4 Main Financial Objectives of Business Firm

The following points highlight the four main objectives of business firm. The objectives are: 1. Profit Maximization Objective 2. Wealth Maximization Objective 3. Value Maximization Objective 4. Other Maximization Objectives.

1. Profit Maximization Objective:

Profit as an objective has emerged from over a century of economic theory. In this traditional economic theory, the typical firm was small, owner managed and competing with a large number of similar firms.

Under these circumstances, profit is the rational objective because:

(1) The profit of the firm became the income of the owner. Maximization of profit then ensured the self-interests of the owner/manager, who both decide the actions of the firm and ensure that these are carried out.

(2) The force of competition imposed profit maximization upon the firm to survive in business. The behavioural assumption of profit maximization has served economic theory well. Because profit is the difference between revenue and costs, once revenue and costs are identified the assumption of profit maximization enables predictions to be readily made about the consequence of any environmental change.

Moreover, given identifiable profits, the techniques of classical optimization can be used for decision-making. However, in recent years, doubts have been expressed about the accuracy of the profit maximization model as a description of current business behaviour. The true objective of the firm is something closely related to profit. Often the objective is tied to survival, security or the maintenance of liquid assets.

Each of these objectives is complementary to profit, in that the maximization of profit may ensure the attainment of that objective. The behaviour of the firm can then be modelled as if the firm was maximizing profit. It has traditionally been argued that the objective of a company is to earn profit, hence the objective of Financial management is also maximization of profits.

The profit maximization objective of a firm is criticized for the following reasons:

(a) The concept of profit maximization is vague and narrow.

(b) It ignores the risk factor, as well as, timing of returns.

(c) It may allow decisions to be taken at the cost of long-run stability and profitability of the concern.

(d) It emphasizes the short-run profitability and short-term projects.

(e) It may cause to decrease in share price.

(f) The profit is only one of the many objectives of a modern firm in which the different stakeholders participate in firm’s success like shareholders, debenture holders, financial institutions, banks, managers, employees, Government, creditors, suppliers, customers etc.

(g) It fails to consider the social responsibility of business, maximization of firm’s profit at the cost of society is very much short sighted view.

2. Wealth Maximization Objective:

Wealth maximization means maximizing the net present value (or wealth) of a course of action. The net present value of a course of action is the difference between the present value of its benefits and present value of its costs. A financial action which has a positive net present value creates wealth and, therefore, is desirable.

A financial action resulting in negative net present value should be rejected. Between a number of desirable mutually exclusive projects, the one with the higher net present value should be adopted. The maximization of wealth is possible by making decisions of the firm to get a benefit that exceeds costs. For long-range planning and management controls, a company establishes its overall goals.

Profit as an objective of the firm has emerged from over a century of economic theory. The behavioural assumption of profit maximization has served economic theory well.

Because profit is the difference between revenue and costs and profit maximization leads to wealth maximization of the firm. The separation of ownership from management, the increase in the intensity of competition has lead to the redefinition of profit maximization goal of a firm.

As the owners of the company are its shareholders, the primary financial objective of corporate finance is usually stated to be maximization of shareholders wealth. Since shareholders receive their wealth through dividends and capital gains, shareholders wealth will be maximized by maximizing the value of dividends and capital gains that shareholders receive overtime.

The shareholder wealth maximization goal states that management should seek to maximize the present value of the expected future returns to the owners of the firm. The present value is defined as the value today of some future payment or stream of payments, evaluated at an appropriate discount rate.

The discount rate takes into account the returns that are available from alternative investment opportunities during a specific future time period. The wealth maximization objective takes into consideration the time and risk of expected benefits. The difficulty arises in selecting appropriate rate for discounting future cash flow.

If greater risk is associated with receiving of future economic benefit, the higher the discount rate is adopted and it lowers the value of investors wealth. Since an organization is a coalition of groups viz., owners, managers, employees, suppliers, customers, Government etc., maximization of wealth is not just for shareholders but for all the stakeholders in the firm.

The wealth maximization goal is advocated on the following grounds:

(a) It takes into consideration long-run survival and growth of the firm.

(b) It is consistent with the object of owners economic welfare.

(c) It suggests the regular and consistent dividend payments to the shareholders.

(d) The financial decisions are taken with a view to improve the capital appreciation of the share price.

(e) It considers the risk and time value of money.

(f) It considers all future cash-flows, dividends and earnings per share.

(g) Maximization of firm’s value is reflected in the market price of share, since it depends on shareholders’ expectations as regards profitability, long-run prospects, timing differences of returns, risk, distribution of returns etc. of the firm.

(h) Profit maximization partly enables the firm in wealth maximization.

(i) The shareholders always prefer wealth maximization rather than maximization of inflow of profits.

The wealth maximization objective of a firm is criticized as narrow and it ignores the concept of wealth maximization of society, since society’s resources are used to the advantage of a particular firm. The society’s resources should be optimally allocated, it should result in capital formation and growth of the economy, which ultimately leads to maximization of economic welfare of the society.

The welfare to the people is gauged through optimum utilization of resources, reasonable prices of goods made available to society, supply of quality products, payment of taxes to the Government, contentment of suppliers, meeting the financial obligations in time, repayment of principal and interest of loans to banks and financial institutions etc.

3. Value Maximization Objective:

The goal of firm is to maximize the present wealth of the owners i.e., equity shareholders in a company. A company’s equity shares are actively traded in the stock markets, the wealth of the equity shareholders is represented in the market value of the equity shares. The firm’s cash-flow and its impact on value maximization is shown in figure 21.2.

The prime goal for company form of organization is to maximize the market value of equity shares of the company. The market price of a share serves as an index of the performance of the company. It takes into account present and prospective future earnings per share, risk associated with the business, dividend and retention policies of the firm, level of gearing etc.

The shareholder’s wealth is maximized only when the market value of the share is maximized. In the present context, the term ‘wealth maximization’ of Financial management is redefined as ‘value maximization’. The objective of maximizing economic welfare of shareholders is achieved through maximization of their wealth. The maximization of utility value of shareholders can be achieved by maximizing their economic welfare.

In company form of business, the wealth created is reflected in the market value of its shares. Therefore, the financial decisions will cause to create wealth and it is indicated or reflected in market price of company’s shares. Hence the prime objective of financial management is to maximize the value of the firm.

4. Other Maximization Objectives:

i. Sales Maximization Objective:

The interests of the company are best served by the maximization of sales revenue, which brings with it the benefits of growth, market share and status. The size of the firm, prestige, and aspirations are more closely identified with sales revenue than with profit.

ii. Growth Maximization Objective:

Managers will seek the objectives which give them satisfaction, such as salary, prestige, status and job security. On the other hand, the owners of the firm (shareholders) are concerned with market values such as profit, sales and market share.

These differing sets of objectives are reconciled by concentrating on the growth of the size of the firm, which brings with it higher salaries and status for managers and larger profits and market share for the owners of the firm.

iii. Maximization of ROI:

The strategic aim of a business enterprise is to earn a return on capital. If in any particular case, the return in the long-run is not satisfactory, then the deficiency should be corrected or the activity be abandoned for a more favourable one. Measuring the historical performance of an investment centre calls for a comparison of the profit that has been earned with capital employed.

The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit. Return on investment analysis provides a strong incentive for optimal utilization of the assets of the company.

This encourages managers to obtain assets that will provide a satisfactory return on investment and to dispose of assets that are not providing an acceptable return. In selecting amongst alternative long-term investment proposals, ROI provides a suitable measure for assessment of profitability of each proposal.

iv. Social Objectives:

The business enterprise is an integral part of the functioning of a country. As such, in return for the privileges and rights granted to it by the state, the business firm should be made increasingly responsible for social objectives.

v. Group of Objectives:

According to Cyert and March, the firm as an organization is not a unified structure but a coalition of individuals, some organized into groups, each with varying interests and objectives, and they have the following five objectives of a firm:

a. Production Goal:

This would ensure that output neither fluctuated widely nor fell below some previously determined minimum acceptable level.

b. Inventory Goal:

Sufficient stocks of raw materials, components and finished goods should be held to ensure that production is uninterrupted by shortages and that there is enough stock to satisfy customer needs.

c. Sales Goal:

The management of the firm, and particularly those responsible for marketing, are both

judged and judge themselves by the ability to maintain and expand sales levels.

d. Market Share Goal:

Market share should not fall below an acceptable level. As a performance indicator market share is easily measured, and often used by shareholders.

e. Profit Goal:

Sufficient profit must be made to be able to finance capital investments and to distribute as dividends to shareholders.

The profits are not merely an objective, they are the very reason for the existence of the business enterprise. The assumption of profit maximization has the enormous advantage of enabling decisions to be modelled. But at the same time non-profit maximizing theories cannot be ignored.