Fundamentals of Financial Management Introduction

Fundamentals of Financial Management

1. Financial Management UNIT 1 PART 1 BY DR. MAUMITA CHOUDHURY Back to Agenda Page

2. It is the duty of the top management to lay down the objectives or goals which are to be achieved by the business. In order to make wise-financial decisions a clear undertaking of the objectives of the business is necessary. Objectives provide a framework within which various decisions relating to investment, financing and dividend are to be taken. In other words, objectives lay down a criterion by which the efficiency and profitability of a particular decision is evaluated. The choice of such a criterion lies between profit maximization and wealth maximization. Hence, there are two approaches in this regard:  

3. Profit Maximization Profit Maximization: According to this approach, all activities which increase profits should be undertaken and which decrease profits should be avoided. Profit maximization implies that the financial decision making should be guided by only one test, which is, select those assets, projects and decisions which are profitable and reject those which are not.

4. The following arguments are advanced in Favour of this approach: Measurement of Performance Efficient Allocation and Utilization of Resources Source of Incentive Helpful in Facing Adverse Business Conditions Helpful in the Growth of the Firm

5. The profit maximization approach has been criticized on several grounds Ambiguous (unclear) Ignores the Time Value of Money Ignores Risk Factor Ignores Future Profits Ignores Social Obligations of Business Neglects the Effect of Dividend Policy on Market Price of the Shares.

6. Wealth Maximization This approach is now universally accepted as an appropriate criterion for making financial decision as it removes all the limitations of profit maximization approach. It is also known as Net Present Value (NPV) maximization approach. According to this approach the worth of an asset is measured in terms of benefits received from its use less the cost of its acquisition, Benefits are measured in terms of cash flow received from its use rather than accounting profit which was the basis of measurement of benefits in profit maximization approach. Measuring benefits in terms of cash flow avoids the ambiguity in respect of the meaning of the term profit. Another important feature of this approach is that it also incorporates the time value of money. While measuring the value of future cash flows an allowance is made for time and risk factors by discounting or reducing the cash flows by a certain percentage. This percentage is known as discount rate.