Goals Of Corporate Financial Management-Some Thoughts

There is a multiplicity of goals of management. Wealth maximization is a wholesome goal. Maximization of profit, profitability, liquidity and solvency are other goals. But these are sectional and fragmented. Similarly, minimization of cost of capital, risk and dilution of control address particular aspects. Well, all these put together throw much light on the whole gamut of management as such. Now, maximization of economic value is added to the list of goals of management.

Further more, the goal of the management should be to achieve the objective of the corporate owners, who are the suppliers of capital, namely shareholders. The finance manager’s function is not to fulfill his own objectives, which may include higher salaries, earning reputation or maintaining and advancing his personal power and prestige. It is, rather, to the extent manager is successful in this Endeavour, and he will also achieve his personal objectives. It is generally agreed that the financial objective of the firm should be the maximization of owner’s wealth.

However, there is disagreement as to how the economic welfare of owners can be maximized. Two well known and widely discussed criteria which are put forth for this purpose are: (a) profit maximizations, and (b) wealth maximization.

PROFIT MAXIMISATION

Traditionally, the business has been considered as an economic institution and profit has come to be accepted as a rationally valid criterion of measuring efficiency. In support of this contention, the following arguments are usually put forward:

(i) Profit is a prime motive or main incentive which paves the way for better and more efficient performance. It is a reward for entrepreneurial ability. Persons or groups of persons compete with one another and work hard in order to excel others in giving better and more efficient performance simply because they are attracted towards earning more and more profit. This promotes enterprising spirit and leads to economic development of the society.

(ii) Profit is not only an objective, but also a criterion or measuring-rod of efficient management. In this way it is both a goal as well as a measure of good performance. The degree of success or failure over a period can be tested on the basis of the degree of profitability in a company.

(iii) All business decisions are taken keeping in view their probable impact on profit. Thus, it has become a part of the decision-making process.

(iv) In a society or in a business enterprise efficient allocation of scarce resources and their judicious utilization are possible on the basis of profit criterion. Resources flow from low profitable ventures to high profitable ventures.

(v) In a society which is devoid of profit motive or incentive, there will be no place left for mutual   competition   to excel one another in efficiency,   skill   and competence. In such a situation the pace of growth and progress is bound to slow down.

Limitations: As a goal, however, profit maximization suffers from certain basic weaknesses: (1) It is vague, (2) it is a short-run point of view, (3) it ignores risk, and (4) it ignores the timing of returns. An unambiguous meaning of the profit maximization objective is neither available nor possible. It is rather very difficult to know about the following: Does it mean short-term profits or long-term profits? Does it refer to profit before or after tax? Does it refer to total profits or profit per share? Besides it is being ambiguous, the profit maximization objective takes a short-run point of view. Prof. Ducker and Prof. Galbraith contradict the theory of profit maximization and observe that exclusive attention on profit maximization misdirects managers to the point where they may endanger the survival of the business. Prof. Galbraith gives the following points to argue his line of reasoning: (1) it undermines the future for today’s profit; (2) it short-changes research promotion and other investments; (3) it may shy away from ‚any capital expenditure that may increase the invested capital base against which profits are based, and the result is dangerous obsolescence of equipment. In other words, the managers are directed into the worst practices of management. Risk and timing factors are also ignored by this objective. The streams of benefits may possess different degrees of certainty and uncertainty. Two firms may have same total expected earnings, but if the earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Also, it does not make a difference between returns received in different time periods, i.e., it gives no consideration to the time value of money and value benefits received today and benefits after six months or one year.

For the reasons given above the profit maximization objective cannot be taken as the objective of management. It can be stated that the appropriate operational-decision criterion should include: (i) It must be precise   and   exact,   (ii)   It   should   consider both   quality   and   quantity dimension, (iii) It should be based on the bigger and the better principle, and (iv) It should recognize the time value of money. For these reasons, wealth (value) maximization has replaced profit maximization as an operational criterion for management decisions.

Consider the example of three business units making profits over three years given below

Year

Unit – 1

Unit – 2

Unit – 3

Rs.

Rs.

Rs.

1

2,00,000

4,00,000

50,000

2

2,00,000

1,50,000

1,50,000

3

2,00,000

50,000

4,00,000

Total

6,00,000

6,00,000

6,00,000

From the above table, it is clear that all the business units making profits of six lakh rupees.  But evidently unit – 2 is the best of three, followed by unit – 1 and unit – 3. Hence profit maximization is not accepted as a flawless goal, since it might lead to unfair means adopted and time value of money is not considered.

WEALTH MAXIMISATION

The maximization of wealth is a more viable objective of management. The same objective, if expressed in other terms, would convey the idea of net present worth maximization. Any action which creates wealth or which has a net present worth is a desirable one and should be undertaken. Wealth of the firm is reflected in the maximization of the present value of the firm i.e., the present worth of the firm. This value may be readily measured if the company has shares that are held by the public, because the market price of the share is indicative of the value of the company. And to a shareholder, the term ‚wealth‘ is reflected in the amount of his current dividends   and the market price of share.

Ezra Solomon has defined wealth maximization objective in the following manner: „The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefits, discounted (or capitalized) at a rate which reflects the certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and   the amount of capital investment required to achieve the benefits.“

What about a public sector firm the equity stock of which, being fully owned by the government, is not traded on stock market? In such a case, the goal of management should be to maximize the present value of the stream of equity returns. Of course in determining the present value of stream of equity returns, an appropriate discount rate has to be applied. A similar observation may be made with respect to other companies whose equity shares are either not traded or very thinly traded.

From the above clarification, one thing is certain that the wealth maximization is a long-term strategy that emphasizes raising the present value of the owner’s investment in a company   and the   implementation of projects that will increase the market value of the firm’s securities. This criterion, if applied, meets the objections raised against the earlier criterion of profit maximization. The manager also deals with the problem of uncertainty by taking into account the trade-off between the various returns and associated levels of risks. It also takes into account the payment of dividends to shareholders. All these ingredients of the wealth maximization objective are the result of the investment, financing and dividend decisions of the firm.

OTHER GOALS  OF MANAGEMENT

The matter is further complicated by the fact that management may in practice have other objectives either instead of, or as well as, that of profit maximization. A few   possibilities are given below.

(a)Growth: The maximization of profit does not necessarily require a firm of large size. Corporate power, however, is often a function of size and this may become a management objective. Non-profit making organisations, such as mutual assurance companies and building societies, where the profit motive cannot operate, often adopt pure growth as an objective.

(b)Risk reduction: Many potentially very profitable enterprises also carry a high risk of expensive failure. Prospecting for oil, for example, is very profitable if a rich strike is made but ruinous if the exploration proves abortive. It may, therefore, be a management objective to ensure survival by the avoidance of risk, profit becoming a secondary objective.

(c)Personal aspirations: People who obtain senior positions in
management are likely to be highly motivated towards their own career
objectives. Important objectives for a manager may therefore be the
improvement of his own salary, career prospects or security. This may mean a desire for quick results which will stand to the immediate credit of the manager involved as against more solid but longer term profit making objectives.

(d)Social objective: Some organisations adopt an altruistic social purpose as a management, objective. Thus they may be concerned to improve working conditions for their employees, to provide a wholesome product for their customers or to avoid anti-social actions such as environmental pollution or undesirable promotional practices.

(e)Efficiency: Some enterprises, such as charities or public services, have as a fundamental objective the provisions of a required service which is not supplied in the marketplace. A suitable management objective for them is the provision of the service at minimum cost.

(f) Orderly liquidation: A firm will sometimes reach a point where it is appropriate for it to go into liquidation. This may be forced on it by a crisis or a failure of its commercial viability or it may be undertaken voluntarily because the purposes of its original foundation have ceased to exist. In either case, once the decision has been taken, the objective of management will be to operate the business until its demise so as to balance the conflicts of interests of employees, shareholders and customers, to fulfil contractual obligations, e.g. to pay creditors and debenture holders, and to bring a tidy conclusion to all outstanding matters.

Where a particular management action has implications for more than one objective, a view must be taken as to the balance to be struck. For example, the objective of the maximization of profit may be in conflict with the objective of minimizing risk. The judgment to be made is subjective and, therefore, not susceptible to analysis although it is usually made by   reference to some explicit or implicit overall corporate objective.

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Source by DR.R.SRINIVASAN