Goals of Financial Management

5. Solvency Maximization

Solvency is long run liquidity. Liquidity is short-run solvency. The business has to pursue the goal of solvency maximization. Solvency is the capacity of the business to meet all its long-term liabilities. The earning capacity of the business, the ratio of profit before interest and tax to interest, the ratio of cash flow to debt amortization, the equity-debt ratio and the proprietary ratio influence the solvency of a business. Higher the above ratios greater is the solvency and vice-versa.

Is this a significant goal? Yes, Solvency is a guarantee for continued operation, which in turn is necessary for survival, growth and expansion. Borrowed capital is a significant source of finance. Its cost is less; it gives tax leverage; So, equity earnings increase; so market valuation increases. So, wealth maximization is enabled through borrowed capital. But to use borrowed capital, solvency management is essential. You have to decide the extent to which you can use debt capital and ensure that the cost of debt capital is minimum. Higher dependence and higher cost (higher than the ROI) would spell doom to the business. If the cost is less, (cost is the post tax interest rate), and your earnings are stable, a higher debt may not be difficult for servicing. Solvency maximization is increasing your ability to service increasing debt and does not mean using less debt capital. Increasing the debt service ability would require generating more and stable cash flows through the operations of the business. Ultimately, the nature of investments and business ventures influence solvency.

6. Minimization of Risk

So far, maximization financial goals were dealt with. Now, if we turn the coin, the minimization goals come to light. Minimization of risk is one of the goals. Risk refers to fluctuation, instability or variations in what we cherish to obtain. Variations in sales, profit, capacity utilization, liquidity, solvency, market value and the like are referred to risk. Business risk and financial risk are prominent among different risks. Business risk refers to variation in profitability while financial risk refers to variation in debt servicing capacity. The business risk, alternatively, refers to variations in expected returns. Greater the variations, greater the business risk. Risk minimization also does not mean taking no risk at all. It means minimizing risk given the return and given the risk maximizing return. Risk reduction is possible by going in for a mix of risk-free and risky investments. A portfolio of investments with risky and risk-free investments, could help reducing business risk. So, diversification of investments, as against concentration, helps in reducing business risk.

Financial risk arises when you depend more on high-geared capital structure and your cash flows and profits before interest and tax (PBIT) vary. To minimize financial risk, the quantum of debt capital be limited to the serviceable level, which depends on the minimum level of PBIT and the cash flow. Of course, debt payment scheduling and rescheduling may help in financial risk reduction and the creditor must be agreeing to such schedules/reschedules. Here; too, a portfolio of debt capital can be thought of to reduce risk.

7. Minimization of Cost of Capital

Minimization of cost of capital is a laudable goal of financial management. Capital is a scarce resource, a price has to be paid to obtain the same. The minimum return expected by equity investors, the interest payable to debt capital providers, the discount for prompt payment of dues, etc., are the costs of different forms of capital. The different sources of capital – equity, preference share capital, long term debt, short-term debt and retained earnings, have different costs. In theory, equity is the costliest source. Preference share capital and retained earnings cost less than equity. The debt capital costs less, besides there is the tax advantage. So, to minimize cost you have to use more debt and less of other forms of capital. Using more debt to reduce cost is however is beset with some problems, viz., you take heavy financial risk, create charge on assets and so on. Some even argue, that more debt means more risk of insolvency and bankruptcy cost arises. So, debt capital has, besides the actual cost, another dimension of cost – the hidden cost. So, minimizing cost of capital means minimizing the total of actual and hidden costs.

This is a good goal. Minimization of capital cost increases the value of the firm. If the overall cost of capital is less, the firm can take up even marginal projects and make good returns and serve the society as well. But, it should avoid the temptation to fritter away scarce capital. Capital should be directed into productive and profitable avenues only.

8. Minimization of Dilution of Control

Control on the business affairs is, generally, the prerogative of the equity shareholders. As the Board holds a substantial equity it wants to preserve its hold on the affairs of the business. The non-controlling shareholders too, in heir financial pursuit, want no dilution of their enjoyment of fruits of equity ownership. Dilation takes place when you increase the capital base. By seeking debt capital control dilation is minimized. Also, by rights issue of equity dilation of control can be minimized.

It is evident, minimization of dilution of control is essentially a financing -mix decision and the latter’s relevance and significance had been already dealt with. But you cannot minimize dilution beyond a point, for providers of debt capital, directly or indirectly, affect business decisions. The convertibility clause is a shot in the arm for those creditors. Yes, controlling power has to be distributed.

9. Wealth Maximization

Wealth maximization means maximization of net worth of the business, i.e. the market valuation of a business. In other words, increasing the market valuation of equity share is what is pursued here. This objective is considered to be superior and wholesome. The pros and cons of this goal are analyzed below.

Taking the positive side of this goal, we may mention that this objective takes into account the time value of money. The basic valuation model followed discounts the future earnings, i.e. the cash flows, at the firm’s cost of capital or the expected return. The discounted cash inflow and outflow are matched and the investment or project is taken up only when the former exceeds the latter.

The term cash flow used here is capable of only one interpretation, unlike the term profit. Cash inflow refers to profit after interest and tax but before depreciation. Otherwise put, profit after tax and interest as increased by depreciation. Cash outflow is the investment. Salvage value of investment, at its present value can be reduced from investment or added to inflow. So, the cash flow concept used in wealth maximization is a very clear concept.

This goal considers the risk factor in financial decision, while the earlier two goals of financial management  are silent as though risk factor is absent. Not only risk is there and it is increasing with the level of return generally. So, by ignoring risk, you cannot maximize profit for ever wealth maximization objective give credence to the whole scheme of financial evaluation by incorporating risk factor in evaluation. This incorporation is done through enhanced discounting rate if need be. The cash flows for normal-risk projects are discounted at the firm’s cost of capital, whereas risky projects are discounted at a higher than cost of capital rate so that the discounted cash inflows are deflated, and the chance of taking up the project is reduced. Cash flows – inflows and outflows are matched. So, one is related to the other: i.e. there is the relativity criterion too. So, wealth maximization goal comes clear off all the limitations all the goals mentioned above. Hence, wealth maximization goal is considered a superior goal. This is accepted by all participants in the business system.

1o. Maximization of Economic Value Added

A modern concept of financial management goal is emerging now, called as maximization of economic value added (EVA). EVA = NGPAT – INTE, where, EVA is economic value added, NGPAT is net generating profit after tax but before interest and dividend and INTE is cost of combined capital. INTE = Interest paid on debt capital plus fair remuneration on equity. EVA is simply put excess of profit over all expenses, including expenses towards fair remuneration paid/payable on equity fund.

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