02. Objectives of the Firm Unit 1 Part 1.pptx

The objective of a firm simply means what the firm is trying to achieve through its business activities.
Different firms may have different objectives depending on their nature, size, ownership, and stage of growth. Let’s break it down in simple words with examples:

1. Profit Maximization

Meaning: Earning the maximum possible profit is the oldest and most traditional objective.

Why: Profit is the reward for risk-taking and ensures survival.

Example: A local shopkeeper sets prices in such a way that he earns as much as possible after covering costs.

2. Wealth Maximization

Meaning: Focus on increasing the value of shareholders’ wealth (share price + dividends).

Why: More modern and broader than just profit because it includes growth, sustainability, and market value.

Example: Infosys or Reliance working to increase their stock value for investors.

1. Objectives of Financial Management Unit 1 Part 1 Financial Management Rashid Usman Ansari Reference Financial Management Khan & Jain 6 th Edition 1

2. The term objective is used in the sense of a goal or decision criterion for the three decisions involved in financial management. Therefore, it implies that what is relevant is not the overall objective of the business but only an operationally useful criterion to judge the three decisions of FM. The term objective is used in a narrow sense. It is only normative in nature. Introduction 2

3. Two approaches have been widely discussed in Financial Literature: Profit/EPS Maximisation Approach Wealth Maximisation Approach Continued 3

4. According to this approach, actions that increase profits (total)/EPS should be undertaken and those that decrease profits/EPS are to be avoided. As applicable to financial management, it implies that the investment, financing and dividend policy decisions of a firm should be oriented towards maximization of profits/EPS. The term profit is used in the sense of ‘profitability’, which signifies economic efficiency. Used in this sense, it implies that firm should select assets , projects and decisions which maximize profit and reject those which do not. Profit Maximisation Approach 4

5. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged. It leads to efficient allocation of resources, as resources tend to be directed to uses which in terms of profitability are the most desirable. It also ensures maximum social welfare as individual search for maximum profitability provides the famous ‘invisible hand’ by which total economic welfare is maximized. Arguments in favour of Profit Maximisation 5

6. Ambiguity Timing of Benefits Quality of Benefits 6 Problems in Applying Profit Maximisation

7. Profit as a term is ambiguous. It is not clear what has to be maximised . For example: Profit after tax, Profit before tax, return on capital employed, return on total assets etc. 7 Ambiguity

8. Profit maximization ignores timings of the benefits received. In other words, profit maximization does not consider time value of money. Following example illustrates the same: 8 Timing of Benefits Time Period Alternative A (Rs. In Lacs) Alternative B (Rs. In Lacs) I 50 Nil II 100 100 III 50 100 Total 200 (220.5) 200 (210)

9. Quality refers to the degree of certainty with which benefits can be expected. Risk is the likelihood that actual outcomes may differ from expected outcomes. Investors are assumed to be risk-averters, that is , they want to avoid risk. The example on the next slide throws light on the issue of quality of benefits being ignored in profit maximization approach. 9 Quality of Benefits

10. State of Economy Alternative A Profit (Rs. In Crs.) Alternative B Profit (Rs. In Crs.) Recession 9 00 Normal 10 10 Boom 11 20 Total 30 30 10 Continued

11. It is also known as Value Maximisation or Net Present Worth Maximisation. It satisfies all the requirements of a good decision criteria like exactness, time value of money and quality of benefits. It is universally accepted as an appropriate operational decision criterion for financial management decisions. 11 Wealth Maximisation Approach

12. 12 How Wealth is Maximised ?

13. 13 Continued

14. Year Cashflow ( Inflow) Positive Investment ( outflow) Negative 1 t=1 3 lacs not equal to 3 lac A1 Discounting Rate, k = cost of capital or capitalisation rate ( 10 Lacs ) t=0 C 2 t=2 3 A2 2 things TVM Risk Present Value will remain same 3 t=3 3 A3 4 t=4 3 5 t=5 3 An Costs and Benefits W=Wealth or Net Present Value 14