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
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
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
a). those that are based on misapprehensionsabout
the workability and fairness of the private enterprise
b) those that arise out of the difficultiesof applying this
criterion in real world situations.
The main technical default of this criterion are as
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 differencesin 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)
Period A B
I 5,000 ----
II 10,000 10,000
III 5,000 10,000
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
But the return from both alternatives differs in one important
-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
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
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
Uncertainly about Expected Benefits (profit)
State of Economy A B
Recession Period I 900 Nil
Normal Period II 1,000 1,000
Boom Period III 1,100 2,000
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
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
Investment decision, Financial decision, Dividend
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
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
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
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
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.