Financial management and its objectives - Profit Maximization and Wealth Maximization?

Q2. Define Financial management and its objectives?

Or Financial management means maximization of economic welfare of its shareholders. 

OR Compare and contrast profit maximization and wealth maximization?

Ans. Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfil their business activities.

In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity.

Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern.

Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm.

The term financial management has been defined by Solomon, “It is concerned with the efficient use of an important economic resource namely, capital funds”.

The most popular and acceptable definition of financial management as given by S.C. Kuchal is that “Financial Management deals with procurement of funds and their effective utilization in the business”.

Howard and Upton : Financial management “as an application of general managerial principles to the area of financial decision-making.

Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporation Finance or Business Finance.

Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as:

1.  Profit maximization

2.  Wealth maximization.

Profit Maximization

Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features.

1.  Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.

2.  Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern.

3.  Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.

4.  Profit maximization objectives help to reduce the risk of the business.

Favorable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of the business concern:

(i)   Main aim is earning profit.

(ii)  Profit is the parameter of the business operation.

(iii)  Profit reduces risk of the business concern.

(iv)  Profit is the main source of finance.

(v)   Profitability meets the social needs also.

Unfavorable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:

(i)   Profit maximization leads to exploiting workers and consumers.

(ii)  Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc.

(iii)  Profit maximization objectives leads to inequalities among the sake holders such as customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

(i)   It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern.

(ii)  It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period.

(iii)  It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern.

Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business.

Favourable Arguments for Wealth Maximization

(i)   Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders.

(ii)  Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern.

(iii)  Wealth maximization considers both time and risk of the business concern.

(iv)  Wealth maximization provides efficient allocation of resources.

(v)   It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

(i)   Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities.

(ii)  Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization.

(iii)  Wealth maximization creates ownership-management controversy.

(iv)  Management alone enjoy certain benefits.

(v)   The ultimate aim of the wealth maximization objectives is to maximize the profit.

(vi)  Wealth maximization can be activated only with the help of the profitable position of the business concern.

Profit maximization and wealth maximization critically examined wealth maximization is superior to profit maximisation.

 Wealth maximisation is based on cash flow. It is not based on the accounting profit as in the case of profit maximisation.

 Through the process of discounting, wealth maximisation takes care of the quality of cash flow. Converting uncertain distant cash flow into comparable values at base period facilitates better comparison of projects. The risks that are associated with cash flow are adequately reflected when present values are taken to arrive at the net present value of any project.

 Corporates play a key role in today’s competitive business scenario. In an organisation, shareholders typically own the company, but the management of the company rests with the board of directors. Directors are elected by shareholders. Company management procures funds for expansion and diversification of capital markets.

In the liberalised set up, society expects corporates to tap the capital markets effectively for their capital requirements. Therefore, to keep the investors happy throughout the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion.

 When a firm follows wealth maximisation goal, it achieves maximisation of market value of share. Afirm can practise wealth maximisation goal only when it produces quality goods at low cost. On this account, society gains because of the societal welfare. Maximisation of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers, as it brings to the market the products and services that a consumer needs.

 Another notable feature of the firms that are committed to the maximisation of wealth is that, to achieve this goal they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and benefit to the society.

 From the point of evaluation of performance of listed firms, the most remarkable measure is that ofperformance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholder’s wealth maximisation could be considered as a superior goal compared to profit maximisation.

 Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximisation of market value of shares will lead to maximisation of the net wealth of shareholders.Therefore, we can conclude that maximisation of wealth is probably the more appropriate goal of financial management in today’s context. Though this cannot be a goal in isolation, it is important to understand that profit maximisation as a goal, in a way, leads to wealth maximisation.

DIFFERENCE BETWEEN PROFIT AND WEALTH MAXIMIZATION

Goal	Objective	Advantages	Disadvantages
Profit maximization	Large amount of profits	-Easy to calculate profits. -Easy to determine the link between financial decisions and profits.	-Emphasizes the short term. -Ignores risk or uncertainty. -Ignores     the    timing     of returns. -Requires             immediate resources.
Stockholder wealth maximization	Highest market value of common stock	-Emphasizes the long term. -Recognizes         risk          or uncertainty. -Consider           stockholders return.	-Offers no clear relationship between financial decisions and stock price. -Can lead to management anxiety and frustration.