As you have learnt that the Financial Management is concerned with the efficient use of capital funds. It evaluates how are funds procured and used. Financial Management includes taking decision in three inter related areas. These are : investment, financing and dividend policy. The decisions are taken by the finance manager considering the objectives of the firm. The objectives provide a framework for optimal financial decision of the company. There are two approaches for this purpose.
i) Profit Maximisation Approach
ii) Wealth Maximisation Approach
Let us learn them in detail.
Profit Maximisation Approach
According to this approach, actions that increase profits should be undertaken and that decrease profits should be avoided. This approach focuses on maximisation of profits and income of the company. The company should decide those projects which are profitable. The projects which are not profitable should be rejected. The behavior of a Company is analysed in terms of profit maximisation in economic theory. In the profit maximisation, a firm either produces maximum output for a minimum input, or uses minimum input for a given output. Therefore, the efficiency is the most significant aspect for the company. Profit is a test of economic efficiency which provides a yardstick for evaluating the economic performance.
There are several criticisms of profit maximisation approach. The main technical flaws are ambiguity, timing of benefits and quality of benefits. These are discussed as below:
a) Ambiguity :There is an ambiguity in the concept of profit. Different scholars have interpreted this concept differently. The profit may be total profit before tax or after tax or profitability rate. The rate of profitability may be determined in relation to share capital; owner’s funds, total capital employed or sales. The profit does not indicate about the short-term and long-term profits. The short-term profit may not be the same as those in the long term. For example, a firm may maximise its short-term profit by avoiding current expenditures on maintenance of a machine. In lack of maintenance, the machine may not be able to operate for manufacturing the products. As a result, the firm will have to make huge investment to replace the machine. In this way, the profit maximisation suffers in the long run due to maximisation of short-term profit.
b) Timing of benefit : The profit maximisation approach ignores the differences in the time pattern of the benefits received. It does not consider the difference between returns received in different time periods. It treats all benefits irrespective of the timings equally. This is not true in actual practice. The benefits in early years should be valued more than benefits in later years.
c) Quality of benefits : This approach ignores the quality aspect of benefits in financial action of the company. The quality refers to the degree of certainty with which benefits can be expected. The more certain the expected return, the higher is the quality of the benefits. An uncertain and fluctuating return may lead to high risk for stakeholders.
The above criticisms show that the profit maximisation approach may not be only decider for financing, investing and dividend decision of the company. It does not consider the risk and time value of money.
Wealth Maximisation Approach
This approach is also known as value maximisation or Net Present Worth maximisation. It tries to remove the technical limitations of profit maximisation approach.
Wealth maximisation means maximising the Net Present Value (or wealth) of a course of action. The net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which leads to positive Net Present Value may create wealth, this should be acceptable by the company. A financial action which leads to negative NPV and does not create wealth should not be accepted. Thus, the project which has the potential of highest NPV should be decided.
The objective of wealth maximisation takes into account the timing and risk of expected benefits. These problems are taken care by selecting an appropriate rate for discounting the expected flow of future benefits. You should understand that the benefits are measured in terms of cash flows. The flow of cash is important in investment and financial decisions, not the accounting profits. The wealth created by a Company through its actions is reflected in the market value of company’s shares. The value of the company’s share is represented by the market price. The market price of the company’s share reflects sound financial decision of the company. It shows the performance indicator of the company.
There are three requirements of a suitable operational objective of financial courses of action. These are : exactness, quality of benefits and the time value of money. Let us learn them in detail.
1) Exactness : The value of an asset should be determined in terms of returns. The worth of a course of action should be valued in terms of the returns less the cost of undertaking the particular course of action. The important factor in computing the value of a financial course of action is the exactness in computing the benefits associated with the course of action. This approach focuses on cash flows and not on accounting profit. The computation of cash inflows and cash outflows should be precise.
2) Quality, benefit and time value of money : The wealth maximisation considers both the quality and quantity dimensions of benefits. It also considers the time value of money. You have understood from earlier discussion that the quality of benefits refers to certainty with which benefits are received in future.
The more certain the expected cash inflows, the better the quality of benefits and higher the value. If the flows are less certain, the quality would be less and the value of benefits would be less. You should also understand that money has time value. Therefore, the benefits received in earlier years should be valued higher than benefits received later.
In order to deal with the uncertainty and timing dimensions of the benefits of financial decision, the adjustments need to be made in the cash flow pattern. The cash flow pattern should incorporate risk and make an allowance for differences in the timing of benefits. Thus, Net Present Value maximisation appears to be superior to the profit maximisation approach.
It involves a comparison of value of cost. Let us consider an action that has a discounted value which reflects both time and risk. If this action exceeds cost, it is said to create value. Such actions should be selected. Contrary to this, actions with less value than cost, reduce wealth, such actions should be rejected. Therefore, the Net Present Value Maximisation appears to be superior to the profit maximisation.
