Thus, making profit is an essential condition to survive for an organization. Requires finance, which an organization can obtain if it earns sufficient profit. Therefore, an organization needs to maximize its profit to finance its various activities on a regular basis.
Refers to estimating the development of the organization. Profit is an indicator of growth of an organization. Therefore, if an organization wishes to grow then it strives to maximize its profit. Refers to estimating the capability of an organization to use its funds rationally. If an organization is earning high profit then it is said to be efficient. Therefore, profit maximization is an indicator of efficiency of the organization.
In addition, it is the most important element to judge the credibility of an organization. Refers to the fact that organizations may have objectives other than the profit maximization. For example, some organizations may pursue goals of sales maximization or greater stability. Refers to the fact that the objective of profit maximization does not take into consideration the welfare of the society.
If an organization wishes to survive in the long run then it must take into account the effects of its operations on the society. Means that the profit maximization approach does not take into account the past performance and the future aspects of a business.
It is merely concerned with the profit maximization of its organization. Means that the profit maximizing approach does not take into consideration the long-term objectives, such as wealth maximization. This approach focuses only on profit maximization, which is short-term in nature. The wealth maximization approach has been recommended by several economists to overcome the limitations of profit maximization approach. The objective of wealth maximization approach is to increase the wealth of the shareholders.
The wealth maximization approach aims at maximizing the wealth of the shareholders by increasing EPS. Implies that the wealth maximization approach is considered better than profit maximization because wealth maximization approach focuses on the long-term growth and development of an organization. Refers to achieving the goals of different departments, such as production, marketing, and human resource, of an organization.
If the organization has enough wealth then it can easily fulfill the requirements of all its departments. Refers to the increase in the value of shares due to increase in overall wealth of the organization. The wealth maximization approach focuses on the appreciation of EPS by increasing the profitability and productivity of the organization.
Indicates the growth in productivity and fall in the cost of production. The wealth maximization approach ensures that the resources of an organization have been used effectively to accomplish the objectives of the organization. Refers to the fact that the wealth maximization approach takes into consideration the impact of its operations on the society.
The wealth maximization approach also promotes the usage of eco-friendly techniques of production to ensure the social interest of the organization. Although, wealth maximization approach is a very successful approach and widely accepted by the organizations; yet it suffers from some limitations. Refers to the fact that the wealth maximization approach is applied successfully only in large organizations. The small organizations have limited financial resources; therefore, they prefer to maximize their profit first.
Refers to the fact that the dividends are not awarded regularly to the shareholders. The organization retains profit with itself to invest in further profitable projects for increasing its wealth. An organization adopts the wealth maximization approach, if it wants to survive in the long run.
In the wealth maximization approach, the organization needs to understand the risk return trade-off because the estimation of risk would help in predicting the returns for long-term investments. Let us discuss the concept of risk-return trade-off to better understand the implication of the wealth maximization approach. Different investment decisions involve different degrees of risks.
If an investment decision does not carry high risk then the return on that investment would not be higher. For example, the government securities are considered to be one of the safest modes of investments and they carry very moderate returns. Therefore, higher the risk in an investment, higher would be the returns. The relationship between risk and return is explained with the help of risk return trade-off, which is shown in Figure The relationship between risk and return as shown in Figure-5 can be simply expressed as follows:.
A risk premium is provided to investors, if they invest in risky securities. It is an additional amount that is provided over the risk-free rate to the investors. A proper balance between risk return should be maintained to maximize the market value of an organization. The difference between the profit maximization and wealth maximization approach are as follows:.
Does not involve descriptive approach as it is intended to accomplish the short-term objectives. Does not provide clarity on whether the earnings would be distributed or retained in the organization. Does not involve directly in increasing the EPS of the organization. The profitability of the organization indirectly increases EPS.
Involves directly in increasing EPS of the organization. The growth in the value of the shares increases the wealth of the shareholders. The prime goal of an organization is to maximize the market value of its equity shares. The value of these shares acts as a benchmark to measure the performance of the organization.
Value maximization is similar to wealth maximization, which focuses on increasing the value of shares that in turn means increasing the wealth of shareholders. However, value maximization is a broader concept than wealth maximization as value maximization seeks to maximize not only the value of its equity shares but also the value of all its financial assets.
If an organization is able to maximize its value then it can generate sufficient returns to pay dividend to the shareholders and finance all its activities, operations, and projects. The primary objective of financial management should, therefore, be consistent with the overall objectives of the business.
The financial management of an organisation seeks to achieve the following objectives:. Traditionally, the primary objective of a business is to earn profit. The finance manager has to take decisions in a manner that the profits of the concern are maximised. Profit is the parameter to measure the efficiency of a business concern. Profit maximisation is also the narrow approach which aims at maximising the profit of the concern and hence reducing the risk of the business.
However, profit maximisation cannot be the sole objective of a company because of the following difficulties:. The time value of money is not taken into account. The value of returns today cannot be equated with those received five years hence. The more certain the expected return, the higher the quality of benefits. Wealth maximisation is a modern approach in financial management involving improvements in a business concern.
This objective helps in increasing the market value of shares. Wealth maximisation has been accepted as an appropriate criterion for financial management as it overcomes the limitations of profit maximisation. Firstly, it considers the time value of money, by discounting the future cash flows at an appropriate rate. Secondly, wealth maximisation is based on cash flows and not profits. Cash flows are more exact and definite than profits, leaving no scope for any ambiguity. Thirdly, profit maximisation presents a short term view in comparison to wealth maximisation.
Short term profit maximisation compromises with the long term sustainability of business. Lastly, wealth maximisation takes into account the risk and uncertainty factor. Higher the uncertainty, greater is the discounting rate and vice-versa. To conclude, wealth maximisation as an objective of financial management enables the shareholders to achieve their objectives and is, therefore, superior to the profit maximisation objective.
It not only serves the interests of the owners by increasing the value of their shares but ensures security to other lenders as well. The interests of the society are also taken care of when the resources are used economically and efficiently. Wealth maximisation objective views profits from the point of long-run perspective. It takes into account the long term profitability along with other objectives of business. The functions of finance, namely, investment, financing and dividend policy decisions, should help to achieve the stated objectives of the firm.
Since business firms are profit seeking organisations, their objectives are frequently expressed in terms of money. This is the frequently stated goal of the firm. This has the benefit of being a simple and straightforward statement of purpose. According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In other words, the profit maximisation objective implies that the functions of finance of a firm should be oriented to the maximisation of profits.
Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged. In other words, profit maximisation aims at efficient allocation of resources, in order to increase the profitability. One practical difficulty with profit maximisation criterion for financial decision making, is that the term profit is a vague and ambiguous concept.
The term profit has no precise connotation, therefore it is amenable to different interpretations by different people and it conveys different meanings to different people. Profit in the short run may be quite different from profits in the long run. If a firm continues to operate a piece of machinery, vehicle, or building, without proper maintenance, it may be possible to increase short term profits. But the firm will pay the price for these short term savings in future years, when the machine, vehicle, or building, is no longer capable of operating, because of prior neglect.
It is clear that maximisation of profits does not mean, neglecting the long term picture in favour of short term benefits. A technical objection to profit maximisation as a guide to financial decision making is that, it ignores the differences in the time pattern of benefits received, from investment proposals, or courses of action.
As per this objective, while working out profitability the bigger the better principle is adopted, as the decision is based on the total benefits received, over the working life of the asset, irrespective of when they were received. This can be made clear with the help of an example, given in Table 1.
It is clear from Table 1. But the returns from alternative A are higher in the earlier years, as compared to alternative B, where the returns are larger in later years. As benefits received sooner, are more valuable than benefits received later. The reason is that the benefits received in the earlier years can be reinvested to earn a return. This is known as the time value of money. The limitation of profit maximisation objective is that it does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timing, as equally valuable.
This is not true in actual practice, as the benefits received in earlier years should be valued more profitable than equivalent benefits, in later years. Since money received earlier has a higher value than money received later, therefore the profit maximisation objective must consider the timing of cash flows and profits. So the assumption of equal value for benefits irrespective of timing, is inconsistent with the real world situation.
Apart from earning profits, business firms have to fulfill certain social objectives, such as the upliftment of the poor, environment protection, helping the weaker sections of the society, etc. Some business firms are interested in the growth of sales, even if they have to accept less profits to attain this objective.
For example- new firms, are interested in capturing the market, rather than maximising profits. Similarly when new products are introduced, free samples are distributed, or the selling price will be less, in order to promote the product. Some business firms are interested in diversifying their activities into different products, even though it may result in short term decline in profits. For example- Godrej, Bajaj, Tata, Reliance, etc.
Similarly, some firms utilise a portion of profits for social objectives, like running hospitals, schools, charitable services, etc. Infosys Limited, is spending a major portion of its profits for charitable services and Tata, Bajaj, the Manipal group, etc. Now it is an accepted fact that business firms must also try to fulfill social objectives, rather than just maximise the profits. Another technical limitation of profit maximisation is that it ignores the quality aspect of benefits, associated with a financial course of action — that is, profit received in normal, boom, or in a depression state of economy, are different.
The term quality, refers to the degree of certainty with which benefits can be expected. Or the more uncertain or fluctuating the expected benefits, the lower the quality of benefits, the Investors expect steady returns and they want to minimise risk. The profit maximisation objective considers only the size of profits, the degree of uncertainty associated with it, is completely ignored.
Under depression, alternative A can provide Rs. In other words, the earnings associated with alternative B, are more uncertain or risky, as they fluctuate widely depending on the state of the economy. Obviously alternative A is better from the point of risk and uncertainty. The profit maximisation objective fails to reveal this. It is clear from the limitations, that the profit maximisation concept is vague and not clearly defined.
Therefore, an appropriate operational decision criterion for financial management, should:. The other objective of financial management, that is, wealth maximisation removes these technical limitations.
It is explained below. This objective is universally accepted, as an operational decision criterion for financial management, because it satisfies all the three requirements of a suitable operational objective, of financial courses of action, namely, exactness, quality of benefits and the time value of money.
As per this objective, the value of an asset should be viewed in terms of the benefits it can produce. The networth of a course of action can be calculated by total cash inflows, minus the investment. This calculation is the precise estimation of the benefits associated with the course of action. Thus the wealth maximisation criterion is based on the concept of cash flows, generated by the decision, rather than the accounting profit, which is the basis of measurement for profit maximisation.
It is worth pointing out that cash flow is a precise concept with a definite meaning, compared to the accounting profit which is vague, and can be interpreted in different meanings by different people. This is the first operational feature of the wealth maximisation objective. The second important feature of the wealth maximisation objectives is that it considers both the quantity and quality dimensions of benefits.
At the same time, it also incorporates the time value of money. This is done by discounting the cash flows. Assume that project X costs Rs. Here the Net Present Value is Rs. Thus as per the wealth maximisation objective, a financial plan which has a positive Net Present Value creates wealth, therefore it is accepted. At the same time, a financial plan with a negative Net Present Value is rejected. For mutually exclusive projects, the one with the highest Net Present Value should be adopted.
For example- in the above illustration, if there are two projects X and Y with initial investment of Rs. Then, project Y is accepted, because it has a higher NPV. It is an accepted principle that the wealth or net present value of the firm will be maximised, if this criterion is followed in making financial decisions. Thus Net Present Value Maximisation, is superior to the profit maximisation as an operational objective.
It compares values and cost of the financial decision. It is moreover, a precise and unambiguous concept. It is thus a feasible decision criterion for financial management decisions. If wealth is maximised, the owners can adjust their cash flows in such a way, so as to optimise their investment.
Financial management is one of the functional areas of business. Therefore, its objectives must be consistent with the overall objectives of business. The overall objective of financial management is to provide maximum return to the owners on their investment in the long term.
This is known as wealth maximisation. Wealth maximisation means maximising the market value of investment in shares of the company. In order to maximise wealth, financial management must achieve the following specific objectives:. Very often maximisation of profits is considered to be the main objective of financial management.
Profitability if an operational concept that signifies economic efficiency. Some writers on finance believe that it leads to efficient allocation of resources and optimum use of capital. Profit is a test of economic efficiency and contributes to social welfare through optimum use of service resources. It is said that profit maximisation is a simple and straightforward objective. It also ensures the survival and growth of a business firm.
But modern authors on financial management have criticised the goal of profit maximisation. Ezra Solomon has raised the following objections against the profit maximisation objective:. It is amenable to different interpretations, e.
It is based on the assumption of bigger the better and does not take into account the time value of money. The values of benefits received today and those received a year after are not the same. The streams of benefits may have varying degrees of uncertainty. Two projects may offer the same total expected earnings but if the earnings of one fluctuate less widely than those of the other it will be less risky and more preferable.
More uncertain or fluctuating the expected earnings, lower is their quality. The goal of profit and maximisation implies maximising earnings per share which is not necessarily the same as maximising market-price share. It ignores the interests of workers, consumers, government and the public in general. The exclusive attention on profit maximisation may misguide managers to the point where they may endanger the survival of the firm by ignoring research, executive development and other intangible investments.
Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected.
If two or more desirable courses of action are mutually exclusive i. In short, the operating objective for financial management is to maximise wealth or net present worth. Wealth maximisation is more operationally viable and valid criterion because of the following reasons:. The wealth maximisation means maximising the market value of shares.
Adjustments are made for risk uncertainty of expected returns and timing time value of money by discounting the cash flows. It is a long-term strategy emphasising the use of resources to yield economic values higher than joint values of inputs. It rather helps in the achievement of these other objectives. In fact, achievement of wealth maximisation also maximises the achievement of the other objectives.
Therefore, maximisation of wealth is the operating objective by which financial decisions should be guided. The above description reveals that wealth maximisation is more useful objective than profit maximisation. It views profits from the long-term perspective. The true index of the value of a firm is the market price of its shares as it reflects the influence of all such factors as earnings per share, timing of earnings, risk involved, etc.
Quite often the two objectives can be pursued simultaneously but the maximisation of profits should never be permitted to overshadow the broader objective of wealth maximisation. Considering financial management belongs to the functional areas of business, its objectives must be in line with the overall objectives of business. A financial manager works so as to maximize his returns on long-term investments; this is known as wealth maximization.
The process of maximizing wealth implies an increase in the market value of investments in shares of the company. Financial management ought to achieve the following objectives in order to maximize wealth:. A lot of managers assume profit maximization as its main objective of financial management. Profitability is an operational concept that signifies economic efficiency.
Some of the financial managers and writers are of the view that it leads to efficient allocation of resources and optimum utilization of capital invested. It is well evident that profit maximization is quite simple, clear and straightforward. Maximizing profit level gets the survival and growth of business firms along. However, the goal of profit maximization has been criticized by modern authors. Ezra Solomon has raised the following arguments against the objective of profit maximization:.
The value of benefits received today and those received a year later are not the same. Two projects may have the same total expected earnings but if the earning of one fluctuates less widely than those of other it will be less risky and more preferable. The goal of profit maximization implies maximizing earnings per share which is not necessarily the same as maximizing market-price share. The exclusive attention on profit maximization may misguide managers to the point where they may endanger the survival of the firm by ignoring research, executive development and other intangible investments.
While presenting his views against focusing on profit maximization as its objective, Solomon advocated wealth maximization as a goal of financial decision-making. Wealth maximization or net present worth maximization may be defined as — The gross present worth of a course of action, is equal to the capitalized value of the flow of future expected benefits, discounted or as capitalized at a rate which reflects their certainty or uncertainty.
Following arguments have been presented in favour of assuming wealth maximization as an important objective:. All the adjustments related to the same are made in regard to the risks involved uncertainty of expected returns and timing time value of money by discounting the cash flows. It is a long-term strategy emphasizing the use of resources to yield economic values higher than joint values of inputs. Rather, it supports the strategies for achieving these objectives.
In fact, achievement of wealth maximization creates inter-linkages so as to achieve other objectives of the enterprise. Therefore, maximization of wealth is the operating objective by which financial decisions should be guided. The arguments presented above make it clear that wealth maximization is a better objective than that of profit maximization.
The former takes profit into account from the long-term perspective. The true reflector of market standing or reputation of a firm is the market price of its shares. The market price of shares takes into account the influence of all such factors as earnings per share, timing of earnings, risk involved, etc. However, profit maximization can be a part of wealth maximization strategy.
Quite often the two objectives can be pursued simultaneously but the maximization of profits should never be permitted to overshadow the broader objectives of wealth maximization. Finance managers are expected to put funds to best use and maximize returns to owners. To survive and flourish in a competitive environment, every firm must earn profits. How much to earn is a matter of debate and discussion.
Without profits, of course, business would collapse under its own weight. When a firm is able to generate sufficient profits, it is able to please its shareholders. Number of shares held multiplied with market price of share. Raise funds at lowest possible cost; plan for an optimal capital structure for the firm cost. Many writers believe that profitability is the real test of how funds are put to use.
It indicates economic efficiency. You make profits only when funds are put to excellent use. Without making profits, a business cannot grow and expand its operations. The prospect of making money excites people to give their best to business. It will spur people to put in extra effort while running the race. In a way, profit has the benefit of being a simple and straightforward statement of purpose.
It makes sense to talk about profit as a rational economic goal. When a firm makes money, it can give something to society as well and fulfill its social obligations. More importantly, when every firm makes money, it indicates efficient allocation of scarce resources of an economy. A firm which seeks to make profits, thus, is able to maximize social economic welfare as well. The problem, according to modern writers, is not about making money. It is about maximization of profits. The concept of profit maximization has become the focal point of attack for a variety of reasons:.
The Concept of is a Vague One: It is put to loose interpretation in many cases. Are we talking about short run profits or long run profits? In fact, it is ambiguous in its computation. We are not very clear about what profit figure would appease the hungry owners. At what point firms would stop looking at profit as the ultimate goal of business? Are we talking about total profit, operating profit, profit before tax or after tax?
The fact that money received today has a higher value than money received next year is discounted. The amount of risk and uncertainty associated with a course of action is ignored The profit maximization objective considers only the quantity of profits realized by following a course of action without looking at the degree of risk and uncertainty associated with the proposal closely.
If returns from a proposal look uncertain or even fluctuating from time to time it should be put to close scrutiny. In the name of making money a firm should not blindly embark on a journey that would put its future at risk. It does not consider the effect of dividend policy on the market price of the share. To improve the earnings per share, the firm should retain profits rather than distribute them. If the intent is to maximize earning per share, the firm should never pay dividends.
It should reinvest the money and generate additional returns. Profit maximization policies might compel firms to discount the worth of research and development totally. Wealth maximization implies the maximization of the market price of shares. It is also known as value maximization of net present worth maximization. The net present value criterion involves a comparison of value to cost.
Any action that has a discounted value—taking both time and risk into account—that exceeds its cost is said to create value Solomon. Such actions should be pursued. Actions with less value than cost reduce wealth and should, therefore, be rejected. The wealth of owners improves when the market price of shares improves. Wealth maximization, therefore, is a viable alternative due to the following reasons:. Wealth maximization objective is unambiguous.
It reduces the whole rhetoric surrounding financial goals to just one thing. If you want to get ahead, a firm should try everything possible to improve the market value of its shares. The prospects of a company in terms of future cash flows, quality of earnings, quantity of profits, growth prospects—all get evaluated and judged by investing community from time to time.
Wealth maximization strikes a happy balance between value and cost. Only those proposals that bring in value should be favoured—as a rule. If a proposal looks shaky and risky, and returns look uncertain—it should be rejected.
Proposals that impact the net worth of a company negatively, as a result, are pushed to a corner. Wealth maximization serves as a benchmark, a measuring rod to assess the mood and sentiment of the investing public toward a company—whether a company is able to run the show in sync with other corporate goals or not is automatically put to close scrutiny. Wealth maximization serves as a true indicator of the progress achieved by a company.
If the investing community is impressed with the track record of a company it will get a good rating and its share price would improve over time consistently. As rightly pointed by Solomon, value maximization is simply an extension of profit maximization to a world that is uncertain and multi-period in nature. Where the time period is short and the degree of uncertainty is not great, value maximization and profit maximization amount to essentially the same thing.
Profit maximization can be part of a wealth maximization strategy. Of course, care should be taken to see that profit maximization does not overshadow the broader objective of wealth maximization. To ensure higher, quicker and stable returns to the investors of capital by most suitable employment of funds.
The basic objectives of financial management can be broadly classified into two categories, namely:. Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit maximization refers to increasing the profit of a business organization to the maximum extent possible. In other words, it denotes the maximum profit to be earned by an organization in a given time period.
It means different things for different people i. It treats all earnings as equal though they occur in different periods. If the company fails to provide more wages, bonus and better working environment, they become unrest. It may also lead to labour turnover. Wealth maximization refers to the increase in value of capital of the firm in terms of market price. This increase in market price is determined by the volume of capital, the capital structure, the cost of capital and rate of return to the investors.
With reference to a business, risk refers to uncertainty with regard to whether we will earn any returns on the investment and whether we will earn the desired return. Some projects involve less risk whereas some projects involve more risk.
Projects with high risks usually also earn a high return on investment. The firm should avoid projects which involve high profits together with high risks. A firm which earns profits has to distribute part of its profits to its owners of shareholders. A firm should have a large, stable and diversified volume of sales. This strengthens the position of the firm in the market.
This increases the wealth of the firm. All the stakeholders of a firm including the general public keep a close watch on everything that a firm does. Some actions of a firm may have adversely impact on the value of the shares of a firm. A firm must not do anything that is considered as adversely affecting the value of the equity shares of a firm.
A firm has to take reasonable steps to maintain the value of equity shares at reasonable levels. It is a prescriptive idea. So, when different sets of people own and different sets of people manage a company, there is a possibility of conflict of interest between the owners and the managers.
The managers may manage the company in such a way that the managerial utility is maximized but the wealth of the shareholders may not necessarily maximize. In conclusion, it can be said that the firm should follow the objective of wealth maximization to an extent it is viable in the context of its social responsibility and constraints imposed by the government.
Besides, the above basic objectives the following are the other objectives of financial management. The market price of shares depends on the manner in which the funds are invested and the returns are earned. The market price of shares increase only if the returns on investments exceed the costs involved. Increased profits lead to increased market price of shares. Being a profit seeking organisation the management is supposed to set profit maximization as the basic financial objective of the enterprise.
Profitability objective may be stated in terms of profits, return on investment, or profit-to-sales ratios. According to this objective, all such actions as increased income and cut down costs should be undertaken and those that are likely to have adverse impact on profitability of the enterprise should be avoided. Advocates of the profit maximisation objective are of the view that this objective is simple and has the in-built advantage of judging economic performance of the enterprise.
Further, it will direct the resources in those channels that promise maximum return. Since the finance manager is responsible for the efficient utilisation of capital, it is plausible to pursue profitability maximisation as the operational standard to test the effectiveness of financial decisions. However, profit maximisation objective suffers from several drawbacks rendering it an ineffective decisional criterion.
Ambiguity of the term profit, as used in the profit maximisation objective, is its first weakness. It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or profitability rate. Which of these variants of profit should the management pursue to maximise so as to attain the profit maximisation objective remains vague. Furthermore, the word profit does not speak anything about the short-term and long-term profits. Profits in the short-run may not be the same as those in the long-run.
A firm can maximise its short-term profit by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the machine being put to use may no longer be capable of operating after sometime with the result that the firm will have to defray huge investment outlay to replace the machine. Thus, the profit maximisation objective suffers in the long-run for the sake of maximising short-term profit.
Obviously, long-term consideration of profit cannot be neglected in favour of short-term profit. Profit maximisation objective fails to provide any idea regarding timing of expected cash earnings. For instance, if there are two investment projects and suppose one is likely to produce streams of earnings of Rs.
Choice of more worthy projects lies in the study of time value of future inflows of cash earnings. The interest of the firm and its owners is affected by the time value factor. Profit maximisation objective does not take cognizance of this vital factor and treats all benefits, irrespective of the timing, as equally valuable.
Another serious shortcoming of the profit maximisation objective is that it overlooks risk factor. Future earnings of different projects are related with risks of varying degrees. Hence, different projects may have different values even though their earning capacity is the same. A project with fluctuating earnings is considered more riskier than the one with certainty of earnings.
Naturally, an investor would provide less value to the former than to the latter. Risk element of a project is also dependent on the financing mix of the project. Project largely financed by way of debt is generally more riskier than the one predominantly financed by means of share capital. In view of the above, the profit maximisation objective is inappropriate and unsuitable as an operational objective of the firm. Suitable and operationally feasible objectives of the firm should be precise and clear cut and should give weightage to time value and risk factors.
All these factors are well taken care of by the wealth maximisation objective. Wealth maximisation objective is a widely recognised criterion with which the performance of a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth maximisation is also stated as net present worth. Net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits.
Gross present worth represents the present value of expected cash benefits discounted at a rate which reflects their certainty or uncertainty. Thus, wealth maximisation objective as decisional criterion suggests that any financial action which creates wealth or which has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected.
The wealth maximisation objective when used as decisional criterion serves as a very useful guideline in taking investment decisions. This is because the concept of wealth is very clear. It represents the present value of the benefits minus the cost of the investment.
The concept of cash flow is more precise in connotation than that of accounting profit. Thus, measuring benefit in terms of cash flows generated avoids ambiguity. The wealth maximisation objective considers time value of money. It recognises that cash benefits emerging from a project in different years are not identical in value.
This is why annual cash benefits of a project are discounted at a discount rate to calculate the total value of these cash benefits. At the same time, it also gives due weightage to risk factor by making necessary adjustments in the discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at a higher discount rate cost of capital , while lower discount rate is applied to discount expected cash benefits of a less risky project.
In this way, the discount rate used to determine the present value of future streams of cash earnings reflects both the time and risk. In view of the above reasons, wealth maximisation objective is considered superior to profit maximisation objective.
It may be noted here that value maximisation objective is simply the extension of profit maximisation to real life situations. Where the time period is short and the magnitude of uncertainty is not great, value maximisation and profit maximisation amount to almost the same thing. In view of globalisation of business, emergence of common currencies, integration of financial markets and infotech revolution, and fast paced growth of informational, computational and recreational technologies, global markets have become highly competitive where the market is driven by customers who need to be delighted every time.
A company can delight customers in terms of cost, quality, speed and flexibility. This requires the company to be excellent in its operations — doing superb and superior things every time with minimum cost. A finance manager has to set the financial objectives in such a way as to help the organisation to achieve its objective of excellence.
Value maximisation is maximisation of present value of its future expected net earnings streams discounted at the expected rate of return of the investors. Additional value accrues only with efforts that maximise profit pool. Sustained value creation alone can ensure the viability of an organization and protect the interests of all its stakeholders. Translating this interest into reality represents the greatest challenge for corporate financial management in the years ahead.
It includes the disaggregation of processes, the mapping of the value chain beyond the confines of legal entities, the adoption of flexible organisational structures and the creation of net-worked organizations.
The profit pool concept is based on the concept of looking beyond the core business and spotting out activities with untapped sources of profit. For instance, the dominant player in the truck rental business — a company having a fleet of older trucks and high maintenance costs than its rivals charging lower prices — is fated to fall from industry leader to industry laggard.
The untapped sources of profit in the case of this organization could be the accessories business, consisting of the sale of boxes and insurance and the rental of trailers and storage space — all the ancillary products and services customers need to complete the job that has only begun when they rent a truck.
The margins in truck rentals are low because customers shop aggressively for the best daily rate. Accessories are another matter altogether. Once a customer signs a rental agreement for a truck, his propensity to do further comparison shopping ends. He becomes, in fact, a captive of the company from which he is renting the truck. Because there is virtually no competition, this piece of the value chain, the accessories businesses enjoys highly attractive margins.
By crafting a strategy to maximise its control of the profit pool, the company was eventually able to dictate the terms of competition within the industry. The Lesson — there are many different sources of profit in any business and the company that sees what others do not, the profit pools, might create or exploit and as such will be best prepared to capture a disproportionate share of industry profits. Although the concept is simple, the structure of a profit pool is usually quite complex. The pool will be deeper in some segments of the value chain than in others, and depths will vary within an individual segment as well.
Segment profitability may, for example, vary widely by customer group, product category, geographic market or distribution channel. The shape of a profit pool reflects the competitive dynamics of a business. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.
Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:. The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. To ensure optimum funds utilization.
Once the funds are procured, they should be utilized in maximum possible way at least cost. To ensure safety on investment, i. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern.
Estimations have to be made in an adequate manner which increases earning capacity of enterprise. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.
Choice of sources of funds: For additional funds to be procured, a company has many choices like-. Choice of factor will depend on relative merits and demerits of each source and period of financing. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible.
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