Decisions in Financial Management

 

       It is generally agreed that the financial objective of the firm should be maximization of owners’ economic welfare. However, there is disagreement as to how the economic welfare of owners can be maximized. The well known and widely discussed criterion which are put forward for this purpose are: (a)Profit maximization and (b) Wealth Maximization.

 

       The terms profit maximisation is deep rooted in the economic theory. When firms pursue the policy of maximising profits society’s resources are efficiently utilised. According to this approach the firm should undertake those activities that would increase profits and those that decrease profits should be avoided. The PM criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximisation of profit.

 

       The reasoning behind profitability maximisation, as a guide to financial decision making is simple. Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged. Moreover it leads to efficient allocation of resources as resources tend to be directed to uses, which in terms of profitably are the most desirable.

 

       It ensures maximum social welfare. Financial Management is concerned with the efficient use of an important economic resource (input) namely capital. It is therefore agreed that profitability maximisation shall serve as the basic criterion for financial management decision.

 

The PMC has however been questioned and criticized on several grounds. The reasons fall into 2 broad groups.

a). those that are based on misapprehensions about the workability and fairness of the private enterprise itself;

b) those that arise out of the difficulties of applying this criterion in real world situations.

 

The main technical default of this criterion are as follows:

1. One practical difficulty is that the term profit is a vague and ambiguous concept. It has no precise connotations. It is amenable to different interpretations. For example Profit may be short-term profit or long term profit, it may be total profit or rate of profit. It may be before tax or after tax, profit per share, operating profit or profit to the shareholders.

It may be return on total capital employed or total assets or shareholders equity and so on. If profit maximization is taken to be as an objective, the question arises, which of these variants of profit should a firm try to maximise? A vague expression like profit cannot serve as the basic contains for financial management decision.

 

2. Timing of benefits is a more important technical objection to PM. It ignores the differences in the time pattern of the benefit received from the investment proposals or courses of action.

While working out profitability, the bigger the better principle is adopted as the decision is based on the total benefits received over the working life of the assets, irrespective of when they were received.

Time Pattern of Benefits (profit)

Alternative Alternative

Period A B

I 5,000 ----

II 10,000 10,000

III 5,000 10,000

---------- ----------

20,000 20,000

======== =====

It can be seen from the above table that the total profit associated with the alternatives A and B are identical. If PM is the decision criterion, both the alternative would be ranked equally.

But the return from both alternatives differs in one important respect

-while alternative A provides higher return in earlier years. The returns from alternative B are larger in later years. As a result the 2 alternative courses of action are not strictly identical.

 

A basic rule of financial planning is earlier the better as benefits received sooner are more valuable than benefits received later. The reason for the superiority of benefits now over benefits later lies in the fact that the former can be reinvested to earn a return, which is defined to as time value of money. The profit maximisation does not consider the distinction between returns received in different time periods and treats all benefits respective of the timing as equally valuable. This is not true in actual practice as benefits in early years should be valued more than equivalent benefits in later year. This assumption of equal value is inconsistent with real world situations.

 

3. Quality Benefits- Probably the most important technical limitation of PM as an operational objective is that it

ignores the quality aspect of benefits associated with a financial course of action.

The term quality refers to the degree of certainty with which benefit can be expected. As a rule, the more certain the expected return, the higher the quality of benefits. Conversely the more uncertain or fluctuating the expected benefits, the lower the quality of benefits.

An uncertain and fluctuating return implies risk to the investors. It can be safely assumed that the investors are risk averters, i.e. they want to avoid or at least minimize risk. They can therefore be reasonably expected to have a preference for return, which is more certain in the sense it has smaller variance over the years.

 

The problem of uncertainly renders profit maximization unsuitable as an operational criterion for financial management as it considers only the size of benefits and gives no weight to the degree of uncertainly of the future benefits.

Uncertainly about Expected Benefits (profit)

Alternative Alternative

State of Economy A B

Recession Period I 900 Nil

Normal Period II 1,000 1,000

Boom Period III 1,100 2,000

-------- --------

3,000 3,000

It is clear from the table that the total returns associated with the 2 alternatives are identical in a normal situation but the range of variations is very wide in B and narrow in A. The earnings associated with B are more uncertain (risky) as they fluctuate widely depending on the state of the economy. Obviously A is better from the point of view of risk and uncertainty. PM criterion fails to reveal this.

 

Further, the objectives of PM does not allow for the effect of dividend policy on the market price of the share. If the objectives were to maximize earnings per share, the firm would never pay dividend.

 

To summaries -- PM criterion is inappropriate and unsuitable as an operational objective of investment, financing and dividend decision of a firm. It is not only vague and ambiguous but also it ignores 2 important dimensions of financial analysis namely:

(a) Risk and (b) Time value of money

 

        A business unit is not run solely with the objective of earning the maximum profit possible. There are firm which are prepared to accept lower profits in order to have growth in the volume of sales and to have stability. There are some firms, which undertake project, which may yield lower profits but contribute to social welfare.

        Further PM at the cost of a social and moral obligations and ethical trade practices is not a good business policy. All these quality aspects of business activities are ignored by the concept of PM.

 

A firm pursing the objective of PM starts exploiting workers and consumers. Hence, it is immoral and leads to a number of corrupt practices. Further, it leads to social inequalities and lower human values, which are an essential part of an ideal social system.

 

It is agreed that PM should be the objective for the conditions of perfect competitions and in the wake of imperfect competition it cannot be the legitimate objectives for the firm.

 

A company is financed by shareholders and financial intuitions and it is controlled by professional managers. Workers, government and society are also concerned with it. So financial management has to reconcile the conflicting interest of all the parties connected with the firm. Thus PM as an objective of FM has been considered inadequate.

 

 

An appropriate operational decision criterion for financial management should be:

        precise and exact

        based on the bigger the better principle.

        consider both quantity and quality dimensions of benefits and

        recognize the time value of money.

Wealth Maximization Decision Criterion

The financial management decision can be classified into 3 basic kinds-

Investment decision, Financial decision, Dividend decision.

These three components of the financial functions interact among themselves in order to attain the objectives of financial management, namely wealth maximisation.

 

This is also known as Value Maximisation or Net Present Worth Maximisation. It is almost universally accepted as an appropriate operational decision criterion for FM decisions as it removes the technical limitations, which characterizes the PM criterion. Its features satisfy all the 3 requirements of a suitable operational objective of financial course of action, namely exactness, quality of benefits and time value of money.

 

The value of assets should be viewed in terms of the benefits it can produce. The worth of a course of action can be judged in terms of the value of the benefit it produce less the cost of undertaking it. A significant element in computing the value of a financial course of action is the precise estimate of the benefit associated with it.

The WMC is based on the concept of cash flow generated by the decision rather than the accounting profits, which is the basis of the measurement of benefits in the case of PMC. Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting profits.

        Other things being equal, less uncertain cash flows should be valued more highly then more uncertain cash flows.

       It consider both the quantity and quality dimension of benefits and also incorporates the time value of money. The more certain the expected returns (cash inflows) the better the quality of benefits and the higher the value. The terms value is used in terms of worth to the owner i.e. ordinary shareholders.

       The value of a stream of cash flows with WMC is calculated by discounting its element back to the present at a capitalisation rate that reflects both time and risk.

       The capitalisation (discount) rate that is employed is therefore the rate that reflects the time and risk performance of the owner or supplies of capital. The capital rate has a measure of quality(risk) and timing and is expressed in decimals notation e.g. 15%=0.15. The higher the risk and the longer the period, the larger the capitalization rate.

 

 

The NPW/W Max is superior to the PM.

It involves a comparison of value to cost.

 

In the words of Eyra Slomen “the gross present worth of a course of action is equal to the capitalisation value of the flow of the future expected benefit, discounting (or capitalised) at a rate which reflects their certainly or uncertainty’.

 

Wealth or NPW is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which created wealth or which has Net Present Worth above gross is a desirable one and should be undertaken. Any financial action, which does not meet this test, should be rejected. If two or more desirable course of action is mutually exclusive (i.e. if only one can be undertaken) then the decision should be to do that which creates most wealth or shows the greatest amount of NPW.

It would also be noted that the focus of financial management is on the value to the owners or supplies of equity capital. The wealth of owners is reflected in the market value of shares. So WM implies the maximisation of the market price of shares.

 

       This concept takes into account even the dividend policy of the company. This concept allows the dividend policy of the company to have its effect on the Market Value of the equity share. The objective of the WMC is in total agreement of the objective of

maximising the economic welfare of the shareholder of the company.

 

        It serves the interest of suppliers of loaned capital, employees, management and society. Besides shareholders there are short term and long-term supplies of funds that have financial interest in the concern.

 

       Short terms 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 earning and have also a priority over shareholders in return of their funds. It also ensures security to lenders.

 

       WM objectives not only serve shareholders’ interest by increasing the value of holding.

 

       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 will be served if the interest of various groups is served properly. Management is the elected body of shareholders. The shareholder may not like to change the management if

it is able increase the value of their holdings. The efficient allocation of productive resources will be essential for raising the wealth of the country. The economic interest of society is severed if various resources are put to economical & efficient use.