Financial Management - Objectives

Profit and Wealth Maximisation

1. FINANCIAL MANAGEMENT By: Smt.UMA MINAJIGI REUR HEAD, DEPT. OF COMMERCE & Management Smt. V G Degree College for Women, Kalaburagi

2. Nature of Financial Management The nature of financial management refers to its objectives, scope and functions . Objectives of Financial Management Basic Objectives Other Objectives Maintenance of Liquid Assets Profit Maximisation Wealth Maximisation To protect liquidity and solvency of the firm. To utilise the available financial resources effectively To provide social welfare. To build-up adequate reserves for financing, growth and expansion. To ensure a fair rate of return in investment of equity.

3. Basic Objectives: Maintenance of Liquid Assets: What are Liquid assets ? Liquid assets are those assets that can easily be converted into  cash  in a short amount of time. Liquid assets include things like cash, money market instruments, and marketable securities. The financial management assures that there are adequate liquid assets, i.e , cash in hand to meet all its obligations.

4. Profit Maximisation Profit maximization is the traditional approach and the primary objective of financial management. It implies that every decision relating to business is evaluated in the light of profits. All the decisions with respect to new projects,  acquisition  of assets, raising capital etc are studied for their impact on profits and profitability. If the result of a decision is perceived to have a positive effect on the profits, the decision is taken further for implementation. Basic Objectives:

5. Profit Maximisation All business firms are profit seeking organisations. Main aim is earning profit. Profit is a measure of efficiency of business enterprise. Profit is the parameter of the business operation. Profit reduces risk of the business concern. Profit is the main source of finance. Profitability meets the social needs also.

6. PROFIT MAXIMIZATION THEORY / MODEL The Rationale / Benefits: Profit maximization theory of directing business decisions is encouraged because of following advantages associated with it. ECONOMIC SURVIVAL Profit maximization theory is based on profits and profits are a must for survival of any business. MEASUREMENT STANDARD Profits are the true measurement of the viability of a business model. Without profits, the business losses its primary objective and therefore has a direct risk to its survival. SOCIAL AND ECONOMIC WELFARE The profit maximization objective indirectly caters to social welfare. In a business, profits prove efficient utilization and allocation of resources. Resource allocation and payments for land, labor , capital, and organization takes care of social and economic welfare.

7. LIMITATIONS OF PROFIT MAXIMIZATION : Profit maximization is criticized for some of its limitations which are discussed below: THE HAZINESS OF THE CONCEPT “PROFIT” The term “Profit” is a vague term. It is because different mindset will have a different perception of profit. For e.g. profits can be the  net profit ,  gross profit , before tax profit, profit per share or the rate of profit etc. There is no clearly defined profit maximization rule about the profits. IGNORES TIME VALUE OF MONEY The profit maximization formula simply suggests “higher the profit better is the proposal”. In essence, it is considering the naked profits without considering the timing of them. Another important dictum of finance says “a dollar today is not equal to a dollar a year later”. So, the  time value of money  is completely ignored. Alternatively we can say that it ignores timing pattern of cash flow.   IGNORES THE RISK A decision solely based on profit maximization model would take a decision in favour of profits. In the pursuit of profits, the risk involved is ignored which may prove unaffordable at times simply because higher risks directly question the survival of a business. Between project A and B, project A may be more profitable however if it is substantially riskier, than project B may be preferable. IGNORES QUALITY The most problematic aspect of profit maximization as an objective is that it ignores the intangible benefits such as quality, image, technological advancements etc. The contribution of intangible assets in generating value for a business is not worth ignoring. They indirectly create assets for the organization.

8. Profit maximization ruled  the traditional business mindset which has gone through drastic changes. In the modern approach of business and financial management, much higher importance is assigned to  wealth maximization   in comparison of  Profit Maximization vs. Wealth Maximization .  The losing importance of profit maximization is not baseless and it is not only because it ignores certain important areas such as risk, quality, and the time value of money but also because of the superiority of wealth maximization as an objective of the business or financial management.

9. Wealth Maximisation Wealth maximization: Wealth maximization (shareholders' value maximization) is also a main objective of financial management. Wealth maximization means to earn maximum wealth for the shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He also tries to increase the market value of the shares. The market value of the shares is directly related to the performance of the company. Better the performance, higher is the market value of shares and vice-versa. So, the finance manager must try to maximize shareholder's value.

10. This concept is to improve the value or wealth of the shareholders. It considers both time and risk of the business concern. It provides efficient allocation of resources. It ensures the economic interest of the society. Wealth Maximisation

11. Thus, Wealth maximisation objective of a firm is to maximise its wealth and the value of its shares. Wealth Maximisation

12. Wealth maximization is a modern approach to  financial management . Maximization of profit used to be the main aim of a business and financial management till the concept of wealth maximization came into being. It is a superior goal compared to  profit maximization  as it takes broader arena into consideration. Wealth or Value of a business is defined as the market price of the capital invested by  shareholders . Wealth Maximisation

13. THE CONCEPT OF WEALTH MAXIMIZATION DEFINED AS FOLLOWS: It simply means maximization of shareholder’s wealth. It is a combination of two words viz. wealth and maximization. A wealth of a shareholder maximizes when the net worth of a company maximizes. To be even more meticulous, a shareholder holds share in the company/business and his wealth will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization. Finance managers are the agents of shareholders and their job is to look after the interest of the shareholders. The objective of any shareholder or investor would be a good return on their capital and safety of their capital. Both these objectives are well served by wealth maximization as a decision criterion for business.

14. Factors affecting wealth maximisation: Avoid high level of risk: To maximise the value of the firm, proper balance should be maintained between risk and return. Pay Dividends: Payment of regular dividend on shares increase the market value of shares and also the goodwill of the firm. Maintain growth in sales: Increase in sales, increase the earnings. Hence, the company should have large volume of sales. Maintaining the market value of shares: Firm should take numerous steps to maintain the market value of shares at reasonable level. Maximisation of shareholders wealth is closely related to the maximisation of firms value in the market.

15. Advantages: Avoiding the Ambiguity Quality of benefits Time Value of Money Promotes the economic welfare of shareholders Payment of regular Dividends. Wealth Maximisation Disadvantages: Equity of wealth is not maintained. Firms wealth is not considered Benefits to the society is not considered Government restrictions Reduce the profitability Prescriptive idea

16. Difference between Profit Maximisation and Wealth Maximisation The essential difference between the maximization of profits and the maximization of wealth is that the profits focus is on short-term earnings , while the wealth focus is on increasing the overall value of the business entity over time. These differences are substantial, as noted below: Planning duration . Under profit maximization, the immediate increase of profits is paramount, so management may elect not to pay for discretionary expenses , such as advertising, research, and maintenance. Under wealth maximization, management always pays for these discretionary expenditures . Risk management . Under profit maximization, management minimizes expenditures, so it is less likely to pay for hedges that could reduce the organization's risk profile. A wealth-focused company would work on risk mitigation, so its risk of loss is reduced.

17. Pricing strategy . When management wants to maximize profits, it prices products as high as possible in order to increase margins. A wealth-oriented company could do the reverse, electing to reduce prices in order to build market share over the long term. Capacity planning . A profit-oriented business will spend just enough on its productive capacity to handle the existing sales level and perhaps the short-term sales forecast . A wealth-oriented business will spend more heavily on capacity in order to meet its long-term sales projections. It should be apparent from the preceding discussion that profit maximization is a strictly short-term approach to managing a business, which could be damaging over the long term. Wealth maximization focuses attention on the long term, requiring a larger investment and lower short-term profits, but with a long-term payoff that increases the value of the business. Difference between Profit Maximisation and Wealth Maximisation Continued …..

18. HOW TO CALCULATE WEALTH? Present Value of Cash Inflows = CF 1 + CF 1 +……….+ CF n ——— ——— ——— (1 + K) 1 (1 + K) 2 (1 + K) n Wealth is said to be generated by any financial decision if the present value of future cash flows relevant to that decision is greater than the costs incurred to undertake that activity. Increase in wealth is equal to the present value of all future cash flows less the cost/investment. In essence, it is the  net present value   (NPV) of a financial decision. Increase in Wealth = Present Value of cash inflows – Cost. Where,  

19. ADVANTAGES OF WEALTH MAXIMIZATION MODEL: Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal of a financial decision. Firstly , the wealth maximization is based on  cash flows  and not on profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity associated with  accounting  profits. Profit can easily be manipulative, if there is a change in accounting assumption/policy, there is a change in profit. There is a change in method of  depreciation , there is a change in profit. It is not the case in case of Cashflows. Secondly , profit maximization presents a  shorter term  view as compared to wealth maximization. Short-term profit maximization can be achieved by the managers at the cost of long-term sustainability of the business.

20. Contd …. Thirdly , wealth maximization considers the  time value of money . It is important as we all know that a dollar today and a dollar one-year latter do not have the same value. In wealth maximization, the future cash flows are discounted at an appropriate discounted rate to represent their present value. Suppose there are two projects A and B, project A is more profitable however it is going to generate profit over a long period of time, while project B is less profitable however it is able to generate return in a shorter period. In a situation of an uncertainty, project B may be preferable. So, timing of returns is ignored by profit maximization, it is considered in wealth maximization. Fourthly , the wealth-maximization criterion considers the  risk and uncertainty factor  while considering the discounting rate. The discounting rate reflects both time and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

21. ECONOMIC VALUE ADDED In the light of modern and improved approach to wealth maximization, a new initiative called “ Economic Value Added  (EVA) ” is implemented and presented in the annual reports of the companies. Positive and higher EVA would increase the wealth of the shareholders and thereby create value. Economic Value Added = Net Operating Profits after tax –  Capital Employed  x  Weighted Average Cost of Capital . In summary, the wealth maximization as an objective to financial management and other business decisions enables the shareholders to achieve their objectives and therefore is superior to profit maximization. For financial managers, it is a decision criterion being used for all the decisions. For more clarity, refer  Profit Maximization vs. Wealth Maximization .

22. HOW TO MAXIMIZE SHAREHOLDER’S WEALTH? Capital  investment decisions  of a firm have a direct relation with wealth maximization. All capital investment projects with an  internal rate of return  (IRR) greater than  cost of capital  or having positive NPV or creates value for the firm. These projects earn more than the ‘required rate of return’ of the firm. In other words, these projects maximize the wealth of the shareholders because they are earning more than what they can earn by investing themselves.   By analyzing the projects with the methods of  capital budgeting , we come to know whether wealth will or won’t be created in a particular project. But, what is the real source of wealth creation? What is that characteristic of the project which becomes the root cause of value creation? SOURCE OF WEALTH CREATION Normally, two types of environment are faced by us – one is external and other is internal. If both the conditions support an organization, it tastes the success. A most important external factor which creates value is industry attractiveness and a similar internal factor is the competitive advantage of the firm. Two main sources of wealth creation or value creations are the industry attractiveness and competitive advantage of the firm.

23. Functions of Financial management Managerial Functions (Executive Functions) Incidental Functions (Routine Functions) Fund requirement decision Financial Planning Financing decision Investment decision Dividend decision Cash flow and requirements Appraisal of Financial performance Borrowing Policy decision Advise the top management To make efforts for increasing productivity and capital To supply the funds To negotiate with bankers and other Financial institutes To safe guard cash balance Proper custody and safe keeping of documents Record keeping and reporting To provide information to the top management To keep track of stock exchange quotations.