Answer: Financial Management means maximisation of economic welfare of its shareholders. Maximisation of economic welfare means maximisation of wealth of its shareholders. Shareholders’ wealth maximisation is reflected in the market value of the firms’ shares. Experts believe that, the goal of the financial management is attained when it maximises its value. There are two versions of the goals of financial management of the firm – Profit Maximisation and Wealth Maximisation.
Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns, with the best output and price levels. A firm’s performance is evaluated in terms of profitability. Allocation of resources and investors perception of the company’s performance can be traced to the goal of profit maximisation. Profit maximisation has been criticised on many accounts: 1. The concept of profit lacks clarity. What does profit mean? o Is it profit after tax or before tax?
o Is it operating profit or net profit available to share holders? Differences in interpretation on the concept of profit expose the weakness of profit maximisation. 2. Profit maximisation ignores time value of money. It does not differentiate between profits of current year with the profit to be earned in later years. 3. The concept of profit maximisation fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk of the firm. 4. The concept of profit maximisation apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Profit maximisation fails to meet the standards stipulated in an operational and a feasible criterion for maximising shareholders wealth, because of the deficiencies explained above.
Wealth maximisation means maximising the net wealth of a company’s shareholders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation. The following arguments are in support of the superiority of wealth maximisation over profit maximisation Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements. Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented. Superiority of Wealth Maximisation over Profit Maximisation
1. It is based on cash flow, not based on accounting profit. 2. Through the process of discounting it takes care of the quality of cash flows. Distant cash flows are uncertain. Converting distant uncertain cash flows into comparable values at base period facilitates better comparison of projects. There are various ways of dealing with risk associated with cash flows. These risks are adequately considered when present values of cash flows are taken to arrive at the net present value of any project. 3. In today’s competitive business scenario corporates play a key role. In company form of organization, shareholders own the company but the management of the company rests with the board of directors. Directors are elected by shareholders and hence agents of the shareholders. Company management procures funds...