Under the modern approach to financial management the business firm or financial manager has to do major three functions (at least) as; where to invest funds and amount to invest, the dividend payment ratio of the period, and from where to raise funds and in what combination and policies. The goals of financial management direct all these functions.
For every business organization, financial decisions are inevitable and continued. To take such decisions effectively or to formulate financial decisions efficiently the firm should have certain objectives or targets and to achieve them it has to undertake its various activities in various scales.
Thus every managerial activity is aimed towards goal achievement. Goals ensure criteria for planning, decision making. A manager must regard the goals of an organization while making decisions to accomplish those encoded goals. It is generally agreed that the goal of financial management or a business firm firm should be the maximization of the owner’s economic wellbeing.
However, there is a divergence as to how the economic welfare of owners can be maximized. Two well recognized and widely discussed criteria are taken as main goals or the purpose of the organization as profit maximization and share-holders wealth maximization. A proper understanding of the goals of financial management provides an outline to the finance manager for decision making. The two widely discussed goals of the financial management are briefly discussed below;
Profit Maximization Goal
Profit Maximization is regarded as the proper objective of the firm or the most popular goal of financial management in a general ground. However, it is not a comprehensive goal as that of shareholder wealth optimization.
Under this goal, all the organizational actions are aimed at profit maximization. In alternative words, the activities that enlarge profit ought to be undertaken and those that decrease profits should be avoided by the managers. According to this goal, profit is the test of efficiency and effectiveness of the organization or finance manager/financial decisions. All the decisions are taken for maximizing profit in the organization. Here term profit maximization means maximizing the rupee income of a firm by ensuring excess revenue over cost. Thus the financial manager should select all those alternatives which are expected to contribute profit to the firm.
The arguments in favor of this goal are below;
- This objective is simple and straight forward. It is easily explicable by the business organization.
- This objective works as the criterion for decision making. Every alternative is evaluated based on maximizing profit.
- In the free market economy, an organization that maximizes profit can attract the best economic resources in their business.
- An organization with maximum profit fulfills the interests of other stakeholders by the means of that profit.
- Profit is the basis for the evaluation of performance and efficiency.
However, this goal is not free from criticisms and they are below:
Uncertain or not a clear goal
The term ‘profit’ is vague. It may mean different to different people. Some people may perceive profit as long-term profit, some may perceive as short-term profit. So, if profit maximization is taken as a goal of an organization, it might create confusion for the people working in the organization. Simply issuing shares and using the proceeds in treasury bills can maximize the amount of profit. However, this would result in a decrease in earning per share. This goal is thus unclear whether the financial manager should take such steps to maximize the profit.
Ignores the time value of benefits
The profit maximization goal of the firm ignores the time of realization of profit. The values of earning in different periods do not possess the same value to the investors or the business firms. It is because the benefits received in a later period are not as valuable as those received in the earlier period. It means the concept of the time value of money is fully ignored by this goal. (The detailed concept of the time value of money will be discussed in coming articles).
Ignores the quality of benefits
Under the profit-maximization goal, only the size of total benefits is considered and quality of it (risk associated with the probable future earnings) is ignored. It selects projects with bigger profits exclusive of taking into consideration the degree of uncertainty and it results in exposing an organization to higher risk.
Unsuitable in the modern business world
The profit maximization goal was developed in the 19th century when the majority of businesses were self-financed. It is considered outdated, unrealistic, difficult, and unsuitable in the present business world. The modern business is characterized by separate business and management. The owners or shareholders or debenture holders cannot impose profit maximization goal as many people are engaged in a firm, their interest might conflict with each other. This goal might lead to inequality of income and wealth due to which profit maximization goal is not suitable in the present business world.
Wealth Maximization Goal
This goal is considered as an improved version of profit maximization goal. It is also known as the net present value maximization goal. This goal is introduced with an objective of improvement in the shortcomings of profit maximization goals. Stockholder’s wealth maximization means the maximization of the market value of their stock. As stockholders are the real owners of the business organization thus maximization the market value of their investment is measured by the term maximization of value of the firm.
According to the value maximization goals of financial management, the decision that maximizes shareholders’ wealth should be taken. It is a comprehensive and universally accepted goal that fits the modern business world. Wealth or value for the shareholders is optimized when a decision ensures net present value. The difference between the present value of the benefit of a project and the present value of its cost is the net present value. According to this goal, only those projects that have positive net present value should be accepted since it creates wealth for shareholders of an organization.
A financial decision resulting in positive NPV considered an increase in wealth. Negative NPV is thus rejected. NPV is calculated as;
NPV=CF1/ (1+k) 1 +CF2/ (1+k) 2+……+CFn/ (1+k) n– NCO
Where CF stands for cash flow during the given periods, k stands for the required rate of return on investment, NCO stands for net cash outlay or net present value of cost and NPV stands for net present value and it is the difference between the present value of future cash inflows and the present value of cost.
The goal of wealth maximization is a suitable and operationally viable criterion to choose among alternative financial actions. It provides clear-cut measures of what financial managers should do to maximize shareholders’ wealth. This goal includes both on the one hand profit and the other hand increment in the price of common stock of the company. It is not vague and ambiguous as it gives some meaning to all and by definition, it considers the time value of money as well as risk element also.
The arguments for shareholders wealth maximization goal are mentioned below:
Clear and certain
According to this goal, each financial decision ought to be evaluated in terms of cash flows. The costs and benefits of every decision should be measured in terms of cash flow rather than measuring in terms of accounting profit. Other things remaining constant the bigger the size of cash flow to the shareholders, the higher will be the wealth to the shareholders. Therefore, this goal is comparatively clear, certain and does not create confusion for the people working in the organization.
It considers the time value of cash flows
The cash flows at two different points in time have a different value. The cash flow received earlier has more value as it can be reinvested as comparing to cashflow received in later periods. The wealth maximization goal considers these things. It does so by converting all cash flows received in different periods into present value.
It considers the quality of benefits
Cash flows estimated from different projects though the same in quantity but may differ from quality. If one set of cash flow is certainly comparing it to another then it is considered as qualitative comparing it with the less certain one.
Valu maximization goals of financial management are also supposed that they will resolve the agency problem between owners and management. If management works for shareholders value maximization then they will be accepted for a long period as the management team of the company. Just in the opposite if they don’t work in favor of the owners they will be replaced by the new management. Thus management of the company is always guided by the motives.
References and suggested readings
Pradhan, S. (1992). Basis of Financial Management. Kathmandu: Educational Enterprise (P) Ltd.
Paudel, Rajan B., Keshar J. Baral, Rishi R. Gautam, and Surya B. Rana. (2010). Fundamentals of Financial Management. Kathmandu: Asmita Books Publishers & Distributes.