows the concept of profit from the field of
accounting and thus tends to concentrate on the immediate effect of a
financial decision as reflected in the increase in the profit of that year or in
near future.

So, the profit maximization fails to be an operationally feasible


objective of financial management. A goal as already stated should be
precise, well defined and must be capable to take cognizance of all
possible costs and benefits of all the alternatives being evaluated.
Revision Bullet Points:
1. Profit maximization:
Profit Maximization is the main objective of business because:
(i) Profit acts as a measure of efficiency and
(ii) It serves as a protection against risk.

Arguments in favour of Profit Maximization:


(i) When profit earning is the main aim of business the ultimate objective should
be profit maximization.
(ii) Future is uncertain. A firm should earn more and more profit to meet the
future contingencies.
(iii) The main source of finance for growth of a business is profit. Hence, profit
maximization is required.
(iv) Profit maximization is justified on the grounds of rationality as profits act as a
measure of efficiency and economic prosperity.
Revision Bullet Points:

Arguments against Profit Maximization:


(i) It leads to exploitation of workers and consumers.
(ii) It Ignores the risk factors associated with profit.
(iii) Profit in itself is a vague concept and means differently to different people.
(iv) It is narrow concept at the cost of social and moral obligations. Thus,
profit maximization as an objective of Financial Management has been
considered inadequate.
(v) It Ignores the Timing of Returns
Revision bullet points:

MAXIMIZING EPS
• Ignores timing and risk of the expected benefit
• Market value is not a function of EPS. Hence maximizing EPS will not result in
highest price for company's shares
• Maximizing EPS implies that the firm should make no dividend payment so
long as funds can be invested at positive rate of return—such a policy may not
always work

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2. Maximization of Shareholders’ Wealth : In the theory of financial
management, it is well accepted that the objective of financial
management is the maximization of shareholders’ wealth. This objective is
generally expressed in term of maximization of the value of a share of a firm.

The shareholders’ wealth is represented by the present value of all the


future cash flows in the form of dividends or other benefits expected from the
firm. The market price of share reflects this value. Therefore, the
economic value of the shareholders’ wealth is the market price of the
share.
The goal of maximization of shareholder’s 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 shareholder’s wealth implies a long


term perspective of the goal.

In its operational terms, this objective seems to be practical and operative.


The objective of wealth maximization implies that the market price of a
share is linked to three basic financial decisions i.e. the investment
decision, the financing decision and the dividend decision.
However, there are certain problems with the implementation of the goal of
maximization of shareholder’s wealth.

The main problem is the assumption underlying this goal i.e. there is an
efficient capital market wherein the effect of a decision is truly reflected in
the market of share. In practice, the share price in the market is subject to
the influence of so many extraneous factors.

Moreover, this objective seems to be uncontroversial on theoretical


grounds but in practice there are three basic stakeholders in any firm i.e.
the shareholders, the professional managers and the creditors. The
objectives of these three stakeholders in the firm are often very different
resulting in conflict among them.
Revision Bullet Points:
2. Wealth Maximization:

Arguments in favour of Wealth Maximization:


(i) Due to wealth maximization, the short term money lenders get their payments in time.
(ii) The long time lenders too get a fixed rate of interest on their investments.
(iii) The employees share in the wealth gets increased.
(iv) The various resources are put to economical and efficient use.
Argument against Wealth Maximization:
(i) It is socially undesirable.
(ii) It is not a descriptive idea.
(iii) Only stock holders wealth maximization does not lead to firm‘s wealth maximization.
(iv) The objective of wealth maximization is endangered when ownership and management
are separated.
In spite of the arguments against wealth maximization, it is the most appropriative
objective of a firm.
An overview of financial management

Pandey,I.M,Financial Management

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