Financial management is concerned with procurement and use of funds. Its main aim is to use business funds in such a way that the firm’s value / earnings are maximized. Financial management provides a frame work for selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximize the owner’s economic welfare. This objective can be achieved by;
- Profit Maximization, and
- Wealth Maximization.
1. Profit Maximization
Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured. The accumulated profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc. Thus, profit maximization is considered as the main objective of business. The following arguments are advanced in favor of profit maximization as the objective of business:
- When profit-earning is the aim of business then profit maximization should be the obvious objective.
- Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise.
- Economic and business conditions do not remain same at all times. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under unfavorable situation, only if it has some past earnings to rely upon. Therefore, a business should try to earn more and more when situation is favorable.
- Profits are the main sources of finance for the growth of a business. So, a business should aim at maximization of profits for enabling its growth and development.
- Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximization also maximizes socio-economic welfare.
However, profit maximization objective has been criticized on many grounds. They are:
- A firm pursuing the objective of profit maximization starts exploiting workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices.
- It is also argued that profit maximization should be the objective in the conditions of perfect competition and in the wake of imperfect competition today, it cannot be the legitimate objective of a firm
- One has to reconcile the conflicting interests of all the parties connected with the firm. Thus, profit maximization as an objective of financial management has been considered inadequate. Even as an operational criterion for maximizing owner’s economic welfare, profit maximization has been rejected because of the following drawbacks;
- The term ‘profit’ is vague and it cannot be precisely defined. It means different things for different people. Should we consider short-term profits or long-term profits? Does it mean total profits or earnings per share? Even if, we take the meaning of profits as earnings per share and maximize the earnings per share, it does not necessarily mean increase in the market value of share and the owner’s economic welfare.
- Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings as equal when they occur in different periods. It ignores the fact that cash received today is more important than the same amount of cash received after, three years.
- It does not take into consideration the risk of the prospective earnings stream. Some projects are more risky than other.
- The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization.
2. Wealth Maximization
Wealth maximization is the appropriate objective of an enterprise. When the firm maximizes the stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. It means that by maximizing stockholder’s wealth the firm is operating consistently towards maximizing stockholder’s utility.
A stockholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share.
This objective helps in increasing the value of shares in the market. The share’s market price serves as a performance index or report card of its progress. It also indicates how well management is doing on behalf of the shareholder.
However, the maximization of the market price of the shares should be in the long run. Every financial decision should be based on cost-benefit analysis. If the benefit is more than the cost, the decision will help in maximizing the wealth.
Implications of Wealth Maximization
There is a rationale in applying wealth maximizing policy as an operating financial management policy. It serves the interests of suppliers of loaned capital, employees, management and society. Besides shareholders, there are short-term and long-term suppliers of funds who have financial interests in the concern. Short-term 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 earnings and also have a priority over shareholders in return of their funds.
Wealth maximization objective not only serves shareholder’s interests by increasing the value of holdings but ensures security to lenders also. The economic interest of society is served if various resources are put to economical and efficient use.
Criticisms of Wealth Maximization
The wealth maximization objective has also been criticized by certain financial theorists mainly on following accounts;
- It is a prescriptive idea. The objective is not descriptive of what the firms actually do.
- The objective of wealth maximization is not necessarily socially desirable.
- There is some controversy as to whether the objective is to maximize the stockholders wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preferred stockholders, etc.,
- The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organizations.
In spite of all the criticism, we are of the opinion that wealth maximization is the most appropriate objective of a firm and the side costs in the form of conflicts between the stockholders and debenture holders, firm and society and stock holders and managers can be minimized.