Chapter 1: Introduction to Financial Management

Brief Short Answer Questions

1. What do you mean by financial management?

Financial management is the decision making process relating to investment, financing, working capital and dividend decision. It is concerned with procurement of funds from the least costly source of financing and their effective and efficient allocation into productive uses.

2. What is the profit maximization goal?

Profit maximization refers to the maximization of rupee income of the firm. Under this goal, all-profitable financial courses of actions are undertaken and unprofitable projects are avoided. Profit maximization goal emphasizes productivity improvement efforts of the firm. It emphasizes on achieving maximum output from a given level of input or minimizing the use of inputs to achieve a given level of output. The productivity improvement leads to profit maximization.

3. What are the arguments in favor of the profit maximization goal?

 The supporters of profit maximization defend this goal on the following grounds.

• Profit is a measure of economic efficiency of the firm.
• It leads to effective utilization of scarce economic resources.
• Profit is the source of internal financing.
• Maximization of profit to a reasonable level is essential for very existence of the firm.

4. What are the limitations of a profit maximization goal?

The main limitations of the profit maximization goal are as below.

• The term ‘profit’ itself is vague
• It gives multiple meanings such as profit before tax, profit after tax, total profit, profit per share and so on.
• Profit maximization does not recognize the principle of time value of money.
• Profit maximization does not consider the risk associated with investment projects.

5. What do you mean by wealth maximization goal?

Wealth maximization refers to the maximization of shareholder wealth. Shareholder wealth can be maximized by maximizing value of the firm. The value of the firm is maximized when a decision generates net present value. Net present value is the difference between present value of benefits and present value of costs. Positive net present value means positive contribution toward value of the firm that leads to maximization of market price of share. Thus shareholder wealth is maximized.

6. How wealth maximization is superior to profit maximization goal?

Wealth maximization is superior to profit maximization due to the following reasons.

• Wealth maximization goal considers cash flow rather than accounting profit. The meaning of cash flow is clear.
• Wealth maximization goal recognizes the concept of time value of money.
• Wealth maximization decision criterion considers the level of risk associated with streams of cash flows.

7. Why is wealth maximization consistent with stock price maximization?

Wealth maximization is also called stock price maximization or value maximization. Wealth maximization is consistent with stock price maximization in a sense that maximization of wealth is reflected by the increased market price of share. The financial decisions that generate positive NPV maximizes market price of the shares.

8. What do you mean by organization of finance functions?

Organization of finance function refers to the authority and responsibility relationship among persons involved in finance functions in an organization. It is the division of work among the persons who carry out finance functions. Proper organization of finance functions helps to avoid confusion on roles and responsibilities of employees, the duplication and overlap of the activities.

Short Questions Answers

1. What are the differences between stock price maximization and profit maximization? Explain.

Stock price maximization refers to the maximization of market price of shares of common stock. This is also termed as maximizing the value of the firm. Here, the value of the firm is the total of the market value of equity and market value of debt. According to this goal, a firm total value is maximized if a financial course of action generates positive net present value. On the other hand, profit maximization refers to the maximization of accounting profits of the firm. According to this goal, a firm undertakes that financial course of action that generates higher positive accounting profits. The fundamental difference between stock price maximization and profit maximization are as follows:

• Accounting profit versus cash flows: Profit maximization emphasizes on maximizing accounting profits to the firm. The accounting profit has multiple meanings: it can be earnings per share or total profit; earnings before interest and taxes or earnings after taxes. Maximizing earnings per share is not equivalent to maximizing total profit. Similarly, maximizing earnings before interest and taxes is not equivalent to maximizing earnings after taxes. On the other hand, stock price maximization is based on the estimate and use of cash flows from a course of action. The term cash flow has a consistent meaning to all. It refers to the difference between cash inflow and cash outflow from a course of action.
• Recognition of time value of money: Stock price maximization recognizes the concept of time value of money. Under stock price maximization decision criteria all future cash flows from an investment are discounted back to present value at a required rate of return. All investment decisions are based on the present value of future cash flows. However, profit maximization does not recognize the concept of time value of money. It treats a rupee amount of profit today equivalent to the rupee amount of profit in one year.
• Recognition of risk: Stock price maximization is based on the consideration of risk involved in financial decisions. The level of risk associated with cash flow streams are reflected by selecting the appropriate required rate of return to determine the present value. Generally, for a risky cash flow, higher discount rate is used to determine the present value under stock price maximization goal. However, profit maximization does not consider the level of risk involved in financial decisions.
• Stock price maximization leads to efficient allocation of resources but profit maximization does not: Stock price maximization promotes efficient allocation of resources of the firm. While allocating resources, it takes into consideration the riskiness associated with the income stream. This ensures the economic use of capital. In the absence of a stock price maximization goal, the firm may face the problem of inadequate capital formation and lower economic growth.
• Stock price maximization represents the interest of both shareholders and managers but profit maximization does not: In the modern enterprise ownership and management is separate. Ownership is vested upon shareholders because they supply capital to run the business. Shareholders appoint management to run the corporate firm on their behalf. Management should work fairly with the capital of shareholders and should promote their welfare. If management is able to maximize stock price, shareholder wealth will be enhanced and managerial performance stands outstanding for the firm. Thus, both shareholders and managers will be satisfied with the stock price maximization goal.

2. Which goal would you like to recommend to a firm: stock price maximization or profit maximization? Discuss.

Financial manager should undertake investment, financing, dividend, and working capital decisions to maximize the value of a firm. A firm may have two sets of goals: the profit maximization and shareholders’ wealth maximization goals. Shareholders wealth maximization is a superior goal to profit maximization. According to this goal, the managers should take decisions that maximize the value of the firm. Value of the firm can be maximized by undertaking the course of actions generating positive net present value. In other words, a course of action that generates positive net present value contributes positively towards the value of the firm. Investors are ready to offer higher prices for shares of a company which undertakes projects with positive net present value. Hence, value maximization is reflected in the market price of shares and consistent with shareholders wealth maximization.

The shareholders’ wealth maximization is a superior goal to profit maximization because of the following reasons:

• It recognizes time value of money: Shareholders’ wealth maximization goal recognizes the concept of time value of money. Under shareholders’ wealth maximization decision criteria all future cash flows from an investment are discounted back to present value at a required rate of return. All investment decisions are based on the present value of future cash flows.
• It recognizes the risk: Shareholders’ wealth maximization is based on the consideration of risk involved in financial decisions. The level of risk associated with cash flow streams are reflected by selecting the appropriate required rate of return to determine the present value. Generally, for a risky cash flow, higher discount rate is used to determine the present value under shareholders’ wealth maximization goal.
• It helps in efficient allocation of resources: Shareholders’ wealth maximization promotes efficient allocation of resources of the firm. While allocating resources, shareholders’ wealth maximization objective takes into consideration the riskiness associated with the income stream. This ensures the economic use of capital. In the absence of shareholders’ wealth maximization goal, the firm may face the problem of inadequate capital formation and lower economic growth.
• It represents the interest of both shareholders and managers: In the modem enterprise ownership and management is separate. Ownership is vested upon shareholders because they supply capital to run the business. Shareholders appoint management to run the corporate firm on their behalf. Management should work fairly with the capital of shareholders and should promote their welfare. If management is able to maximize the firm’s value, shareholder wealth will be enhanced and managerial performance stands outstanding for the firm. Thus, both shareholders and managers will be satisfied with shareholders’ wealth maximization goal.
• It emphasizes on cash flow: Value of the corporate firm depends on the cash flow it generated over the time rather than accounting profits. In shareholders’ wealth maximization criterion, the cash flow is used rather than accounting profit as the basic input for decision-making. The accounting profit is ambiguous and it may mean different things to different people. However, the meaning of cash flows is clear- it means profit after tax plus non-cash outlays to all.

3. Will profit maximization also result in stock price maximization? Discuss the factors affecting the firm’s stock price. 

According to conventional theory of the firm, profit maximization is considered to be the principal objective of the firm because price and output decisions associated with a firm are usually based on the profit maximization criteria. Profit maximization refers to maximizing rupee income of the firm. According to this goal, the actions that increase profits should be undertaken and those that decrease profits are to be avoided. Those who are in favor of profit maximization argue that profit is a test of economic efficiency; it leads to effective utilization of scarce economic resources in every business firm; and it leads to total economic welfare since it increases the economic efficiency of every individual firm. Therefore, profit maximization is considered to be a basic criterion for financial decision-making.

However, there is an alternate goal to profit maximization called stock price maximization which is considered to be the better goal than profit maximization. According to this goal, the managers should take decisions that maximize the shareholder wealth. Shareholder wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Investors pay higher prices for shares of a company which undertake projects with positive net present value. As a result, wealth maximization is reflected in the market price of shares.

Generally, there is high correlation between earnings per share, cash flow and stock price. Thus in some cases, profit maximization may lead to stock price maximization. For example, if a firm’s reported profit is higher in several years, it is perceived favorably by the market participants that the firm has a large potential reinvestment opportunity that generates higher expected cash flows. As a result this is positively reflected in stock price. However, stock prices depend not just on today’s earnings and cash flows but also on the future cash flows and riskiness of the future earnings stream. Some actions may increase earnings and yet reduce stock price. For example, a firm that undertakes actions today to maximize profits may see a drop in its stock price, if the market believes that these actions compromise future earnings and dramatically increase the firm’s risk. Thus, in this circumstance, profit maximization may not lead to stock price maximization.

A firm’s stock price is determined by a number of factors. Any financial decisions. that affect the level, timing and riskiness of expected cash flows will have an impact on stock price. For example, investment decisions, financing decisions and dividend decisions are likely to affect the level, timing, and riskiness of the firm’s cash flows, and therefore the price of its stock. Stock prices are also affected by external factors such as legal constraints, the general state of the economy, tax laws, interest rates, and the condition of the stock market.

4. What is the goal of financial management? What are the shortcomings of the goal of profit maximization

There are two sets of goals of financial management: profit maximization and shareholders wealth maximization. According to conventional theory of the firm, profit maximization is considered to be the principal objective of the firm because price and output decisions associated with a firm are usually based on the profit maximization criteria. Profit maximization refers to maximizing rupee income of the firm. According to this goal, the actions that increase profits should be undertaken and those that decrease profits are to be avoided. Those who are in favor of profit maximization argue that profit is a test of economic efficiency; it leads to effective utilization of scarce economic resources in every business firm; and it leads to total economic welfare since it increases the economic efficiency of every individual firm. Therefore, profit maximization is considered to be a basic criterion for financial decision-making. Shareholders wealth maximization is the most accepted goal of a firm. According to this goal, the managers should take decisions that maximize the shareholder wealth. Shareholder wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted. Wealth maximization is considered to be superior to profit maximization because the profit maximization goal suffers from a number of drawbacks. They are as follows:

• It is ambiguous: Profit is a vague term. It conveys different meanings to different people. For example, the term profit may mean long-term profit or short-term profit after tax or profit before tax, gross profit or net profit, earning per share, return on equity etc. So if profit maximization is taken as a goal of the firm, there will be confusion in decision-making. Merely issuing shares and using the proceeds in Treasury bills can maximize the amount of profit. However, this would result in a decrease in the earning per share (EPS). This goal is not clear whether the financial manager should take such steps to maximize the profit. profit,
• It ignores time value of money concepts: Benefits received in earlier periods are valuable than those received in the later period. But, profit maximization goal ignores this fundamental truth. The benefits received earlier are more valuable than those received later because the earlier benefits can be reinvested to earn return. Thus, earlier the better principle matches the real world situation. But profit maximization goal ignores the fundamental truth, earlier the better.
• It ignores the quality of benefits: Quality of benefits refers to the degree of certainty with which the future benefits can be expected from the financial course of action. The quality of expected benefits are said to be lower if they are more uncertain or fluctuating. Profit maximization considers only the size of total benefits, not its quality. So, it selects projects with larger benefits without considering their degree of certainty and exposes the firm to high risks. So profit maximization cannot be taken as an appropriate decision criterion.
• Unsuitable in modern business environment: Profit maximization objective was developed in the 19th century when the majority of business was self-financing. The modem business is characterized with separate ownership and management. The owners and managers have their own rights and responsibilities. The owners or investors, therefore, cannot impose profit maximization goals in a firm. Maximizing profits goal is considered outdated, unethical, unrealistic, difficult and unsuitable in present context. It increases conflict of interest among a number of stakeholders such as customers, employees, government, society etc. It might lead to inequality of income and wealth. So it is doubtful that it leads to optimum social welfare as advocated.

5. Is profit maximization an appropriate goal for financial managers? Explain. 

According to conventional theory of the firm, profit maximization is considered to be the principal objective of the firm because price and output decisions associated with a firm are usually based on the profit maximization criteria. Profit maximization refers to maximizing rupee income of the firm. According to this goal, the actions that increase profits should be undertaken and those that decrease profits are to be avoided. Those who are in favor of profit maximization argue that profit is a test of economic efficiency; it leads to effective utilization of scarce economic resources in every business firm; and it leads to total economic welfare since it increases the economic efficiency of every individual firm. Therefore, profit maximization is considered to be a basic criterion for financial decision-making. However, this goal is not appropriate on the following grounds. a. It is ambiguous: Profit is a vague term. It conveys different meanings to different people. For example, the term profit may mean long-term profit or short-term profit, profit after tax or profit before tax, gross profit or net profit, earning per share, return on equity etc. So if profit maximization is taken as a goal of the firm, there will be confusion in decision-making. Merely issuing shares and using the proceeds in Treasury bills can maximize the amount of profit. However, this would result in a decrease in the earning per share (EPS). This goal is not clear whether the financial manager should take such steps to maximize the profit.

• It ignores time value of money concepts: Benefits received in earlier periods are valuable than those received in the later period. But, profit maximization goal ignores this fundamental truth. The benefits received earlier are more valuable than those received later because the earlier benefits can be reinvested to earn return. Thus, earlier the better principle matches the real world situation. But profit maximization goal ignores the fundamental truth, earlier the better.
• It ignores the quality of benefits: Quality of benefits refers to the degree of certainty with which the future benefits can be expected from the financial course of action. The quality of expected benefits are said to be lower if they are more uncertain or. fluctuating. Profit maximization considers only the size of total benefits, not its quality. So, it selects projects with larger benefits without considering their degree of certainty and exposes the firm to high risks. So profit maximization cannot be taken as an appropriate decision criterion.
• Unsuitable in modern business environment: Profit maximization objective was developed in the 19th century when the majority of business was self-financing. The modern business is characterized with separate ownership and management. The owners and managers have their own rights and responsibilities. The owners or investors, therefore, cannot impose profit maximization goals in a firm. Maximizing profits goal is considered outdated, unethical, unrealistic, difficult and unsuitable in present context. It increases conflict of interest among a number of stakeholders such as customers, employees, government, society etc. It might lead to inequality of income and wealth. So it is doubtful that it leads to optimum social welfare as advocated.

6. Explain the primary responsibilities of a corporate financial manager?

Financial managers consist of the group of persons including chief financial officer, treasurer and controller. They are responsible for undertaking corporate investment decisions, financing decisions and dividend decisions. Besides these managerial decisions, the financial managers are also responsible for the routine finance functions like financial statements analysis, financial supervision and control, maintaining relationships with banks and financial institutions and other suppliers of funds. Some of the major responsibilities of financial managers are as follows:

• To analyze the financial implications of all departmental decisions: Besides decisions in the finance department, other departments’ decisions like marketing. personnel, production, and research and development have financial implications. For example, the production department has to acquire new equipment to improve the production efficiency. The financial manager should interact with other departmental managers and should assess the financial implications associated with their departmental decisions.
• To analyze investment decision: Investment decision is concerned with allocating resources into long-term investment projects and working capital. Financial manager should estimate the costs and benefits of each investment alternative, use the correct project appraisal method and reach the right investment decision. It includes both acquisitions of long-term assets as well as maintaining appropriate investment in working capital. These decisions have a significant impact on the value of the firm.
• To analyze financing decisions: The financial manager is also supposed to play a significant role in identifying and using different sources of financing to satisfy its investment needs of long-term assets and working capital. The financial manager can rely on long-term and short-term funds. Similarly he/she can evaluate the use of debt versus equity capital. While deciding on these different sources of funds the financial manager should think of the maturity composition of assets and liabilities, cost of capital and financial risk involved. The appropriate mix of long-term versus short-term funds and debt versus equity capital can lower the cost of capital and financial risk.
• To make appropriate dividend decisions: Dividend decision is concerned with determining the proportion of earnings to be distributed to shareholders in the form of dividend. Financial manager should determine the appropriate dividend policy of the firm that can enhance shareholder wealth. For this, the financial manager should consider the cost of capital, capital expenditure needs of the firm, tax situation of shareholders, and their effect on market price of share.
• To analyze the financial market situation and risk: A firm needs to raise funds from the financial market. The situation of the financial market affects both cost and risk. Therefore, the financial manager is supposed to play a significant role in closely analyzing financial market situations to take the market advantages and to avoid the risk. He/she should continuously watch the market movements and analyze the market response towards securities offered by firms.

Long Questions Answer

1. What are the differences between stock price maximization and profit maximization? Explain.

Stock price maximization refers to the maximization of market price of shares of common stock. This is also termed as maximizing the value of the firm. Here, the value of the firm is the total of the market value of equity and market value of debt. According to this goal, a firm total value is maximized if a financial course of action generates positive net present value. On the other hand, profit maximization refers to the maximization of accounting profits of the firm. According to this goal, a firm undertakes that financial course of action that generates higher positive accounting profits. The fundamental difference between stock price maximization and profit maximization are as follows:

• Accounting profit versus cash flows: Profit maximization emphasizes on maximizing accounting profits to the firm. The accounting profit has multiple meanings: it can be earnings per share or total profit; earnings before interest and taxes or earnings after taxes. Maximizing earnings per share is not equivalent to maximizing total profit. Similarly, maximizing earnings before interest and taxes is not equivalent to maximizing earnings after taxes. On the other hand, stock price maximization is based on the estimate and use of cash flows from a course of action. The term cash flow has a consistent meaning to all. It refers to the difference between cash inflow and cash outflow from a course of action.
• Recognition of time value of money: Stock price maximization recognizes the concept of time value of money. Under stock price maximization decision criteria all future cash flows from an investment are discounted back to present value at a required rate of return. All investment decisions are based on the present value of future cash flows. However, profit maximization does not recognize the concept of time value of money. It treats a rupee amount of profit today equivalent to the rupee amount of profit in one year.
• Recognition of risk: Stock price maximization is based on the consideration of risk involved in financial decisions. The level of risk associated with cash flow streams are reflected by selecting the appropriate required rate of return to determine the present value. Generally, for a risky cash flow, higher discount rate is used to determine the present value under stock price maximization goal. However, profit maximization does not consider the level of risk involved in financial decisions.
• Stock price maximization leads to efficient allocation of resources but profit maximization does not: Stock price maximization promotes efficient allocation of resources of the firm. While allocating resources, it takes into consideration the riskiness associated with the income stream. This ensures the economic use of capital. In the absence of a stock price maximization goal, the firm may face the problem of inadequate capital formation and lower economic growth.
• Stock price maximization represents the interest of both shareholders and managers but profit maximization does not: In the modern enterprise ownership and management is separate. Ownership is vested upon shareholders because they supply capital to run the business. Shareholders appoint management to run the corporate firm on their behalf. Management should work fairly with the capital of shareholders and should promote their welfare. If management is able to maximize stock price, shareholder wealth will be enhanced and managerial performance stands outstanding for the firm. Thus, both shareholders and managers will be satisfied with the stock price maximization goal.

2. Which goal would you like to recommend to a firm: stock price maximization or profit maximization? Discuss.

Financial manager should undertake investment, financing, dividend, and working capital decisions to maximize the value of a firm. A firm may have two sets of goals: the profit maximization and shareholders’ wealth maximization goals. Shareholders wealth maximization is a superior goal to profit maximization. According to this goal, the managers should take decisions that maximize the value of the firm. Value of the firm can be maximized by undertaking the course of actions generating positive net present value. In other words, a course of action that generates positive net present value contributes positively towards the value of the firm. Investors are ready to offer higher prices for shares of a company which undertakes projects with positive net present value. Hence, value maximization is reflected in the market price of shares and consistent with shareholders wealth maximization.

The shareholders’ wealth maximization is a superior goal to profit maximization because of the following reasons:

• It recognizes time value of money: Shareholders’ wealth maximization goal recognizes the concept of time value of money. Under shareholders’ wealth maximization decision criteria all future cash flows from an investment are discounted back to present value at a required rate of return. All investment decisions are based on the present value of future cash flows.
• It recognizes the risk: Shareholders’ wealth maximization is based on the consideration of risk involved in financial decisions. The level of risk associated with cash flow streams are reflected by selecting the appropriate required rate of return to determine the present value. Generally, for a risky cash flow, higher discount rate is used to determine the present value under shareholders’ wealth maximization goal.
• It helps in efficient allocation of resources: Shareholders’ wealth maximization promotes efficient allocation of resources of the firm. While allocating resources, shareholders’ wealth maximization objective takes into consideration the riskiness associated with the income stream. This ensures the economic use of capital. In the absence of shareholders’ wealth maximization goal, the firm may face the problem of inadequate capital formation and lower economic growth.
• It represents the interest of both shareholders and managers: In the modem enterprise ownership and management is separate. Ownership is vested upon shareholders because they supply capital to run the business. Shareholders appoint management to run the corporate firm on their behalf. Management should work fairly with the capital of shareholders and should promote their welfare. If management is able to maximize the firm’s value, shareholder wealth will be enhanced and managerial performance stands outstanding for the firm. Thus, both shareholders and managers will be satisfied with shareholders’ wealth maximization goal.
• It emphasizes on cash flow: Value of the corporate firm depends on the cash flow it generated over the time rather than accounting profits. In shareholders’ wealth maximization criterion, the cash flow is used rather than accounting profit as the basic input for decision-making. The accounting profit is ambiguous and it may mean different things to different people. However, the meaning of cash flows is clear- it means profit after tax plus non-cash outlays to all.

3. Will profit maximization also result in stock price maximization? Discuss the factors affecting the firm’s stock price. 

According to conventional theory of the firm, profit maximization is considered to be the principal objective of the firm because price and output decisions associated with a firm are usually based on the profit maximization criteria. Profit maximization refers to maximizing rupee income of the firm. According to this goal, the actions that increase profits should be undertaken and those that decrease profits are to be avoided. Those who are in favor of profit maximization argue that profit is a test of economic efficiency; it leads to effective utilization of scarce economic resources in every business firm; and it leads to total economic welfare since it increases the economic efficiency of every individual firm. Therefore, profit maximization is considered to be a basic criterion for financial decision-making.

However, there is an alternate goal to profit maximization called stock price maximization which is considered to be the better goal than profit maximization. According to this goal, the managers should take decisions that maximize the shareholder wealth. Shareholder wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Investors pay higher prices for shares of a company which undertake projects with positive net present value. As a result, wealth maximization is reflected in the market price of shares.

Generally, there is high correlation between earnings per share, cash flow and stock price. Thus in some cases, profit maximization may lead to stock price maximization. For example, if a firm’s reported profit is higher in several years, it is perceived favorably by the market participants that the firm has a large potential reinvestment opportunity that generates higher expected cash flows. As a result this is positively reflected in stock price. However, stock prices depend not just on today’s earnings and cash flows but also on the future cash flows and riskiness of the future earnings stream. Some actions may increase earnings and yet reduce stock price. For example, a firm that undertakes actions today to maximize profits may see a drop in its stock price, if the market believes that these actions compromise future earnings and dramatically increase the firm’s risk. Thus, in this circumstance, profit maximization may not lead to stock price maximization.

A firm’s stock price is determined by a number of factors. Any financial decisions. that affect the level, timing and riskiness of expected cash flows will have an impact on stock price. For example, investment decisions, financing decisions and dividend decisions are likely to affect the level, timing, and riskiness of the firm’s cash flows, and therefore the price of its stock. Stock prices are also affected by external factors such as legal constraints, the general state of the economy, tax laws, interest rates, and the condition of the stock market.

4. What is the goal of financial management? What are the shortcomings of the goal of profit maximization?

There are two sets of goals of financial management: profit maximization and shareholders wealth maximization. According to conventional theory of the firm, profit maximization is considered to be the principal objective of the firm because price and output decisions associated with a firm are usually based on the profit maximization criteria. Profit maximization refers to maximizing rupee income of the firm. According to this goal, the actions that increase profits should be undertaken and those that decrease profits are to be avoided. Those who are in favor of profit maximization argue that profit is a test of economic efficiency; it leads to effective utilization of scarce economic resources in every business firm; and it leads to total economic welfare since it increases the economic efficiency of every individual firm. Therefore, profit maximization is considered to be a basic criterion for financial decision-making. Shareholders wealth maximization is the most accepted goal of a firm. According to this goal, the managers should take decisions that maximize the shareholder wealth. Shareholder wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted. Wealth maximization is considered to be superior to profit maximization because the profit maximization goal suffers from a number of drawbacks. They are as follows:

• It is ambiguous: Profit is a vague term. It conveys different meanings to different people. For example, the term profit may mean long-term profit or short-term profit after tax or profit before tax, gross profit or net profit, earning per share, return on equity etc. So if profit maximization is taken as a goal of the firm, there will be confusion in decision-making. Merely issuing shares and using the proceeds in Treasury bills can maximize the amount of profit. However, this would result in a decrease in the earning per share (EPS). This goal is not clear whether the financial manager should take such steps to maximize the profit. profit,
• It ignores time value of money concepts: Benefits received in earlier periods are valuable than those received in the later period. But, profit maximization goal ignores this fundamental truth. The benefits received earlier are more valuable than those received later because the earlier benefits can be reinvested to earn return. Thus, earlier the better principle matches the real world situation. But profit maximization goal ignores the fundamental truth, earlier the better.
• It ignores the quality of benefits: Quality of benefits refers to the degree of certainty with which the future benefits can be expected from the financial course of action. The quality of expected benefits are said to be lower if they are more uncertain or fluctuating. Profit maximization considers only the size of total benefits, not its quality. So, it selects projects with larger benefits without considering their degree of certainty and exposes the firm to high risks. So profit maximization cannot be taken as an appropriate decision criterion.
• Unsuitable in modern business environment: Profit maximization objective was developed in the 19th century when the majority of business was self-financing. The modem business is characterized with separate ownership and management. The owners and managers have their own rights and responsibilities. The owners or investors, therefore, cannot impose profit maximization goals in a firm. Maximizing profits goal is considered outdated, unethical, unrealistic, difficult and unsuitable in present context. It increases conflict of interest among a number of stakeholders such as customers, employees, government, society etc. It might lead to inequality of income and wealth. So it is doubtful that it leads to optimum social welfare as advocated.

5.  Is profit maximization an appropriate goal for financial managers? Explain. 

According to conventional theory of the firm, profit maximization is considered to be the principal objective of the firm because price and output decisions associated with a firm are usually based on the profit maximization criteria. Profit maximization refers to maximizing rupee income of the firm. According to this goal, the actions that increase profits should be undertaken and those that decrease profits are to be avoided. Those who are in favor of profit maximization argue that profit is a test of economic efficiency; it leads to effective utilization of scarce economic resources in every business firm; and it leads to total economic welfare since it increases the economic efficiency of every individual firm. Therefore, profit maximization is considered to be a basic criterion for financial decision-making. However, this goal is not appropriate on the following grounds. a. It is ambiguous: Profit is a vague term. It conveys different meanings to different people. For example, the term profit may mean long-term profit or short-term profit, profit after tax or profit before tax, gross profit or net profit, earning per share, return on equity etc. So if profit maximization is taken as a goal of the firm, there will be confusion in decision-making. Merely issuing shares and using the proceeds in Treasury bills can maximize the amount of profit. However, this would result in a decrease in the earning per share (EPS). This goal is not clear whether the financial manager should take such steps to maximize the profit.

• It ignores time value of money concepts: Benefits received in earlier periods are valuable than those received in the later period. But, profit maximization goal ignores this fundamental truth. The benefits received earlier are more valuable than those received later because the earlier benefits can be reinvested to earn return. Thus, earlier the better principle matches the real world situation. But profit maximization goal ignores the fundamental truth, earlier the better.
• It ignores the quality of benefits: Quality of benefits refers to the degree of certainty with which the future benefits can be expected from the financial course of action. The quality of expected benefits are said to be lower if they are more uncertain or. fluctuating. Profit maximization considers only the size of total benefits, not its quality. So, it selects projects with larger benefits without considering their degree of certainty and exposes the firm to high risks. So profit maximization cannot be taken as an appropriate decision criterion.
• Unsuitable in modern business environment: Profit maximization objective was developed in the 19th century when the majority of business was self-financing. The modern business is characterized with separate ownership and management. The owners and managers have their own rights and responsibilities. The owners or investors, therefore, cannot impose profit maximization goals in a firm. Maximizing profits goal is considered outdated, unethical, unrealistic, difficult and unsuitable in present context. It increases conflict of interest among a number of stakeholders such as customers, employees, government, society etc. It might lead to inequality of income and wealth. So it is doubtful that it leads to optimum social welfare as advocated.

6. Explain the primary responsibilities of a corporate financial manager?

Financial managers consist of the group of persons including chief financial officer, treasurer and controller. They are responsible for undertaking corporate investment decisions, financing decisions and dividend decisions. Besides these managerial decisions, the financial managers are also responsible for the routine finance functions like financial statements analysis, financial supervision and control, maintaining relationships with banks and financial institutions and other suppliers of funds. Some of the major responsibilities of financial managers are as follows:

• To analyze the financial implications of all departmental decisions: Besides decisions in the finance department, other departments’ decisions like marketing. personnel, production, and research and development have financial implications. For example, the production department has to acquire new equipment to improve the production efficiency. The financial manager should interact with other departmental managers and should assess the financial implications associated with their departmental decisions.
• To analyze investment decision: Investment decision is concerned with allocating resources into long-term investment projects and working capital. Financial manager should estimate the costs and benefits of each investment alternative, use the correct project appraisal method and reach the right investment decision. It includes both acquisitions of long-term assets as well as maintaining appropriate investment in working capital. These decisions have a significant impact on the value of the firm.
• To analyze financing decisions: The financial manager is also supposed to play a significant role in identifying and using different sources of financing to satisfy its investment needs of long-term assets and working capital. The financial manager can rely on long-term and short-term funds. Similarly he/she can evaluate the use of debt versus equity capital. While deciding on these different sources of funds the financial manager should think of the maturity composition of assets and liabilities, cost of capital and financial risk involved. The appropriate mix of long-term versus short-term funds and debt versus equity capital can lower the cost of capital and financial risk.
• To make appropriate dividend decisions: Dividend decision is concerned with determining the proportion of earnings to be distributed to shareholders in the form of dividend. Financial manager should determine the appropriate dividend policy of the firm that can enhance shareholder wealth. For this, the financial manager should consider the cost of capital, capital expenditure needs of the firm, tax situation of shareholders, and their effect on market price of share.
• To analyze the financial market situation and risk: A firm needs to raise funds from the financial market. The situation of the financial market affects both cost and risk. Therefore, the financial manager is supposed to play a significant role in closely analyzing financial market situations to take the market advantages and to avoid the risk. He/she should continuously watch the market movements and analyze the market response towards securities offered by firms.