GOAL OF A FIRM

In general firm means business enterprise. There are two types of objectives of a firm –
1) Profit maximization.
2) Wealth maximization.

1) PROFIT MAXIMIZATION
According to the Weston and Brigham” The maximization of the firm’s net income is
called profit maximization. If total income is more than the total expenses then it is
called profit. That means, profit = total income – total expenses. The profit maximization
criterion implies that the investment, financing and dividend policy decisions of a firm
should be oriented to the maximization of profit.

Some people believe that the owner’s objective is always to maximize profits. To achieve
the goal of profit maximization the financial manager takes only those actions that are
expected to make a major contribution to the firm’s overall profits. For corporations
profits can be measured by EPS (Earnings available for the common stockholders by the
number of shares outstanding).

Example:
Earnings Per Share (EPS)
Investment Year-1 Year-2 Year-3 Total
X 1.4 1.00 0.40 2.80
Y 0.60 1.00 1.40 3.00

According to this goal project y is preferable.

Rationale behind Profit Maximization

• Profit is the yardstick of efficiency: Firm takes different types of decision regarding
production, business expansion, principal, by, sell, dividend policy etc. and profit act
as significant yard stick to evaluate the firm’s decision. It provides the yardstick by
which economic performance can be judged.

Criticism of Profit Maximization

• Ambiguity or vague: The term profit is a vague or ambiguous. It has no precise
definition. It indicates different meaning to different people. Profit may be –
✓ Short Term or Long Term.
✓ Total Profit or Net Profit;
✓ Before Tax or After Tax.

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• Ignores Timing of return: Profit maximization does not properly consider the timing of
cash flows to be received by the firm.

Profit (Tk.)
Investment
Year-1 Year-2 Year-3 Total
A 5000 2000 2000 9,000
B 2000 2000 6000 10,000

According to the profit maximization objective, the investment B should be accepted.

Though total earning from investment A is smaller than those from B, the investment
A provides much greater earnings in the first years. The larger earning in the year 1
could be reinvested to provide greater future earnings, but this aspect is not
considered by the profit maximization goal. So, profit maximization does not consider
the timing of return.

• Ignore Cash flows Concept: A firm’s earnings do not represent cash flows available to
the stockholders. A greater EPS does not necessarily mean that dividend payments will
increase. Furthermore, a higher EPS does not necessarily translate into higher stock
price. Sometimes firms experience increase in earnings without any correspondent
favorable changes in stock price. Only when earnings increases are accompanied by
increased future cash flows, a higher stock price is expected.

• Risk is ignored: Profit maximization disregards risk. A basic premise in managerial

finance is that a trade-off exists between risk and return. For higher risk stockholders
expect higher return and vice versa.

Year-wise profit distribution

Project Y1 Y2 Y3 Y4 Y5 Total
A 200 -100 200 -300 650 650
B 50 100 110 150 200 610
800

600

400
Profit

200

0
0 1 2 3 4 5 6
-200

-400
Year
Project A Project B

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 This figure and graphs shows that project-A is more risky than project-B. Profit
maximization goals avoids this typical of variability. It only notices whether total profit
after a certain period is increasing or not. So we can easily say that profit maximization
does not consider the risk dimension of financial decision.

• It ignores the effect dividend policy on the market price of the share: If the only
objective is to maximize the EPS or profit, the firm would never pay dividend. It could
always improve EPS or profit by retaining earnings and investing them at any positive
rate of return, however small. To the extent that the payment of dividends can affect
the value of the stock, the maximization of earnings per share or profit will not be a
satisfactory objective by itself.

2) WEALTH MAXIMIZATION
Wealth maximization is also known as value maximization or net present worth
maximization. Wealth maximization means maximization of wealth of the firm as well as
share holders. Share holders are the owner of the firm. They hire managers to run the
firm for them. The firms borrow money from bank or issuing bonds. So, maximization of
wealth of the share holder should be the objective of the firm. Therefore, only those
actions that are expected to increase share price should be undertaken. The wealth of
corporate owners is measured by the share price of the stock.

Stockholder’s current
= Number of shares owned * Current stock price per share
wealth In firm

Wealth maximization is considered as better measure than profit maximization because of

following reasons:
• Clear concept of wealth: In this case wealth is precisely defined. There is no
difference between firm’s wealth and share holder’s wealth. Net cash flow is
considered in order to get clear idea of wealth.
• It considers time value of money: Value of money is changing according to the time
changing. In the profit maximization concept it gives emphasis on quantities measure
of profit. But in wealth maximization it gives emphasis on qualitative measure of
profit.
• Focus on market price of share: The main objective of financial management is
economic welfare of the owner. Economic welfare is ensured when share price is
increased.

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 • Risk trade off: The project which profit is higher risk is also higher. The wealth
maximization suggests invest such types of project which can earn regular and
certain income with the lower risk.
• Look for growth: Wealth maximization concept give emphasize on sales and look for
sustainable growth. If sustainable growth ensured ultimately share price will
increase.

Principles of Finance / Business Finance

1. Principles of Profitability: Principles of profitability states that a firm should not
distribute all its profit as dividend to shareholders. If the firm distribute all its profit it
may not be able invest in profitable investment alternatives. So, a portion of the profit
should be retained by the firm as reserve to meet the financial need in future. It
increases the firm capability of internal financing and reduces the dependency on
external financing.

2. Principles of Risk & Return: This principle states

that investment decision should depend on risk &
return relationship of alternative investment
projects. As we know, “The higher the risk, the
higher the return”, but it does not mean that the
firm should always invest in risky projects. A firm
should invest in a project which has “Optimum Risk-
return Relationship”.

3. Principles of Liquidity & Profitability: A firm can earn profit by investing in

different profitable projects. But it does not mean that a firm should invest all their
capital in assets rather they should maintain cash in hand to maintain their day to day
activities and to run the organization properly. Liquidity means having enough money
in the form of cash, or near-cash assets, to meet your financial obligations. As because
Liquidity & Profitability has inverse or negative relationship, a large amount of
investment in assets increases firm’s profitability but reduces firm’s cash in hand (or
liquidity), on the other hand if firm maintain large cash in hand (or liquidity) it reduces
firm’s investment capability which in turn reduces firm’s profitability. So the
management should maintain adequate amount of liquidity as well as invest in assets
to earn profit.
4. Principles of Time Value of Money: Time value of money is very much important in
the time of taking financial decision. As the time passes the value of money decreases.
A fixed amount of money available today is more valuable than the same amount of
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 money available in the future. In the period of investment, Taka 100 today is not valued
equally to the Taka 100 after 1 year.
5. Principles of Diversity: Financial Managers use this principle in the time of asset
management. The main idea of this principle is that “Do not put all your eggs in one
bucket”. A financial manager should not invest all their capital or fund in one project or
in asset rather he/she will invest in multiple projects to reduce the risk of loss. He/she
will invest in projects with negative relationship. By doing this the risk of loss can be
minimized. Considering the risk of loss is essential in the time of making financial
decision.

Investment Return Investment Return Investment Return

Security A Security B Combination of A & B

Time Time Time

Figure: Effect of Diversification on Portfolio Risk.

Here the return over time for security A are cyclical in that time they move with the
economy in general. Returns for security B, however, are perfectly counter cyclical.
Equal amount invested in both securities will reduce dispersion of return and hence the
risk. Benefits of diversification occur as long as the securities are not perfectly,
positively correlated.
6. Principles of Business Cycle: According to principle, in the time of taking a financial
decision adjustment should be
Production
made with business cycle. The
demand for money varies
depending on the situation,
seasonality and business life cycle.
When there is a peak season the
demand for money increases and
there is a through the demand for
money decreases. So the financial
manager should be concern about this matter and should arrange money.

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7. Principle of Hedging: According to the principle of hedging each asset should be
offset with a financing instrument of the same approximately maturity. Short-term or
seasonal variations in current assets would be financed with short-term debt; the
permanent component of current assets and all fixed asset would be financed with
long-term debt or with equity. This principle minimizes the risk that firm will be unable
to pay off its maturing obligations.

Types of Assets Sources of Finance

Temporary Current Asset Short-term non-spontaneous debt.
Permanent Current Asset Long-term debt, Equity, Spontaneous
All Fixed Assets current liabilities

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