Objective/Goal of Financial Management:
Financial management deals with the planning and control of firm’s financial resources. The most fundamental objective of financial management is wealth maximization – whether be a nation’s wealth as in the case of public enterprises or wealth of private investors as in the case of private enterprises. The main objectives of financial management which must ultimately lead to wealth maximization in the long run.
Financial Management Objectives:
Clear objectives are required for wise decision-making. Objectives provide a framework for optimum financial decision-making. In other words they are concerned with designing a method of operating the internal investment and financing of a firm. There are alternative approaches in financial literature regarding objectives. Two of the most widely discussed approaches are:
1. Profit Maximization approach
2. Wealth Maximization approach
Profit maximization decision criterion: Under this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented towards the maximization of profits.
The rationale behind profit maximization as a guide to financial decision making, is due to the following reasons:
a. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged.
b. It leads to efficient allocation of resources as resources tend to be directed to uses, which in terms of profitability are the most desirable.
c. It ensures maximum social welfare. This is so because the quest for value drives scarce resources to their most productive uses and their most efficient uses. The more effectively resources are deployed; the more robust will be the economic growth and the rate of improvement in the standard of living.
The profit maximization criterion however has been questioned and criticized on several grounds. It suffers from the following limitations:
a. Profit in absolute terms is not a proper guide to decision making. It has no precise connotation. It should be expressed either on a per share basis or in relation to investment. Also, profit can be long term or short term, before tax or after tax, it may be the return on total capital employed or total assets or shareholders equity and so on. If profit maximization is taken to be the objective, which of these variants of profit should a firm try to maximize? Therefore, a loose term like profit cannot form the basis of operational criterion for financial management.
b. It leaves considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations.
c. It glosses over the risk factor. Since higher the risk, higher will be the returns and vice-versa. It cannot, for example, certain profit of Rs. 50,000 and an investment project, which has a variable profit outcome with an expected value of Rs. 50,000.
d. Prof. Drucker and Prof. Galbraith contradict the theory of profit maximization and observe that exclusive attention on profit maximization misdirects managers to the point where they may endanger the survival of the business. Prof. Galbraith gives the following points to argue his line of reasoning:
i. It undermines the future for today’s profit.
ii. It shortchanges (reduces) research, promotion and other investments.
iii. It may shy away from any capital expenditure that may increase the invested capital base against which profits are based, and the result is dangerous – obsolescence of equipment.
In other words, the managers are directed into the worst practices of management.
Wealth maximization decision criterion: This is also known as value maximization or net present worth maximization. The focus of financial management is on the value to the owners or suppliers of equity capital. The wealth of the owners is reflected in the market value of the shares. So wealth maximization implies the maximization of the market price shares. It has been universally accepted as an appropriate operational decision criterion for financial management decisions as it removes the technical limitations, which characterize the earlier profit maximization criterion. Its operational features satisfy 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.
Advantages of Shareholder Wealth Maximisation:
a. It is a long term strategy which emphasizes on raising the present value of the owner’s investment in a company and the implementation of projects that will increase the market value of the firm’s securities.
b. Recognises the risk or uncertainty.
c. Recognises the timings of returns by taking into account the trade-off between the various returns and the associated levels of risk.
d. Considers the shareholders return by taking into account the payment of dividend to shareholders.
Ezra Solomon has defined wealth maximization objective in the following manner: “The gross present worth of course of action is equal to the capitalised value of the flow of future expected benefits, discounted (or capitalized) at a rate which reflects the certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits.”
Despite the forceful argument in favour of the goal of maximizing shareholder value many have challenged it supremacy.
Prof. Solomon (Stanford University) argues that it is useful to distinguish between profits and profitability. Maximisation of profit in the sense of maximizing the wealth accruing to shareholders is clearly an unrealistic motive. Prof. Solomon has stated that wealth maximization also maximizes the achievement of these other objectives and concludes that maximization of wealth provides a useful and meaningful objective as basic guideline (yardstick) by which financial decisions should be evaluated.
Finance theory rests on the premise that the goal of firm should be to maximize the value of the firm to its equity shareholders. This means that the goal of the firm should be to maximize the market value of its equity shares – which represents the value of the firm to its equity shareholders. Maximisation of the wealth of shareholders (as reflected in the market value of equity) appears to be the most appropriate goal for financial decision-making.
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