OBJECTIVE of A FIRM

Goals or objectives are missions or basic purposes raison deter of a firms existence. They
direct the firms actions. A firm may consider itself a provider of high technology, a builder of
electronic base, or a provider of best and cheapest transport services. The firm designs its
strategy around such objectives and accordingly, defines its markets, products and technology. To
support its strategy, the firm lays down policies in the areas of production, purchase, marketing,
technology, finance and so on.
Major objectives which a firm might have
Profit Maximisation model:
This model argues that firms seek to maximize their profits. This is their ultimate goal of
survival. There are several approaches to this problem. The total revenue -- total cost method
relies on the fact that profit equals revenue minus cost, and the marginal revenue -- marginal cost
method is based on the fact that total profit in a perfectly competitive market reaches its
maximum point where marginal revenue equals marginal cost.
Total Cost-Total Revenue Method

To obtain the profit maximizing output quantity, we start by recognizing that profit is equal to
total revenue minus total cost. Given a table of costs and revenues at each quantity, we can either
compute equations or plot the data directly on a graph. Finding the profit-maximizing output is
as simple as finding the output at which profit reaches its maximum. That is represented by
output Q in the diagram.

There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit
curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent
on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net
of costs (B,C) is the greatest. Because total revenue minus total costs is equal to profit, the line
segment C,B is equal in length to the line segment A,Q.Computing the price at which to sell the
product requires knowledge of the firm's demand curve. The price at which quantity demanded
equals profit-maximizing output is the optimum price to sell the product.
Marginal Cost-Marginal Revenue Method

If total revenue and total cost figures are difficult to procure, this method may also be used. For
each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal
revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less
than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost,
marginal profit is zero. Since total profit increases when marginal profit is positive and total
profit decreases when marginal profit is negative, it must reach a maximum where marginal
profit is zero - or where marginal cost equals marginal revenue. This is because the producer has
collected positive profit up until the intersection of MR and MC (where zero profit is collected
and any further production will result in negative marginal profit, because MC will be larger than
MR). The intersection of marginal revenue (MR) with marginal cost (MC) is shown in the next
diagram as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a
demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal
line at a price determined by industry supply and demand. Average total costs are represented by

curve ATC. Total economic profits are represented by area P, A, B, C. The optimum quantity (Q)
is the same as the optimum quantity (Q) in the first diagram.
Wealth Maximisation Model:
The theory of corporate finance suggests an alternative financial objective to profit maximisation
that can provide a day-to-day focus for management. This theory assumes that managements
main job is to maximise the value or wealth of the business. Within this context, management
seeks to ensure that investments made by the business earn a return that is satisfactory to
shareholders. The wealth which a firm generates for its shareholders can be determined by any
one of the following parameters:
Cash Value Added (CVA):
The difference between the operating cash flow that a company demands and the operating cash
flow it generates. Operating cash flow demanded is the cash the company requires to meet its
business costs within a given period. Operating cash flow generated is all of the cash that a
business generates through sales and investments without any reductions for non-cash expenses
such as depreciation, amortization, deferred interest expenses and so on.
Businesses must cover their operating costs - otherwise they operate at a deficit or become
insolvent. Therefore, the cash value that a business can add to its bottom line is a very important
measure of the business's financial solvency and success. A business that adds no cash to its
operation on an ongoing basis is suffering. At the same time, however, when a business's CVA is
regularly very high, it may have to invest more to continue to grow.
Economic Value Added (EVA)
It is defined as the value of an activity that is left over after subtracting from it the cost of
executing that activity and the cost of having lost the opportunity of investing consumed
resources in an alternative activity. In business terms, one could calculate EVA as Income from
Operations - rate of interest in sovereign debt, if sovereign debt can be considered an alternative
opportunity to invest working capital and equity. The concept of Economic Profit is closely
linked to EVA. However, Economic Profit is not adjusted.

Market Value Added (MVA):

It is the difference between the current market value of a firm and the capital contributed by
investors. If MVA is positive, the firm has added value. If it is negative the firm has destroyed
value. The amount of value added needs to be greater than the firm's investors could have
achieved investing in the market portfolio, adjusted for the leverage (beta coefficient) of the firm
relative to the market.
The formula for MVA is:
MVA = Market Value of Capital - Capital invested
Economic Profit:
A firm is said to be making an economic profit when its revenue exceeds the total opportunity
cost of its inputs. It is said to be making an accounting profit if its revenues exceed the total price
the firm pays for those inputs.In a single-goods case, economic profit happens when the firm's
average cost is less than the price of the product or service at the profit-maximizing output. The
economic profit is equal to the quantity output multiplied by the difference between the average
total cost and the price.
Apart from the above two models firms might have the following objectives also:
Sales Maximisation Model:
This model argues that businesses try to maximise sales or revenues rather than profits. There are
several possible motives for such an objective:
Grow or sustain market share
Ensure survival
Discourage competitors (particularly new entrants to a market)

 Build the prestige of the senior management who like to be seen running a large rather
than a particularly profitable business
Achieve bonuses if these are based on revenues rather than profits
Management Discretion Model:
In this model, Williamson argues that management act to further their own interests in other
words to achieve personal utility rather than to meet the interests of outside investors. Businesses
run with this kind of objectives tend to deliver high levels of remuneration to management rather
than the highest possible profits.
Consensus Model:
The consensus model presents a slightly more complicated model of business objectives. In this
case, it is argued that a business is an organizational coalition of shareholders, managers,
employees and customers each with different objectives. Management therefore try to reach a
consensus with these different groups each of which must settle for less than they would
otherwise want. Shareholders, therefore have to settle for profits that are less than the theoretical
maximum, perhaps to ensure that employees do better.
Profit Maximisation vs Wealth Maximisation:
The basic purpose for which a business organization runs is maximization of returns for its
shareholders. Now, returns to a shareholder can be in two forms viz.; maximization of Earning
Per Share (EPS) or maximization of Market Price of Share (MPS). Now, maximization of EPS
depends on an increase in companys performance in which companies often take huge amount
of risk as MPS is product of EPS and Price Earning Ratio (P/E) of organization which is
inversely proportional with risk i.e.; higher the risk lower would be the P/E ratio and lower
would be the MPS.
Hence, the companies are often unable to determine if they should go for wealth maximization or
profit maximization and therefore the question here arises that whether an organization can

achieve both Profit Maximization and Wealth Maximization simultaneously or not. Before
answering this question it is important to look into limitations of both these doctrines.
Limitations of The Doctrine of Profit Maximization
Measuring profit of organizations, in itself is full of ambiguities. For ex. Whether Book profit,
Actual profit, Inflation Adjusted Profit is to be taken. Also, there are several ways to compute
depreciation.
Many companies claim that their sole objective is not profit maximization and they have social
objectives to fulfill. For example, when there was increase in steel prices TISCO India
announced that it would not increase steel prices for next 6 months since they had a social
objective to fulfill and hence when they could have maximized their profit, they did not do the
same because of their social objectives.
Also, equating performance with profit is against social norms since unscrupulous ways to gain
profit can be used by the organizations.
Limitations of The Doctrine of Wealth Maximization:
Measuring Wealth is more tedious to that of measuring value.
For example,Wealth = MP * Number of Shares and MP of shares changes every moment.
Wealth maximization concept is always long term concept and it does not take into account of
speculations that take benefit of short term change in prices with the help of insider information.
Also, Wealth is MP and MP of scrip does not affect the management of company since they aim
at good management and better growth prospects hence increasing the P/E ratio and do not take
care of EPS or MPS of the company.
Now that we have seen that both the doctrines of profit maximization and wealth maximization
have inherent limitations in themselves, it can be advised that a company should go for achieving
profit maximization in short run and wealth maximization without taking much risk so as to
insure that shareholders get both the short term as well as long term returns while the growth of
the business organization is also ensured.

Importance of EVA:
Economic Value Added (EVA) is considered to be one of the most important indicators of the
wealth creation by a company. It is a blossoming model for corporate financial disclosure in
India. EVA measures whether the operating profits are enough compared to the total cost of
capital employed. It indicates the net wealth created by the production of goods and services
during a specified period in a company. An enterprise may survive without profits but its survival
is impossible without adding value. EVA is the difference between the net operating profits and
opportunity cost of all capital invested in an enterprise. It is an alternative to the turnover based
models. It is an estimate of true economic profit or the amount by which earnings fall short of
the required minimum rate of return that shareholders and lenders could get by investing in other
securities of comparable risk. EVA is a broader financial measure of judging the output of a
corporate to the economic growth and development of the nation.
The rational behind EVA is that shareholders have an expectation about what to get from the
company at the beginning of the period . this is the minimum return that a company must give to
its shareholders. But EVA measures what the shareholders get above this minimum.
In a nutshell, EVA can be visualized as:
1

A most accurate value based measure of financial performance practically the same as
economic profit.

A measure indicating the amount of shareholder wealth created or destroyed during each
year.

A framework for complete financial management and incentive compensation.

An organization can perk up EVA by any of the three options:

1

Earn more profit without using more capital.

Downsize unprofitable units or divisions.

Invest when the return is more than the marginal cost of capital.

COMPUTATION OF EVA- different methods.

1
2

profit after taxes minus the cost of equity( multiplied by the share capital base)
net operating profit before interest but after tax minus the weighted average cost of
capital(multiplied by the capital employed).

profit after interest and tax plus the interest component adjusted for taxes minus( WACC
* total capital employed)

The proponents of EVA argue that it is superior to other measures for the following reasons:
1

It has a higher correlation with the market value of the firm.

Under the traditional financial management system inconsistencies arise among the
various parameters. EVA unites all the employees in pursuit of a single goal of
creating value which simplifies and eases decision making.

EVA provides a broader picture of true profits as it does not consider only the cost of
equity but also the cost of borrowed capital.

Further, it links the management compensation to the shareholder value in a much

refined manner i.e. with EVA bonus targets set every year as a percentage gain in
EVA and with no cap on maximum amount of bonus payment.

It is also closely linked to NPV.

It makes the managers responsible for a measure that they have more control
over( the return on capital and the cost of capital) rather than the one that they feel
the cannot control( the market price per share)

EVA is also gaining popularity because of its impartiality towards stakeholders.

Moreover it is influenced by all the decisions that managers have to make like the
investment and the dividend decisions.