1

B.R.C.M. College of
Business Administration
V. T. Choksi Law College Campus, Athwalines, Surat 395007
Ph: (0261) 2257340 Mo. 7802057430 Website: www.brcmbba.ac.in

B.R.C.M. College of Business Administration

S.Y.B.B.A

SEMESTER=IV

Working capital Management

Chapter No=1
1. Concept of Working capital
Introduction of Financial
2. Calculation Management
of Working capital
3. Operating cycle & cash Cycl

FINANCIAL MANAGMENT
CA NIKUNJ Shah
98252-16555
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B.R.C.M. College of
Business Administration
V. T. Choksi Law College Campus, Athwalines, Surat 395007
Ph: (0261) 2257340 Mo. 7802057430 Website: www.brcmbba.ac.in

Course Code: BMBA11403 Semester: IV

Name of the course: Financial Management Credits: 4

Course Type: Professional Core Course Duration: 52 hours

Course Description:

Covers basic financial concepts and practices, and includes analysis of company resources,
types and sources of financing, forecasting, and planning methods, and the roles of the
money and capital markets.

Course Objectives:

� The objective of this course is to inform the students about the basic concepts of
financial management and contemporary theory and policy in order to master the
concepts, theories, and techniques of financial management.
�Develop knowledge on the allocation, management, and funding of financial
resources.
� Improving students’ understanding of the time value of money concept and the role
of a financial manager in the current competitive business scenario.

Course Learning Outcomes:

This course will enable students to:

CLO.1: Describe the effects of decision making of finance manager on shareholders wealth
maximization.

CLO.2: To understand the importance of the time value of money and its use for valuing
the asset.

CLO.3: To understand the importance of procurement of funds and allocation of funds.

CLO.4: To understand the importance of different capital budgeting methods and their
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applications.

CLO.5: Examine the working capital needs and financing of the firm and apply methods to
measure the operating efficiency of business.

Page 1 of 4
B.R.C.M. College of
Business Administration
V. T. Choksi Law College Campus, Athwalines, Surat 395007
Ph: (0261) 2257340 Mo. 7802057430 Website: www.brcmbba.ac.in

CLO.6: Enhancing student’s ability in dealing short-term

dealing with day-to-day working capital decisions; and also longer-term dealing, which
involves major capital investment decisions and raising long-term finance.

Teaching Pedagogy: Teachers are expected to impart knowledge along with traditional
teaching through new and innovative pedagogical approaches like Reading, Lectures,
Assignments, Practical, Tests, Presentations, and Participation in academic and
extracurricular activities.

Module Topics No. of Weightage

Lectures

1 Introduction of Financial Management • 06 10%

Meaning and Nature of Financial
Management (FM),
• Finance and related disciplines, Scope of
Financial Management,
• Goals of FM: Profit Maximization,
Wealth Maximization,
• Traditional and Modern Approach, Functions
of finance – Finance Decision, Investment
Decision, Dividend
Decision and Liquidity Decision, Roles of
a finance manager.
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2 Capital Budgeting 17 30%

• Nature and meaning of capital
budgeting,
• Concept of Time Value of Money,
concept of present value, future value
(Lump sum, simple annuity and
growing annuity),
• Evaluation techniques - Accounting
Rate of Return, Net Present Value,
Internal Rate of Return, Profitably
Index Method and Pay Back Period.

3 Working Capital Management 22 40%

• Meaning, factors affecting working capital,
Operating cycle and cash cycle, •
Determination of working capital
requirement Management of Cash,
• Preparation of Cash Budgets (Receipts
and Payment Method only),
• Cash management technique.

• Receivables Management – Objectives,

Credit Policy, Cash Discount, Debtors
Outstanding and Ageing Analysis, Costs -
Collection Cost, Capital Cost, Default
Cost, Delinquency Cost.
• Working Capital Finance

4 Sources of long term finance and Leverages • 07 20%

Objectives of raising long term sources of
fund
• Features, advantages and disadvantages of
equity shares, preference shares,
debentures, bank loan, leasing and hire
purchase.

• Leverage Analysis: Operating and Financial

Leverage, Combined leverage.
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Books:
Sr. No. Title of the Book Authors Publication and
Edition

1 Financial Management - M.Y. Khan & P.K. Jain Tata McGraw

Text Problem and Cases Hill Publishing
Co.Ltd

2 Financial Management - I. M. Pandey Vikas Publishing

Theory and Practices House

3 Financial Management - Prasanna Chandra Tata McGraw

Theory and Practices Hill Publishing
Co.Ltd
Assessment Pattern:
Continuous In-Semester Evaluation End Semester Examination
(Internal Evaluation) (External Evaluation)

40 Marks 60 Marks
Internal Evaluation:
Mid Semester Examination 10 Marks

Quiz (At the end of each module) 05 Marks

Assignments (Minimum 2 Per course) (Class Assignment / Home 10 Marks

Assignment / Seminar / Presentation / Poster presentation)/ or any other
component designed by the instructor

Practical Assignment (One per course) Case Study / Role Play/ 05 Marks

Statistical Report Analysis/ Portfolio Building / Field Assignment

Attendance 10 Marks

Total Continuous In-semester Evaluation 40 Marks

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MEANING OF FINANCIAL MANAGMENT

INTRODUTION
Financial management is that managerial activity which is concerned with the
planning and controlling of the firm's financial resources.
 It was a branch of economics till 1890,
 Separate discipline,
 It is of recent origin. Still,
 It has no unique body of knowledge of its own and draws heavily on
economics for its theoretical concepts even today.

SCOPE OF FINANCIAL MANGEMENT

1. Conceptual and analytical framework
Financial management provides a conceptual and analytical framework for
financial decision makeing.
2. Acquisitions of funds as well as their allocations.
The finance function covers both Acquisitions of funds as well as their
allocations. Thus, apart from the issues involved in acquiring external funds,
the main concern of financial management is the efficient and wise
allocation of funds to various uses.
3. Integral part of overall management.
Defined in a broad sense, it is viewed as an integral part of overall
management.
4. Viewing the financial problems of a firm.
The financial management framework is an analytical way of viewing the
financial problems of a firm. The main contents of this approach are: What is
the total volume of funds an enterprise should commit? What specific assets
should an enterprise acquire? How should the funds required be financed?
5. Modern Concept
Alternatively, the principal contents of the modern approach to financial
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management can be said to be: (1) How large should an enterprise be, and
how fast should it grow? (II) In what form should it hold assets? and (iii) What
should be the composition of its liabilities?
The three questions posed above cover between them the major financial
problems of a firm. In other words, the financial management, according to
the new approach, is concerned with the solution of three major problems
relating to the financial operations of a firm, corresponding to the three
questions of
What is finance?
1. What are a firm's financial activities?
2. How are they related to the firm's other activities?
3. Firms create manufacturing capacities for production of goods; some provide
services to customers. They sell their goods or services to earn profit.
4. They raise funds to acquire manufacturing and other facilities. Thus, the three most
important activities of a business firm are:
⚫ Production
⚫ Marketing
⚫ Finance

5. A firm secures whatever capital it needs and employs it (finance activity) in

activities, which generate returns on invested capital (production and marketing
activities).

Real and Financial Assets

Real Asset= Tangible Asset & Intangible Asset
 A firm requires real assets to carry on its business. Tangible real assets are physical
assets that include plant, machinery, office, factory, furniture and building.
Intangible real assets include technical know-how, technological collaborations,
patents and copyrights.
 Financial assets,
 Financial assets, also called securities, are financial papers or instruments
such as shares and bonds or debentures.
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 Firms issue securities to investors in the primary capital markets to raise

necessary funds. The securities issued by firms are traded - bought and
sold - by investors in the secondary capital markets, referred to as stock
exchanges.
 Financial assets also include lease obligations and borrowing from banks,
financial institutions and other sources.
 In a lease, the lessee obtains a right to use the lessor's asset for an agreed
amount of rental over the period of lease. Funds applied to assets by the
farm are called capital expenditures or investment. The firm expects to
receive return on investment and might distribute return (or profit) as
dividends to investors.

FINANCE FUNCTIONS
 It may be difficult to separate the finance functions from production, marketing
and other functions, but the functions themselves can be readily identified.
 The functions of raising funds, investing them in assets and distributing returns
earned from assets to shareholders are respectively known as financing decision,
investment decision and dividend decision.
 A firm attempts to balance cash inflows and outflows while performing these
functions. This is called liquidity decision, and we may add it to the list of
important finance decisions or functions. Thus finance functions include:
 Long-term asset-mix or investment decision
 Capital-mix or financing decision
 Profit allocation or dividend decision
 Short-term asset-mix or liquidity decision
 A firm performs finance functions simultaneously and continuously in the normal
course of the business. They do not necessarily occur in a sequence. Finance
functions call for skilful planning, control and execution of a firm's activities.

Investment Decision
1. A firm's investment decisions involve capital expenditures. They are, therefore,
referred as capital budgeting decisions.
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2. A capital budgeting decision involves the decision of allocation of capital or

commitment of funds to long-term assets that would yield benefits (cash flows) in
the future.
3. Two important aspects of investment decisions are: (a) the evaluation of the
prospective profitability of new investments, and (b) the measurement of a cut-
off rate against that the prospective return of new investments could be
compared.
4. Future benefits of investments are difficult to measure and cannot be predicted
with certainty. Risk in investment arises because of the uncertain returns.
Investment proposals should, therefore, be evaluated in terms of both expected
return and risk.
5. Besides the decision to commit funds in new investment proposals, capital
budgeting also involves replacement decisions, that is, decision of recommitting
funds when an asset becomes less productive or non-profitable.
6. There is a broad agreement that the correct cut-off rate or the required rate of
return on investments is the opportunity cost of capital.’ The opportunity cost of
capital is the expected rate of return that an investor could earn by investing his
or her money in financial assets of equivalent risk. However, there are problems in
computing the opportunity cost of capital in practice from the available data
and information. A decision maker should be aware of these problems.

1.Financing Decision
1. Financing decision is the second important function to be performed by the
financial manager. Broadly, he or she must decide when, where from and how to
acquire funds to meet the firm's investment needs.
2. The central issue before him or her is to determine the appropriate proportion of
equity and debt. The mix of debt and equity is known as the firm's capital
structure.
3. The financial manager must strive to obtain the best financing mix or the
optimum capital structure for his or her firm. The firm's capital structure is
considered optimum when the market value of shares is maximized.
4. In the absence of debt, the shareholders' return is equal to the firm's return. The
use of debt affects the return and risk of shareholders; it may increase the return
on equity funds, but it always increases risk as well. The change in the
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shareholders' return caused by the change in the profits is called the financial
leverage. A proper balance will have to be struck between return and risk.
5. When the shareholders' return is maximised with given risk, the market value per
share will be maximised and the firm's capital structure would be considered
optimum. Once the financial manager is able to determine the best
combination of debt and equity, he or she must raise the appropriate amount
through the best available sources. In practice, a firm considers many other
factors such as control, flexibility, loan covenants, legal aspects etc. in deciding
its capital structure.

2.Dividend Decision
1. Dividend decision is the third major financial decision. The financial manager
must decide whether the firm should distribute all profits, or retain them, or
distribute a portion and retain the balance. The proportion of profits distributed
as dividends is called the dividend-payout ratio and the retained portion of
profits is known as
2. Like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders' value. The optimum dividend policy is one that
maximises the market value of the firm's shares.
3. Thus, if shareholders are not indifferent to the firm's dividend policy, the financial
manager must determine the optimum dividend-payout ratio. Dividends are
generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares
issued to the existing shareholders without any charge. The financial manager
should consider the questions of dividend stability, bonus shares and cash
dividends in practice.

3.Liquidity Decision
1. Investment in current assets affects the firm's profitability and liquidity. Current
assets management that affects a firm's liquidity is yet another important finance
function. Current assets should be managed efficiently for safeguarding the firm
against the risk of illiquidity.
2. Lack of liquidity (or illiquidity) in extreme situations can lead to the firm's
insolvency. A conflict exists between profitability and liquidity while managing
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current assets. If the firm does not invest sufficient funds in current assets, it may
become illiquid and therefore, risky.
3. But it would lose profitability, as idle current assets would not earn anything. Thus,
a proper trade-off must be achieved between profitability and liquidity. The
profitability-liquidity trade-off requires that the financial manager should develop
sound techniques of managing current assets. He or she should estimate firm's
needs for current assets and make sure that funds would be made available
when needed.
In sum, financial decisions directly concern the firm's decision to acquire or dispose off
assets and require commitment or recommitment of funds on a continuous basis. It is in
this context that finance functions are said to influence production, marketing and
other functions of the firm. Hence finance functions may affect the size, growth,
profitability and risk of the firm, and ultimately, the value of the firm.

The function of financial management is to review and control decisions to commit or

recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial
Management is directly concerned with production, marketing and other functions,
within an enterprise whenever decisions are made about the acquisition or distribution
of assets.

FINANCIAL MANAGER'S ROLE

1. Who is a financial manager? What is his or her role? A financial manager is a
person who is responsible, in a significant way, to carry out the finance functions.
2. It should be noted that, in a modern enterprise, the financial manager occupies
a key position. He or she is one of the members of the top management team,
and his or her role, day-by-day, is becoming more pervasive, intensive and
significant in solving the complex funds management problems.
3. Now his or her function is not confined to that of a scorekeeper maintaining
records, preparing reports and raising funds when needed, nor is he or she a staff
officer-in passive role of an adviser.
4. The finance manager is now responsible for shaping the fortunes of the
enterprise, and is involved in the most vital decision of the allocation of capital.
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5. In his or her new role, he or she needs to have a broader and far- sighted
outlook, and must ensure that the funds of the enterprise are utilised in the most
efficient manner. He or she must realise that his or her actions have far-reaching
consequences for the firm because they influence the size, profitability, growth,
risk and survival of the firm, and as a consequence, affect the overall value of
the firm. The financial manager, therefore, must have a clear understanding and
a strong grasp of the nature and scope of the finance functions.
6. The financial manager has not always been in the dynamic role of decision-
making. About three decades ago, he or she was not considered an important
person, as far as the top management decision-making was concerned. He or
she became an important management person only with the advent of the
modern or contemporary approach to the financial management. What are the
main functions of a financial manager

1.Funds Rising
1. The traditional approach dominated the scope of financial management and
limited the role of the financial manager simply to funds rising.
2. It was during the major events, such as promotion, reorganisation, expansion or
diversification in the firm that the financial manager was called upon to raise
funds. In his or her day-to-day activities, his or her only significant duty was to see
that the firm had enough cash to meet its obligations. Because of its central
emphasis on the procurement of funds,
3. The notable feature of the traditional view of financial management was the
assumption that the financial manager had no concern with the decision of
allocating the firm's funds. These decisions were assumed as given, and he or she
was required to raise the needed funds from a combination of various sources.
4. The traditional approach did not go unchallenged even during the period of its
dominance. But the criticism related more to the treatment of various topics
rather than the basic definition of the finance function. The traditional approach
has been criticized because it failed to consider the day-to-day managerial
problems relating to finance of the firm. It concentrated itself to looking into the
problems from management's the insider's point of view. Thus the traditional
approach of looking at the role of the financial manager lacked a conceptual
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framework for making financial decisions, misplaced emphasis on raising of

funds, and neglected the real issues relating to the allocation and management
of funds.

2.Funds Allocation
1. The traditional approach outlived its utility in the changed business situation
particularly after the mid-1950s. A number of economic and environmental
factors, such as the increasing pace of industrialization, technological
innovations and inventions, intense competition, increasing intervention of
government on account of management inefficiency and failure, population
growth and widened markets, during and after mid-1950s. necessitated efficient
and effective utilisation of the firm's resources, including financial resources.
2. The development of a number of management skills and decision-making
techniques facilitated the implementation of a system of optimum allocation of
the firm's resources. As a result, the approach to, and the scope of financial
management, also changed. The emphasis shifted from the episodic financing
to the financial management, from raising of funds to efficient and effective use
of funds. The new approach is embedded in sound conceptual and analytical
theories.
3. The new or modern approach to finance is an analytical way of looking into the
financial problems of the firm. Financial management is considered a vital and
an integral part of overall management.
4. In this broader view the central issue of financial policy is the wise use of funds,
and the central process involved is a rational matching of advantages of
potential uses against the cost of alternative potential sources so as to achieve
the broad financial goals which an enterprise sets for itself.
5. Thus, in a modern enterprise, the basic finance function is to decide about the
expenditure decisions and to determine the demand for capital for these
expenditures. In other words, the financial manager, in his or her new role, is
concerned with the efficient allocation of funds. The allocation of funds is not a
new problem, however. It did exist in the past, but it was not considered
important enough in achieving the firm's long run objectives.
Manager must find a rationale for answering the following three questions:
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1. How large should an enterprise be, and how fast should it grow?
2. In what form should it hold its assets? How should the funds required be raised?
3. As discussed earlier, the questions stated above relate to three broad decision
areas of financial management: investment (including both long and short-term
assets), financing and dividend.
4. The "modern" financial manager has to help making these decisions in the most
rational way. They have to be made in such a way that the funds of the firm are
used optimally. We have referred to these decisions as managerial finance
functions since they require special care and extraordinary managerial ability.
5. As discussed earlier, the financial decisions have a great impact on all other
business activities. The concern of the financial manager, besides his traditional
function of raising money, will be on determining the size and technology of the
firm, in setting the pace and direction of growth and in shaping the profitability
and risk complexion of the firm by selecting the best asset mix and financing mix.

3.Profit Planning
1. The functions of the financial manager may be broadened to include profit-
planning function. Profit planning refers to the operating decisions in the areas of
pricing, costs, volume of output and the firm's selection of product lines.
2. Profit planning is, therefore, a prerequisite for optimising investment and
financing decisions." The cost structure of the firm, i.e. the mix of fixed and
variable costs has a significant influence on a firm's profitability. Fixed costs
remain constant while variable costs change in direct proportion to volume
changes. Because of the fixed costs, profits fluctuate at a higher degree than
the fluctuations in sales.
3. The change in profits due to the change in sales is referred to as operating
leverage. Profit planning helps to anticipate the relationships between volume,
costs and profits and develop action plans to face unexpected surprises.

4. Understanding Capital Markets

1. Capital markets bring investors (lenders) and firms (borrowers) together. Hence
the financial manager has to deal with capital markets.
2. He or she should fully understand the operations of capital markets and the way
in which the capital markets value securities.
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3. He or she should also know-how risk is measured and how to cope with it in
investment and financing decisions. For example, if a firm uses excessive debt to
finance its growth, investors may perceive it as risky.
4. The value of the firm's share may, therefore, decline. Similarly, investors may not
like the decision of a highly profitable, growing firm to distribute dividend. They
may like the firm to reinvest profits in attractive opportunities that would enhance
their prospects for making high capital gains in the future. Investments also
involve risk and return. It is through their operations in capital markets that
investors continuously evaluate the actions of the financial manager.

Key Activities of the Financial Manager

1. The primary activities of a financial manager are: (1) performing financial analysis
and planning. (i) making investment decisions and (iii) making financing
decisions.

Performing Financial Analysis and Planning

The concern of financial analysis and planning is with (a) transforming financial
data into a form that can be used to monitor financial condition,(b) evaluating
the need for increased (reduced) productive capacity and (c) determining the
additional/reduced financing required. Although this activity relies heavily on
accrual-based financial statements, its underlying objective is to assess cash
flows and develop plans to ensure adequate cash flows to support achievement
of the firm's goals.

Making Investment Decisions

Investment decisions determine both the mix and the type of assets held by a
firm. The mix refers to the amount of current assets and fixed assets, Consistent
with the mix, the financial manager must determine and maintain certain
optimal levels of each type of current assets. He should also decide the best
fixed assets to acquire and when existing fixed assets need to be
modified/replaced/liquidated. The success of a firm in achieving its goals
depends on these decisions.
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Making Financing Decisions

Financing decisions involve two make areas: first, the most appropriate mix of
short-term and long-term financing, second, the best individual short-term or long
term sources of financing at a given point of time. Many of these decisions are
dictated by necessity, but some require an in-depth analysis of the available
financing alternatives, their costs and their long-term implications

OBJECTIVE OF FINANCIAL MANAGEMNT

Profit/EPS Maximization Decision Criterion
1. Maximization of profits/EPS
According to this approach, actions that increase profits (total)/EPS should be
undertaken and those that decrease profits/EPS are to be avoided. In specific
operational terms, as applicable to financial management, the profit
maximization criterion implies that the investment, financing and dividend policy
decisions of a firm should be oriented to the maximization of profits/EPS
2. Owner-oriented concept
The term profit can be used in two senses. As a owner-oriented concept, it refers
to the amount and share of national income which is paid to the owners of
business, that is, those who supply equity capital. As a tariant, it is described as It
is an operational concept? and signifies economic efficiency. In other words,
profitability refers to a situation where output exceeds input, that is, the value
created by the use of resources is more than the total of the input resources.
Used in this sense, profitability maximisation would imply that a firm should be
guided in financial decision making by one test; select assets, projects and
decisions which are profitable and reject those which are not.
3. Maximisation is used in the second sense.
In the current financial literature, there is a general agreement that profit
maximisation is used in the second sense.
4. Profit is a test of economic efficiency
The rationale behind profitability maximization, as a guide to financial decision
making, is simple. Profit is a test of economic efficiency. It provides the yardstick
by which economic performance can be judged. Moreover, it leads to efficient
 17

allocation resources, as resources tend to be directed to uses which in terms of

profitability are the most desirable. Finally, it ensures maximum social welfare.
5. Total economic welfare is maximised.
The individual search for maximum profitability provides the famous 'invisible
hand by which Total economic welfare is maximised.
6. Basic criterion for financial management
Financial management is concerned with the efficient use of an important
economic resource (input), namely, capital. It is, therefore, argued that profit-
ability maximisation should serve as the basic criterion for financial management
decisions.
Criticised on several grounds.
(1) Those that are based on misapprehensions about the workability and faimess
of the private enterprise itself, and
(2) Those that arise out of the difficulty of applying this criterion in actual
situations. It would be recalled that the term objective, as applied to financial
management, refers to an explicit operational guide for the internal investment
and financing of a firm and not the overall goal of business operations. We,
therefore, focus on the second type of limitations to profit maximization as an
objective of financial management.
The main technical flaws of this criterion are ambiguity, timing of benefits,and

quality of benefits.
1. Ambiguity One practical difficulty with profit maximisation criterion for
financial decision making is that the term profit is a vague and ambiguous
concept. It has no precise connotation. It is amenable to different
interpretations by different people.
2. To illustrate, profit may be short-term or long-term; it may be total profit or rate
of profit; it may be before-tax or after-tax;
3. it may return on total capital employed or total assets or shareholders' equity
and so on. If profit maximisation is taken to be the objective, the question
arises, which of these variants of profit should a firm try to maximise?
Obviously, a loose expression like profit cannot form the basis of operational
criterionfor financial management.
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4.Timing of Benefits
A more important technical objection to profit maximisation, as a guide to
financial decision making, is that it ignores the differences in the time pattern of
the benefits received over the working life of the asset, irrespective of when they
were received.
Time-Pattern of Benefits (Profits)
Time Altemative A (in lakh) Altemative A (in lakh)
Period l 50 -
Period ll 100 100
Period lll 50 100
Total 200 200

1. It can be seen from Table 1.1 that the total profits associated with the
alternatives, A and B, are identical. If the profit maximisation is the decision
criterion, both the alternatives would be ranked equally. But the returns from
both the alternatives differ in one important respect, while alternative A
provides higher returns in earlier years, the returns from alternative B are larger
in later years. As a result, the two alternative courses of action are not strictly
identical. This is primarily because a basic dictum of financial planning is the
earlier the better as benefits received sooner are more valuable than benefits
received later. The reason for the superiority of benefits now over benefits
later lies in the fact that the former can be reinvested to earn a return. This is
referred to as time value of money. The profit maximisation criterion does not
consider the distinction between re- turns received in different time periods
and treats all benefits irrespective of the timing, as equally valuable. This is not
true in actual practice as benefits in early years should be valued more highly
than equivalent benefits in later years. The assumption of equal value is
inconsistent with the rear world situation.
Quality Refers to the Degree of certainty With which benefits Can be expected
Risk is the chance That actual out comes May differ from Those expected
Quality of Benefits Probably the most important technical limitation of profit
maximization as an operational objective, is that it ignores the quality aspect of benefits
 19

associated with a financial course of action. The term quality here refers to the degree
of certainty with which benefits can be expected. As a rule, the more certain the
expected return, the higher is the quality of the benefits. Conversely, the more
uncertain/fluctuating is the expected benefits, the lower is the quality of the benefits.
An uncertain and fluctuating return implies risk to the investors. It can be safely assumed
that the investors are risk-averters, that is, they want to avoid or at least minimise risk.
They can, therefore, be reasonably expected to have a preference for a return which is
more certain in the sense that it has smaller variance over the years.
5.Risk-averters want to avoid risk
The problem of uncertainty renders profit maximisation unsuitable as an operational
criterion for financial management as it considers only the size of benefits and gives no
weight to the degree of uncertainty of the future benefits. This is illustrated in Table 1.2.

State of Economy Alternative A Alternative B

Recession 9 0
Normal 10 10
Boom 11 20
total 30 30

It is clear from Table 1.2 that the total returns associated with the two alternatives are
identical in a normal situation but the range of variations is very wide in case of
alternative B while it is narrow in respect of alterative A. To put it differently, the earnings
associated with alterative B are more uncertain (risky) as they fluctuate widely
depending on the state of the economy. Obviously, alternative A is better in terms of
risk and uncertainty. The profit maximisation criterion fails to reveal this.To conclude,
1. The profit maximisation criterion is inappropriate and unsuitable as an
operational objective of investment, financing and dividend decisions of a firm. It
is not only vague and ambiguous but it also ignores two important dimensions of
financial analysis, namely, risk, and time value of money.
2. It follows from the above that an appropriate operational decision criterion for
financial management should (1) be precise and exact, (i) be based on the
 20

bigger the better' principle. (i) consider both quantity and quality dimensions of
benefits, and (iv) recognise the time value of money.

Wealth Maximization Decision Criterion

1. exactness, quality of benefits and the time value of money,
This is also known as value maximisation or net present worth maximisation. In
current academic literature value maximisation is almost universally accepted as
an appropriate operational decision criterion for financial management
decisions as it removes the technical limitations which characterize the earlier
profit maximisation criterion. Its operational features satisfy all the three
requirements of a suitable operational objective of financial course of action,
namely, exactness, quality of benefits and the time value of money,
2. The precise estimation of the benefits associated with it.
The value of an asset should be viewed in terms of the benefits it can produce.
The worth of a course of action can similarly be judged in terms of the value of
the benefits it produces less the cost of undertaking it. A significant element in
computing the value of a financial course of action is the precise estimation of
the benefits associated with it.
3. Cash-flow is a precise concept with a definite connotation.
The wealth maximisation criterion is based on the concept of cash flows
generated by the decision rather than accounting profit which is the basis of the
measurement of benefits in the case of the profit maximisation criterion. Cash-
flow is a precise concept with a definite connotation. Measuring benefits in terms
of cash flows avoids the ambiguity associated with accounting profits. This is the
first operational feature of the net present worth maximisation criterion.
4. Both the quantity and quality dimensions of benefits.
The second important feature of the wealth maximisation criterion is that it
considers both the quantity and quality dimensions of benefits. At the same time,
it also incorporates the time value of money. The operational implication of the
uncertainty and timing dimensions of the benefits emanating from a financial
decision is that adjustments should be made in the cash-flow pattern,
5. Reflects both time and risk.
Firstly, to incorporate risk and, secondly, to make an allowance for differences in
the timing of benefits. The value of a stream of cash flows with value
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maximization criterion is calculated by discounting its element back to the

present at a capitalisation rate that reflects both time and risk.
6. worth to the owners
The value of a course of action must be viewed in terms of its worth to those
providing the resources necessary for its undertaking. In applying the value
maximisation criterion, the term value is used in terms of worth to the owners,
that is, ordinary shareholders.
7. Discount Rate that is employed
The capitalisation (discount) rate that is employed is, therefore, the rate that
reflects the time and risk preferences of the owners or sup- pliers of capital. As a
measure of quality (risk) and timing, it is expressed in decimal notation. A
discount rate of, say, 15 per cent is written as 0.15. A large capitalisation rate is
the result of higher risk and longer time period. Thus, a stream of cash flows that is
quite certain might be associated with a rate of 5 per cent, while a very risky
stream may carry a 15 per cent discount rate.
8. Superior to the profit maximisation as an operational objective
For the above reasons, the net present value maximisation is superior to the profit
maximisation as an operational objective. As a decision criterion, it involves a
comparison of value to cost. An action that has a discounted value-reflecting
both time and risk-that exceeds its cost can be said to create value. Such
actions should be undertaken. Conversely, actions, with less value than cost,
reduce wealth and should be rejected. In the case of mutually exclusive
alternatives, when only one has to be chosen, the alterative with the greatest
net present value should be selected.
9. Creates wealth or shows the greatest amount of net present worth
The gross present worth of a course of action is equal to the capitalised value of
the flow of future expected benefit, discounted (or captialised) at a rate which
reflects their certainty or uncertainty. Wealth or net present worth is the
difference between gross present worth and the amount of capital investment
required to achieve the benefits being discussed. Any financial action which
creates wealth or which has a net present worth above zero is a desirable one
and should be undertaken. Any financial action which does not meet this test
should be rejected. If two or more desirable courses of action are mutually
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exclusive (ie. if only one can be undertaken), then the decision should be to do
that which creates wealth or shows the greatest amount of net present worth.
10. Measured by the uncertainty of the expected benefits
It can, thus, be seen that in the value maximisation decision criterion, the time
value of money and handling of the risk as measured by the uncertainty of the
expected benefits is an integral part of the exercise. It is, moreover, a precise
and unambiguous concept, and therefore, an appropriate and operationally
feasible decision criterion for financial management decisions.

11. The maximisation of the market price of shares

It would also be noted that the focus of financial management is on the value to
the owners or suppliers of equity capital. The wealth of the owners is reflected in
the market value of shares. So wealth maximisation implies the maximisation of
the market price of shares. In other words, maximisation of the market price of
shares is the operational substitute for value/wealth/net present value
maximisation as a decision criterion.
12. In brief, what is relevant is not the overall goal of a firm but a decision criterion
which should guide the financial course of action. Profit/EPS maximisation was
initially the generally accepted theoretical criterion for making efficient
economic decisions, using profit as an economic concept and defining profit
maximisation as a criterion for economic efficiency. In current financial literature,
it has been replaced by the wealth maximisation decision criterion because of
the shortcomings of the former as an operational criterion, as (1) it does not take
account of uncertainty of risk, (ii) it ignores the time value of money, and (iii) it is
ambiguous in its computation.
13. Owing to these technical limitations, profit maximisation cannot be applied in
real world situations. Its modified form is the value maximisation criterion. It is
important to note that value maximisation is simply extension of profit
maximisation to a world that is uncertain and multiperiod in nature. Where the
time period is short and degree of uncertainty is not great, value maximisation
and profit maximisation amount to essentially the same thing."