FUNDAMENTALS OF FINANCIAL MANAGEMENT

UNIT I

INTRODUCTION

In our present day economy, finance is defined as the provision of money at the time when it
is required. Every enterprise, whether big, medium or small, needs finance to carry on its
operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly
said to be the lifeblood of an enterprise. Without adequate finance, no enterprise can possibly
accomplish its objectives.
The subject of finance has been traditionally classified into two classes:
(i)Public Finance; and
(ii) Private Finance.
Public finance deals with the requirements, receipts and disbursements of funds in the
government institutions like states, local self-governments and central government. Private
finance is concerned with requirements, receipts and disbursements of funds in case of an
individual, a profit seeking business organisation and a non-profit organisation.
Thus, private finance can be classified into :
(i) Personal finance;
(ii) Business finance; and
(iii) Finance of non-profit organisations.
Personal finance deals with the analysis of principles and practices involved in managing
one's own daily need of funds. The study of principles, practices, procedures, and problems
concerning financial management of profit making organisations engaged in the field of
industry, trade, and commerce is undertaken under the discipline of business finance. The
finance of non-profit organisation is concerned with the practices, procedures and problems
involved in financial management of charitable, religious, educational, social and other
similar organisations.
MEANING OF BUSINESS FINANCE
Literally speaking, the term 'business finance' connotes finance of business activities. It is
composed of two words
(i) business, and (ii) finance
Thus, it is essential to understand the meaning of the two words, business and finance, which
is the starting point to develop the whole concept and meaning of the term business finance.
The word "business' literally means a 'state of being busy. All creative human activities
relating to the production and distribution of goods and services for satisfying human wants
are known as business. It also includes all those activities which indirectly help in production
and exchange of goods, such as, transport, insurance, banking and warehousing, etc. Broadly
speaking, the term "business" includes industry, trade and commerce.
Finance may be defined as the provision of money at the time when it is required. Finance
refers to the management of flows of money through an organisation. It concerns with the
application of skills in the manipulation, use and control of money. Different authorities have
interpreted the term "finance" differently.
However, there are three main approaches to finance :
(i) The first approach views finance as to providing of funds needed by a business on most
suitable terms. This approach confines finance to the raising of funds and to the study of
financial institutions and instruments from where funds can be procured.
(ii) The second approach relates finance to cash.
(iii) The third approach views finance as being concerned with raising of funds and their
effective utilisation.
Having studied the meaning of the two terms business and finance; we can develop the
meaning of the term "business finance' as an activity or a process which is concerned with
acquisition of funds, use of funds and distribution of profits by a business firm. Thus,
business finance usually deals with financial planning, acquisition of funds, use and
allocation of funds and financial controls.
Business finance can further be sub-classified into three categories, viz:
(i) sole proprietory finance,
(ii) partnership firm finance, and
(iii) corporation or company finance.
The above classification of business finance is based upon the three major forms of
organisation for a business firm. In sole proprietorship form of organisation, a single
individual promotes, finances, controls and manages the business enterprise. He also bears
the whole risk of business. A partnership, on the other hand, is an association of two or more
persons to carry on as co-owners of a business and to share its profits and losses. It may come
into existence either as a result of the expansion of sole-trade business or by an agreement
between two or more persons. The liability of the partners is unlimited and they collectively
share the risks of the business. A joint stock company or a corporation is an association of
many persons who contribute money or money's worth to a common stock and employ it in
some trade or business and who share profit and loss arising there from. In the words of Chief
Justice Marshall, "a corporation is an artificial being, invisible, intangible and existing only in
contemplation of the law. Being a mere creation of law, it possesses only the properties
which the charter of its creation confers upon it either expressly or as incidental to its very
existence". Corporation is a legal entity having limited liability, perpetual succession and a
common seal. A corporation is regarded as something different from its owners. The assets of
the corporation are owned by it rather than its members, and a corporation's liabilities are the
obligations of the corporation, not the owners or the members.
As the present day business activities are predominantly carried on by company (corporation)
form of organisation, there is a need to give emphasis to the financial practices and problems
of the incorporated enterprises and that is why, some authorities do not make any distinction
between business finance and corporation finance. Further, the principles of business finance
can be applied to both small (proprietory) and large (corporation) forms of business
enterprises.
DEFINITION OF CORPORATION/BUSINESS FINANCE/FINANCIAL
MANAGEMENT
Corporation finance or broadly speaking business finance can be defined as the process of
raising, providing and administering of all money/funds to be used in a corporate (business)
enterprise. Wheeler defines business finance as, "That business activity which is concerned
with the acquisition and conservation of capital funds in meeting the financial needs and
overall objectives of business enterprise."
According to Guthmann and Dougall, "Business finance can be broadly defined as the
activity concerned with the planning, raising, controlling and administering the funds used in
the business." In the words of Prather and Wert, "Business finance deals primarily with
raising, administering and disbursing funds by privately owned business units operating in
non-financial fields of industry."
According to the Encyclopedia of Social Sciences, "Corporation finance deals with the
financial problems of corporate enterprises. These problems include the financial aspects of
the promotion of new enterprises and their administration during early development, the
accounting problems connected with the distinction between capital and income, the
administrative questions created by growth and expansion, and finally, the financial
adjustments required for the bolstering up or rehabilitation of a corporations which has come
into financial difficulties"
Thus, the scope of corporation finance is so wide as to cover the financial activities of a
business enterprise right from its inception to its growth and expansion and in some cases to
its winding up also. Corporation finance, usually, deals with financial planning, acquisition of
funds, use and allocation of funds, and financial controls.
To sum up in simple words, we can say that financial management as practiced by corporate
(business) firma can be called corporation finance or business finance. Finance function has
become so important that it has given birth to Financial Management as a separate subject.
Financial management refers to that part of the management activity which is concerned with
the planning and controlling of firm's financial resources. It deals with finding out various
sources for raising funds for the firm. The sources must be suitable and economical for the
needs of the business. The most appropriate use of such funds also forms a part of financial
management. As a separate managerial activity, it has a recent origin. This draws heavily on
Economics for its theoretical concepts.
In the words of Weston and Brigham, "Financial management is an area of financial decision-
making. harmonising individual motives and enterprise goals."
JF.Bradley defines financial management as, "The area of the business management devoted
to a judicious use of capital and a careful selection of sources of capital in order to enable a
spending unit to move in the direction of reaching its goals."
According to J.L. Massie, "Financial management is the operational activity of a business
that is responsible for obtainting and effectively utilising the funds necessary for efficient
operations."
Howard and Upon are of the opinion that financial management is the application of the
planning and control functions to the finance function.
EVOLUTION OF CORPORATION FINANCE/FINANCIAL MANAGEMENT
Financial management emerged as a distinct field of study only during the twentieth century.
But even before that some references were made to the finance function as a branch of
economics.
The evolution of financial management can be studied under the following three phases:
1. The Traditional Phase
2. The Transitional Phase
3. The Modern Phase
1. The Traditional Phase. Financial management emerged as a distinct field of study only in
the early part of twentieth century as a result of consolidation movement and formation of
large sized business undertakings. In the initial stages of the evolution of financial
management, emphasis was placed on the study of sources and forms of financing the large
sized business enterprises. The grave economic recession of 1930's rendered difficulties in
raising finance from banks and other financial institutions. Thus, emphasis was laid upon
improved methods of planning and control, sound financial structure of the firm and more
concern for liquidity. The ways and means of evaluating the credit worthiness of firms were
developed.
2. Transitional Phase. The post World War II era necessitated roorganisation of industries
and the need for selecting sound financial structure. In the early 50's the emphasis shifted
from the profitability to liquidity and from institutional finance to day to day operations of
the firm. The techniques of analysing capital investment in the form of 'capital budgeting'
were also developed. Thus, the scope of financial management widened to include the
process of decision-making within the firm.
3. The Modern Phase. The modern phase began in mid-fifties and the discipline of financial
management has now become more analytical and quantitative. 1960's witnessed phenomenal
advances in the theory of portfolio analysis' by Microwitz, Sharpe, Lintner etc. Capital Asset
Pricing Model (CAPM) was developed in 1970's. The CAPM suggested that some of the
risks in investments can be neutralised by holding of diversified portfolio of securities. The
'Option Pricing Theory was also developed in the form of the Binomial Model and the Black-
Scholes Model during this period. The role of taxation in personal and corporate finance was
emphasised in 80's. Further, newer avenues of raising finance with the introduction of new
capital market instruments such as PCD's, FCD's, PSB's and CPP's etc. were also introduced.
Globalisation of markets has witnessed the emergence of Financial Engineering' which
involves the design, development and implementation of innovative financial instruments and
the formulation of creative optimal solutions to problems in finance. The techniques of
models, mathematical programming and simulations are presently being used in corporation
finance and it has achieved the prime place of importance. We may conclude that financial
management has evolved from a branch of economics to a distinct subject of detailed study of
its own.
IMPORTANCE OF CORPORATION FINANCE/FINANCIAL MANAGEMENT
Finance is the life blood and nerve centre of a business, just as circulation of blood is
essential in the human body for maintaining life, finance is very essential to smooth running
of the business. It has been rightly termed as universal lubricant which keeps the enterprise
dynamic. No business, whether big, medium or small can be started without an adequate
amount of finance. Right from the very beginning, Le conceiving an idea to business, finance
is needed to promote or establish the business, acquire fixed assets, make investigations such
as market surveys, etc., develop product, keep men and machine at work, encourage
management to make progress and create values. Even an existing concern may require
further finance for making improvements or expanding the business. Thus, the importance of
finance cannot be over-emphasised and the subject of business finance has become utmost
important both to the academicians and practising managers. The academicians find interest
in the subject because the subject is still in its developing stage and the practising managers
are interested in the subject because among the most crucial decisions of a firm are those
related to finance.
The importance of corporation finance (which is a constituent of business finance) has arisen
because of the fact that present day business activities are predominantly carried on company
or corporate form of organisation. The advent of corporate enterprises has resulted into:
(i) the increase in size and influence of the business enterprises,
(ii) wide distribution of corporate ownership, and
(iii) separation of ownership and management.
The above three factors have further increased the importance of corporation finance. As the
owners (shareholders) in a corporate enterprise are widely scattered and the management is
separated from the ownership, the management has to ensure the maximisation of owner's
economic welfare. The success and growth of a firm depends upon adequate return on its
investment. The investors or shareholders can be attracted by a firm only by maximisation of
their wealth through the application of principles and procedures as laid down by Corporation
Finance.
The knowledge of the discipline of Corporation Finance is important not only to the
practising managers, but also to others who deal with a corporate enterprise, such as
investors, lenders, bankers, creditors, etc., as there is always a scope for the management to
manipulate and "window dress the financial statements.
In the present day capitalistic regime, the size of the business enterprises is increasing
resulting into corporate empires empowered with a lot of social and political influence. This
makes corporation finance all the more important.
Further, if we refer to corporation finance as the financial management practiced by business
firms,the importance of financial management can well be described as the importance of
corporation finance.
Financial management is applicable to every type of organisation, irrespective of its size,
kind or nature. It is as useful to a small concern as to a big unit. A trading concern gets the
same utility from its application as a manufacturing unit may expect. This subject is
important and useful for all types of ownership organisations. Where there is a use of finance,
financial management is helpful. Every management aims to utilise its funds in a best
possible and profitable way. So this subject is acquiring a universal applicability.

Financial management is indispensable to any organisation as it helps in:

(i) financial planning and successful promotion of an enterprise:
(ii) acquisition of funds as and when required at the minimum possible cost;
(iii) proper use and allocation of funds;
(iv) taking sound financial decisions;
(v) improving the profitability through financial controls;
(vi) increasing the wealth of the investors and the nation; and
(vii) promoting and mobilising individual and corporate savings.
FINANCE FUNCTION
Finance function is the most important of all business functions. It remains a focus of all
activities. It is not possible to substitute or eliminate this function because the business will
close down in the absence of finance. The need for money is continuous. It starts with the
setting up of an enterprise and remains at all times. The development and expansion of
business rather needs more commitment for funds. The funds will have to be raised from
various sources. The sources will be selected in relation to the implications attached with
them. The receiving of money is not enough, its utilisation is more important. The money
once received will have to be returned also. If its use is proper then its return will be easy
otherwise it will create difficulties for repayment. The management should have an idea of
using the money profitably. It may be easy to raise funds but it may be difficult to repay
them. The inflows and outflows of funds should be properly matched.
APPROACHES TO FINANCE FUNCTION
A number of approaches are associated with finance function but for the sake of convenience,
various approaches are divided into two broad categories:
1. The Traditional Approach
2. The Modern Approach
1. The Traditional Approach: The traditional approach to the finance function relates to the
initial stages of its evolution during 1920s and 1930s when the term 'corporation finance' was
used to describe what is known in the academic world today as the 'financial management.
According to this approach, the scope, of finance function was confined to only procurement
of funds needed by a business on most suitable terms. The utilisation of funds was considered
beyond the purview of finance function. It was felt that decisions regarding the application of
funds are taken somewhere else in the organisation. However, institutions and instruments for
raising funds were considered to be a part of finance function.
The scope of the finance function, thus, revolved around the study of rapidly growing capital
market institutions, instruments and practices involved in raising of external funds. The
traditional approach to the scope and functions of finance has now been discarded as it
suffers from many serious limitations:
(i) It is outsider-looking in approach that completely ignores internal decision making as to
the proper utilisation of funds.
(ii) The focus of traditional approach was on procurement of long-term funds. Thus, it
ignored the important issue of working capital finance and management.
(iii) The issue of allocation of funds, which is so important today is completely ignored.
(iv) It does not lay focus on day to day financial problems of an organisation.
2. The Modern Approach: The modern approach views finance function in broader sense. It
includes both raising of funds as well as their effective utilisation under the purview of
finance. The finance function does not stop only by finding out sources of raising enough
funds, their proper utilisation is also to be considered. The cost of raising funds and the
returns from their use should be compared. The funds raised should be able to give more
returns than the costs involved in procuring them. The utilisation of funds requires decision
making. Finance has to be considered as an integral part of overall management. So finance
function, according to this approach, covers financial planning, raising of funds, allocation of
funds, financial control etc. The new approach is an analytical way of dealing with financial
problems of a firm. The techniques of models, mathematical programming, simulations and
financial engineering are used in financial management to solve complex problems of present
day finance. The modern approach considers the three basic management decisions, i.e.,
investment decisions, financing decisions and dividend decisions within the scope of finance
function.
AIMS OF FINANCE FUNCTION
The primary aim of finance function is to arrange as much funds for the business as are
required from time to time.
This function has the following aims:
1. Acquiring Sufficient Funds. The main aim of finance function is to assess the financial
needs of an enterprise and then finding out suitable sources for raising them. The sources
should be commensurate with the needs of the business. If funds are needed for longer
periods then long-term sources like share capital, debentures, term loans may be explored. A
concern with longer gestation period should rely more on owner's funds instead of interest-
bearing securities because profits may not be there for some years.

2. Proper Utilisation of Funds. Though raising of funds is important but their effective
utilisation is more important. The funds should be used in such a way that maximum benefit
is derived from them. The returns from their use should be more than their cost. It should be
ensured that funds do not remain idle at any point of time. The funds committed to various
operations should be effectively utilised. Those projects should be preferred which are
beneficial to the business.
3. Increasing Profitability. The planning and control of finance function aims at increasing
profitability of the concern. It is true that money generates money. To increase profitability,
sufficient finds will have to be invested. Finance function should be so planned that the
concern neither suffers from inadequacy of funds nor wastes more funds than required. A
proper control should also be exercised so that scarce resources are not frittered away on
uneconomical operations. The cost of acquiring funds also influences profitability of the
business. If the cost of raising funds is more, then profitability will go down, Finance
function also requires matching of cost and returns from funds 4. Maximising Firm's Value.
Finance function also aims at maximising the value of the firm It is generally said that a
concern's value is linked with its profitability. Even though profitability influences a firm's
value but it is not all. Besides profits, the type of sources used for raising funds,
the cost of funds, the condition of money market, the demand for products are some other
considerations which also influence a firm's value.
SCOPE OR CONTENT OF FINANCE FUNCTION /FINANCIAL MANAGEMENT
The main objective of financial management is to arrange sufficient finances for meeting
short-term and long-term needs. These funds are procured at minimum costs so that
profitability of the business is maximised
With these things in mind, a Financial Manager will have to concentrate on the following
areas of finance function.
SCOPE OR CONTENT OF FINANCE FUNCTION
1. Estimating Financial Requirements
2. Deciding Capital Structure
3. Selecting a Source of Finance
4.Selecting a Pattern of Investment
5. Proper Cash Management
6. Implementing Financial Controls
7. Proper Use of Surpluses
1. Estimating Financial Requirements. The first task of a financial manager is to estimate
short term and long-term financial requirements of his business. For this purpose, he will
prepare a financial plan for present as well as for future. The amount required for purchasing
fixed assets as well as needs of funds for working capital will have to be ascertained. The
estimations should be based on sound financial principles so that neither there are inadequate
nor excess funds with the concern. The inadequacy of funds will adversely affect the day-to-
day working of the concern whereas excess funds may tempt a management to indulge in
extravagant spending or speculative activities.
2. Deciding Capital Structure. The capital structure refers to the kind and proportion of
different securities for raising funds. After deciding about the quantum of funds required it
should be decided which type of securities should be raised. It may be wise to finance fixed
assets through long-term debts. Even here if gestation period is longer, then share capital may
be most suitable. Long-term funds should be employed to finance working capital also, if not
wholly then partially. Entirely depending upon overdrafis and cash credits for meeting
working capital needs may not be suitable. A decision about various sources for funds should
be linked to the cost of raising funds. If cost of raising funds is very high then such sources
may not be useful for long. A decision about the kind of securities to be employed and the
proportion in which these should be used is an important decision which influences the short
term and long-term financial planning of an enterprise.
3. Selecting a Source of Finance. After preparing a capital structure, an appropriate source
of finance is selected Various sources from which finance may be raised, include: share
capital, debentures, financial institutions, commercial banks, public deposits, etc. If finances
are needed for short periods then banks, public deposits and financial institutions may be
appropriate; on the other hand, if long-term finances are required then share capital and
debentures may be useful. If the concern does not want to tie down assets as securities then
public deposits may be a suitable source. If management does not want to dilute ownership
then debentures should be issued in preference to shares. The need, purpose, object and cost
involved may be the factors influencing the selection of a suitable source of financing
4. Selecting a Pattern of Investment. When funds have been procured then a decision about
investment pattern is to be taken. The selection of an investment pattern is related to the use
of funds. A decision will have to be taken as to which assets are to be purchased? The funds
will have to be spent first on fixed assets and then an appropriate portion will be retained for
working capital. Even in various categories of assets, a decision about the type of fixed or
other assets will be essential. While selecting a plant and machinery, even different categories
of them may be available. The decision making techniques such as Capital Budgeting.
Opportunity Cost Analysis etc. may be applied in making decisions about capital
expenditures. While spending on various assets, the principles of safety. profitability and
liquidity should not be ignored. A balance should be struck even in these principles. One may
not like to invest on a project which may be risky even though there may be more profits.
5. Proper Cash Management. Cash management is also an important task of finance
manager. He has to assess various cash needs at different times and then make arrangements
for arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to
creditors, (c) meet wage bills; (d) meet day-to-day expenses. The usual sources of cash may
be: (a) cash sales, (b) collection of debts, (c) short-term arrangements with banks etc. The
cash management should be such that neither there is a shortage of it and nor it is idle. Any
shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the
business will mean that it is not properly used. It will be better if Cash Flow Statement is
regularly prepared so that one is able to find out various sources and applications. If cash is
spent on avoidable expenses then such spending may be curtailed. A proper idea on sources
of cash inflow may also enable to assess the utility of various sources. Some sources may not
be providing that much cash which we should have thought All this information will help in
efficient management of cash.
6. Implementing Financial Controls. An efficient system of financial management
necessitates the use of various control devices. Financial control devices generally used are,
(a) Return on (b) Budgetary Control, (e) Break Even Analysis, (d) Cost Control, (e) Ratio
Analysis ( Cost and Internal Audit. Return on investment is the best control device to
evaluate the performance of various financial policies. The higher this percentage, better may
be the financial performance. The use of various control techniques by the finance manager
will help him in evaluating the performance in various areas and take corrective measures
whenever needed.
7. Proper Use of Surpluses. The uitlisation of profits or surpluses is also an important factor
in financial management. A judicious use of surpluses is essential for expansion and
diversification plans and also in protecting the interests of shareholders. The ploughing back
of profits is the best policy of further financing but it clashes with the interests of
shareholders. A balance should be struck in using finds for paying dividend and retaining
earnings for financing expansion plans, etc. The market value of shares will also be
influenced by the declaration of dividend and expected profitability in future. A finance
manager should consider the influence of various factors, such as: (a) trend of earnings of the
enterprise, (b) expected earnings in future, (c) market value of shares, (d) need for funds for
financing expansion, etc. A judicious policy for distributing surpluses will be essential for
maintaining proper growth of the unit.
FUNDAMENTAL PRINCIPLES OF FINANCE
The theory of financial management is based upon certain fundamental principles of finance.
The important principles are given as below:
1. Time Value of Money. Value of money received today is more than the value of same
amount of money received after a certain period of time. Money received in the future is not
as valuable as money received today, the sooner one receives money the better it is.
2. Risk and Return Trade Off. The alternative courses of action imply different risk-return
relationship as there is a positive relationship between the amount of risk assumed and the
amount of expected return. Greater the risk, the larger is the expected return and larger are the
chances of substantial loss. The financial manager has to strike a balance between the two.
3. Cash Flows. The appropriate objective of a firm is not to maximise profits, rather it is to
maximise the shareholder's wealth which depends upon the present value of cash flows
available to them and not the accounting profits.
4. Principle of Cost of Capital. The various sources of raising finance have different cost of
capital and the degree of risk involved. Generally, higher the risk lower is the cost and lower
the risk higher is the cost
5. Principle of Maturity of Payment. This principle is concerned with planning the sources
of finance. According to this principle, a firm should make every effort to relate maturities of
payment to its flow of internally generated funds.
6. Principle of Equity Position. According to this principle, the amount of capital invested
in each asser should be adequately justified by a firm's equity position. Each rupee invested
in the assets should contribute to the net worth of the firm.
7. Leverage. There should be proper mix of debt and equity capital. The use of long-term
fixed inerest hearing debt alongwith equity share capital is called financial leverage.
Operating leverage results from the presence of fixed costs that help in magnifying net
operating income.
OBJECTIVES OF FINANCIAL MANAGEMENT OR GOALS OF BUSINESS
FINANCE
Financial management is concerned with procurement and use of funds. Its main aim is to use
business funds in such a way that the firm's value / earnings are maximised. There are various
alternatives available for using business funds. Each alternative course has to be evaluated in
detail. The pros and cons of various decisions have to looked into before making a final
selection. The decisions will have to take into consideration the commercial strategy of the
business. Financial management provides a framework for selecting a proper course of action
and deciding a viable commercial strategy The main objective of a business is to maximise
the owner's economic welfare.
This objective can be achieved by:
1. Profit Maximisation, and
2. Wealth Maximisation
1. Profit Maximisation
Profit earning is the main aim of every economic activity. A business being an economic
institution must cam profit to cover its costs and provide funds for growth. No business can
survive without earning profit. Profit is a measure of efficiency of a business enterprise.
Profits also serve as a protection against risks which cannot be ensured. The accumulated
profits enable a business to face risks like fall in prices, competition from other units, adverse
government policies etc. Thus, profit maximisation is considered as the main objective of
business.
The following arguments are advanced in favour of profit maximisation as the objective
of business:
(i) When profit-earning is the aim of business then profit maximisation should be the obvious
objective,
(ii) Profitability is a barometer for measuring efficiency and economic prosperity of a
business enterprise, thus, profit maximisation is justified on the grounds of rationality.
(iii) Economic and business conditions do not remain same at all the times. There may be
adverse business conditions like recession, depression, severe competition etc. A business
will be able to survive under unfavourable situation, only if it has some past earnings to rely
upon. Therefore, a business should try to earn more and more when situation is favourable.
(iv) Profits are the main sources of finance for the growth of a business. So, a business should
aim at maximisation of profits for enabling its growth and development
(v) Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of
profit maximisation also maximises socio-economic welfare.
However, profit maximisation objective has been criticised on many grounds. A firm
pursuing the objective of profit maximisation starts exploiting workers and the consumers.
Hence, it is immoral and leads to a number of corrupt practices. Further, it leads to colossal
inequalities and lowers human values which are an essential part of an ideal social system. It
is also argued that profit maximisation should be the objective in the conditions of perfect
competition and in the wake of imperfect competition today, it cannot be the legitimate
objective of a firm. The concept of limited liability in the present day business has separated
ownership and management. A company is financed by shareholders, creditors and financial
institutions and is controlled by professional managers. Workers, customers, government and
society are also concerned with it. So, one has to reconcile the conflicting interests of all
these parties connected with the firm. Thus, profit maximisation as an objective of financial
management has been considered inadequate.
Even as an operational criterion for maximising owner's economic welfare, profit
maximisation has been rejected because of the following drawbacks:
(1) Ambiguity. The term 'profit' is vague and it cannot be precisely defined. It means
different things for different people. Should we consider short-term profits or long-term
profits? Does it mean total profits or earnings per share 7. Should we take profits before tax
or after tax? Does it mean operating profit or profit available for shareholders ? Further, it is
possible that profits may increase but earnings per share decline. For example, if a company
has presently 10,000 equity shares issued and carns a profit of 1,00,000 the earnings per share
are 10 Now, if the company further issues 5,000 shares and makes a total profit of 1.20,000,
the total profits have increased by 20,000, bu the earnings per share will decline to 78. Even
if we take the meaning of profits as earnings per share and maximise the earnings per share it
does not necessarily mean increase in the market value of shares and the owner's economic
welfare
(ii) Ignores Time Value of Money. Profit maximisation objective ignores the time value of
money and does not consider the magnitude and timing of earnings. It treats all earnings as
equal though they occur in different periods. It ignores the fact that cash received today is
more important than the same amount of cash received after, say, three years. The
stockholders may prefer a regular return from investment even if it is is smaller than the
expected higher returns after a long period.
(iii) Ignores Risk Factor. It does not take into consideration the risk of the prospective
earnings stream. Some projects are more risky than others. The earning streams will also be
risky in the former than the latter. Two firms may have same expected earnings per share, but
if the earning stream of one is more risky then the market value of its shares will be
comparatively less.
(iv) Dividend Policy. The effect of dividend policy on the market price of shares is also not
considered in the objective of profit maximisation. In case, earnings per share is the only
objective then an enterprise may not think of paying dividend at all because retaining profits
in the business or investing them in the market may satisfy this aim.

2. Wealth Maximisation
Wealth maximisation is the appropriate objective of an enterprise. Financial theory asserts
that wealth maximisation is the single substitute for a stockholder's utility. When the firm
maximises the stockholder's wealth, the individual stockholder can use this wealth to
maximise his individual utility. It means that by maximising stockholder's wealth the firm is
operating consistently towards maximising stockholder's utility
A stockholder's current wealth in the firm is the product of the number of shares owned,
multiplied with the current stock price per share.
Stockholder's current wealth in a firm = Number of shares owned x Current stock price per
share
Symbolically, Wo=NPo
Given the number of shares that the stockholder owns, the higher the stock price per share the
greater will be the stockholder's wealth. Thus, a firm should aim at maximising its current
stock price. This objective helps in increasing the value of shares in the market. The share's
market price serves as a performance index or report card of its progress. It also indicates
how well management is doing on behalf of the shareholder. We can conclude that:
Maximam Utility refer to Maximum stockholder's wealth refers to Maximum current stock
price per share
However, the maximisation of the market price of the shares should be in the long run. The
long in implies a period which is long enough to reflect the normal market value of the shares
irrespective of short-term fluctuations.
While pursuing the objective of wealth maximisation, all efforts must be put in for
maximising the current present value of any particular course of action. Every financial
decision should be based on cost benefit analysis. If the benefit is more than the cost, the
decision will help in maximising the wealth. On the other hand, if cost is more than the
benefit the decision will not be serving the purpose of maximising wealth.
Implications of Wealth Maximisation. There is a rationale in applying wealth maximising
policy as an operating financial management policy. It serves the interests of suppliers of
loaned capital, employees, management and society. Besides shareholders, there are short-
term and long-term suppliers of funds who have financial interests in the concern. Short-term
lenders are primarily interested in liquidity position so that they get their payments in time.
The long-term lenders get a fixed rate of interest from the earnings and also have a priority
over shareholders in return of their funds. Wealth maximisation ojbective not only serves
shareholder's interests by increasing the value of holdings but ensures security to lenders also.
The employees may also try to acquire share of company's wealth through bargaining etc.
Their productivity and efficiency is the primary consideration in raising company's wealth.
The survival of management for a longer period will be served if the interests of various
groups are served properly. Management is the elected body of shareholders. The
shareholders may not like to change a management if it is able to increase the value of their
holdings. The efficient allocation of productive resources will be essential for raising the
wealth of the company. The economic interest of society are served if various resources are
put to economical and efficient use.
The following arguments are advanced in favour of wealth maximisation as the goal of
financial management:
(i) It serves the interests of owners, (shareholders) as well as other stakeholders in the firm;
Le suppliers of loaned capital, employees, creditors and society.
(ii) It is consistent with the objective of owners economic welfare.
(iii) The objective of wealth maximisation implies long-run survival and growth of the firm.
(iv) It takes into consideration the risk factor and the time value of money as the current
present value of any particular course of action is measured.
(v) The effect of dividend policy on market price of shares is also considered as the decisions
are taken to increase the market value of the shares.
(vi) The goal of wealth maximisation leads towards maximising stockholder's utility or value
maximisation of equity shareholders through increase in stock price per share.
Criticism of Wealth Maximisation.
The wealth maximisation objective has been criticised by certain financial theorists mainly on
following accounts:
(i) It is a prescriptive idea. The objective is not descriptive of what the firms actually do.
(ii) The objective of wealth maximisation is not necessarily socially desirable.
(iii) There is some controversy as to whether the objective is to maximise the stockholders
wealth or the wealth of the firm which includes other financial claimholders such as
debentureholders, preferred stockholders, etc.
(iv) The objective of wealth maximisation may also face difficulties when ownership and
management are separated as is the case in most of the large corporate form of organisations.
When managers act as agents of the real owners (equity shareholders), there is a possibility
for a conflict of interest between shareholders and the managerial interests. The managers
may act in such a manner which maximises the managerial utility but not the wealth of
stockholders or the firm.
In spite of all the criticism, we are of the opinion that wealth maximisation is the most
appropriate objective of a firm and the side costs in the form of conflicts between the
stockholders and debenture holders, firm and society and stockholders and managers can be
minimised.
Financial Management and Profit Maximisation
The primary aim of a business is to maximise shareholders' wealth. This can be done by
increasing the quantum of profits Financial management helps in devising ways and
exercising appropriate cost controls which utilimately help in increasing profitability,
The following elements are involved in maximising profits.
(1) Increase in Revenues. For maximising its profits, a firm will have to increase revenue
receipts. Revenues will go up only when sales increase. There should be all out efforts to
increase the sales. All possible markets should be exploited so that demand for products
increases. This should be followed by increasing production for meeting increased demand.
In a competitive economy, profits can be increased either by raising the price of products or
by increasing the volume of sales. The second alternative will be more appropriate.
(ii) Controlling Costs. Another way of increasing profit is to control or reduce costs. This
will increase the margin of profit per unit. The costs may be controlled by controlling
material wastages increasing labour efficiency, reducing overhead cost by increasing
production etc.
(iii) Minimising Risks. A business operates under a number of uncertainties. Business is
done with an eye on future which itself is uncertain and difficult to predict. There are many
risks, both business and financial It is generally said, more the risk and more the gain. In spite
of this, those financial decisions should be taken which will not involve more risks but at the
same time may help in increasing profitability. A financial manager will have to balance the
pros and cons of various decisions so that risk element is kept under control.
AGENCY PROBLEMS (MANAGER'S VS. SHAREHOLDERS GOALS)
The owners (shareholders) in a large corporate enterprise are widely scattered and the
management is separated from the ownership. The operational decision making authority in
such a company is vested in the hands of managers who act as agents of the shareholders.
Although the duty of the agent (manger) is to act in the best interests of the principal
(shareholders), in actual practice there may be a conflict between the interests of the two. The
managers may not always act towards maximising shareholder's wealth but may pursue their
own goals such as higher salaries at the cost of shareholders. In the same manner, there may
be a conflict between the interests of the shareholders and that of the other stakeholders in the
firm, such as suppliers of loaned capital, employees, creditors and society. The managers may
act towards reconciling the conflicting interests of various stakeholders at the cost of
maximising shareholders' wealth. This conflict in the managers, generally referred to as
agency problem. results into agency costs such as less than maximum value of shareholders'
wealth or increased costs in modifying and integrating the conflicting goals.
FINANCIAL DECISIONS
Financial decisions refer to decisions concerning financial matters of a business firm. There
are many kinds of financial management decisions that the firm makes in pursuit of
maximising shareholder's etc. wealth, viz, kind of assets to be acquired, pattern of
capitalisation, distribution of firm's income
We can classify these decisions into three major groups:
1. Investment decisions.
2. Financing decisions.
3. Dividend decisions.
1. Investment Decisions. Investment Decision relates to the determination of total amount of
assets to be held in the firm, the composition of these assets and the business risk
complexions of the firm as perceived by its investors. It is the most important financial
decision. Since finds involve cost and are available in a limited quantity, its proper utilisation
is very necessary to achieve the goal of wealth maximisation
The investment decisions can be classified under two broad groups (i) Long-term investment
decision and (ii) Short-term investment decision. The long-term investment decision is
referred to as the capital budgeting and the short-term investment decision as working capital
management.
Capital budgeting is the process of making investment decisions in capital expenditure. These
are expenditures, the benefits of which are expected to be received over a long period of time
exceeding one year. The finance manager has to assess the profitability of various projects
before committing the funds. The investment proposals should be evaluated in terms of
expected profitability, costs involved and the risks associated with the projects. The
investment decision is important not only for the setting up of new units but also for the
expansion of present units, replacement of permanent assets, research and development
project costs, and reallocation of funds, in case, investments made earlier do not fetch result
as anticipated earlier.
Short-term investment decision, on the other hand, relates to the allocation of funds as among
cash and equivalents, receivables and inventories. Such a decision is influenced by trade off
between liquidity and profitability. The reason is that, the more liquid the asset, the less it is
likely to yield and the more profitable an asset, the more illiquid it is. A sound short-term
investment decision or working capital management policy is one which ensures higher
profitability, proper liquidity and sound structural health of the organisation..
2. Financing Decisions. Once the firm has taken the investment decision and committed
itself to new investment, it must decide the best means of financing these commitments.
Since, firms regularly
make new investments, the needs for financing and financial decisions are on going. Hence, a
firm will be continuously planning for new financial needs. The financing decision is not
only concerned with how best to finance new assets, but also concerned with the best overall
mix of financing for the firm.
A finance manager has to select such sources of funds which will make optimum capital
structure The important thing to be decided here is the proportion of various sources in the
overall capital mix of the firm. The debt-equity ratio should be fixed in such a way that it
helps in maximising the profitability of the concern. The raising of more debts will involve
fixed interest liability and dependence upon outsiders. It may help in increasing the return on
equity but will also enhance the risk. The raising of finds through equity will bring permanent
funds to the business but the shareholders will expect higher rates of earnings. The financial
manager has to strike a balance between various sources so that the overall profitability of the
concern improves. If the capital structure is able to minimise the risk and raise the
profitability then the market prices of the shares will go up maximising the wealth of
shareholders
3. Dividend Decision. The third major financial decision relates to the disbursement of
profits back to investors who supplied capital to the firm. The term dividend refers to that
part of profits of a company which is distributed by it among its shareholders. It is the reward
of shareholders for investments made by them in the share capital of the company. The
dividend decision is concerned with the quantum of profits to be distributed among
shareholders. A decision has to be taken whether all the profits are to be distributed, to retain
all the profits in business or to keep a part of profits in the business and distribute others
among shareholders. The higher rate of dividend may raise the market price of shares and
thus, maximise the wealth of shareholders. The firm should also consider the question of
dividend stability, stock dividend (bon shares) and cash dividend.