FINANCIAL MANAGEMENT 1) The profit maximization is not an operationaly feasible criteria"Do you agree?

Illustrate your views The profit maximisation is not an operationally feasible criterion.This statement is true because profit maximization can be a short-term objective for any organisation and cannot be its sole objective.Profit maximisation fails to serve as an operational criterion for maximizing the owners economic welfare.It fails to provide an operationally feasible measure for ranking alternative courses of action in terms of their economic efficiency.Finance is regarded as the lifeblood of a business enterprise. It is the basic foundation of all kinds of economic activities. Finance is the master key that provides access to all the sources for being employed in manufacturing and merchandising activities. The success of an organization largely depends on efficient management of its finances. Objectives of Financial Management is generally agreed that the objective of financial management should be maximization of economic welfare of shareholders. In order to achieve this and to make wise decisions, a clear understanding of the objectives which are sought to be achieved is necessary. The objectives provide a framework for optimum financial decision making. The following are the two widely

discusses approaches in financial literature to achieve the above objective. 1. Profit Maximization 2. Wealth Maximization Profit maximization: It is an important concept in economic theory. It simply means that maximizing the rupee income of the firm. According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. The profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits. This objective is justified on the following grounds: The very survival of the organization will be depending upon whether it is able to earn profits or not. Profit is a test of economic efficiency. It indicates the effective utilization of resources. It ensures maximum social welfare. Profit maximization suffers from the following limitations: 1. Profit maximization concept is vague or ambiguous:

The definition of profit itself is ambiguous. Its has no precise connotation. It is amenable to different interpretations by different people. For example, profit may be short-term profit or long-term, it may total profit or rate of profit, it may be before tax or after tax, it may be return on capital employed or return on total assets. Hence, a loose expression like profit cannot form the basis of operational criterion for financial management. 2. It ignores timing of benefits: The second limitation to the objective of profit maximization is that it ignores the differences in time pattern of the benefits received from investment proposals. The principle of the bigger the better is adopted for decision making. 3. It ignores quality of benefits: The profit maximization concept ignores consistency or the degree of certainty in getting returns from investment proposals. In view of the above limitations, the profit maximization criterion is considered as inappropriate and unsuitable operational criterion for financial decisions. It is not only vague and ambiguous but it also ignores risk and time value of money. As an alternative to the profit maximization, the other criterion, that is, wealth maximization is developed.

Wealth Maximization: This is also known as value maximization or net present worth maximization. Net present value is the difference between the gross present value of benefits from an investment proposal and the investment required achieving these benefits. The gross present value of a course of action is found out by discounting or capitalizing its benefits at a rate, which reflects their timing or uncertainty. Any financial action with a positive net present worth should be undertaken otherwise it should be rejected. The objective of wealth maximization resolves two basic limitations of profit maximization. 1. It considers time value of money. 2. It takes care of uncertainty of expected benefits and the benefits are measured in terms of cash flows and not accounting profits. The wealth maximization objective is consistent with the objective of maximization of economic welfare of shareholders. The wealth of shareholders id reflected by the market value of the company shares. Hence, wealth maximization implies the maximization of the market value of the companys shares, which is the fundamental objective of the firm. For the above reasons, the wealth maximization criterion is considered to be superior to the profit maximization as

an operational objective.Profit maximization is considered as the goal of financial management. In this approach, actions that Increase profits should be undertaken and the actions that decrease the profits are avoided. Thus, the Investment, financing and dividend also be noted that the term objective provides a normative framework decisions should be oriented to the maximization of profits. The term profit is used in two senses. In one sense it is used as an owner-oriented.In this concept it refers to the amount and share of national Income that is paid to the owners of business. The second way is an operational concept i.e. profitability. This concept signifies economic efficiency. It means profitability refers to a situation where output exceeds Input. It means, the value created by the use of resources is greater that the Input resources. Thus in all the decisions, one test is used I.e. select asset, projects and decisions that are profitable and reject those which are not profitable.The profit maximization criterion is criticized on several grounds. Firstly, the reasons for the opposition that are based on misapprehensions about the workability and fairness of the private enterprise itself. Secondly, profit maximization suffers from the difficulty of applying this criterion in the actual real-world situations. The term objective refers to an explicit operational guide for the internal investment and financing of a firm and not the overall business operations. Profit maximization implies that either a firm produces maximum output for a

given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency. Let us elaborate the term efficiency.In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. Objections to Profit Maximization is argued that the assumption of perfect competition may not be valid. Also it is argued that an objective developed in the early 19th century when the characteristic features of business structure were selffinancing, private property and single entrepreneurship.

The only aim of the single owner then was to enhance individual wealth, which could easily be satisfied by the profit maximization objective. But modern businesses are characterized by a separation of management and ownership. The stakeholders of a business organization are varied and include shareholders, lenders, customers, employees, government and society. The objectives of these different stakeholders differ and may conflict with each other. The manager of the firm has the challenging task of reconciling these conflicting objectives. Therefore, in such a business situation, profit maximization is regarded as unrealistic, difficult, inappropriate and socially irresponsible.Another criticism is that such an objective tends to result in production of goods and services that are unnecessary from societys point of view. It might also lead to inequality of income and wealth. The price system and therefore, the profit maximization principle may not work due to imperfections in practice. Firms producing same goods and services substantially differ in terms of technology, costs and capital. Therefore, it is difficult to have a truly competitive price system. Thus, it is strongly doubted that the sole objective of profit maximization can lead to social welfare. But it would be incorrect to do away with this objective. Rather, government intervention is required to minimize any market imperfections that exist and make the market truly competitive.

Traditional approach The traditional approach to financial management was popular in the initial stages of its evolution as a separate branch of academic study. Under this approach the role of finance smanager was limited to raising and administering of funds needed by the corporate enterprises to meet their financial needs. It broadly covers the following three aspects: 1.Arrangement of funds from financial institutions. 2.Arrangement of funds through instruments as shares, bonds etc. 3.The legal and accounting relationships between a firm and its sources of funds. The scope traditional approach to the scope of finance function evolved during the 1920s and 1930s and dominated academic thinking during the fifties and through the early forties. It has now been discarded as it suffers from serious limitations. Modern approach The traditional approach outlived its utility due to changed business situations since mid 1950s. The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. According to it, the finance function covers both funds as well as their allocations.

The new approach is an analytical way of viewing the financial problems of a firm . The principle contents of the modern approach to financial management can be said to be: * How large should an enterprise be, and how fast it should grow *In what form should it hold assets *What should be the composition of its liabilities The questions posed above cover between them the major financial problems of a firm. In other words, financial management, according to the new approach is concerned with the solution of three major problems relating to the financial operations of a firm. They are: 1.The investment decision 2.The dividend policy decision. Thus,finance is regarded as the lifeblood of a business enterprise.The success of an organization largely depends on efficient management of its finances. 3. When the corporate income taxes are assumed to exist Modigilani-Miller and the traditional theorists agree that capital structure does affect value. So the basic point of disputes disappears. Do you agree? Why or why not? According to many research of corporation finance, the capital structure decision is one of the most fundamental issues facing to the executives and management level.

The corporate finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The discipline as a whole may be divided among longterm and short-term decisions and techniques with the primary goal being maximizing corporate value while managing the firm's financial risks. Capital investment decisions are long-term choices that investment with equity or debt, and the short-term decisions deals with the balance of current assets and current liabilities which is managing cash, inventories, and short-term borrowing and lending. Corporate finance can be defined as the theory, process and techniques that corporations use to make the investing, financing and dividend decisions that ultimately contribute to maximizing corporate value.Thus, a corporation will first decide in which projects to invest, then it will figure out how to finance them, and finally, it will decide how much money, if any, to give back to the owners. All these three dimensions which are investing, financing and distributing dividends are interrelated and mutually dependent. The capital structure of a company refers to a combination of debt, preferred stock, and common stock of finance that it uses to fund its long-term financing. Equity and debt capital are the two major sources of long-term funds for a firm. The theory of capital structure is closely related to the firm's cost of capital. As the enterprises to obtain funds

need to pay some costs, the cost of capital in the investment activities is also the main consideration of rate of return. The weighted average cost of capital (WACC) is the expected rate of return on the market value of all of the firm's securities. WACC depends on the mix of different securities in the capital structure; a change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least. The decision regarding the capital structure is based on the objective of achieving the maximization of shareholders wealth. With regard to the capital structure of the theoretical basis, most well-known theory is Modigliani-Miller theorem of Franco Modigliani and Merton H.Miller (1958 and 1963). Yet the seeming simple question as to how firms should best finance their fixed assets remains a contentious issue. The Modigliani-Miller Proposition I Theory (MM I) states that under a certain market price process, in the absence of taxes, no transaction costs, no asymmetric information and in an perfect market, the cost of capital and the value of the firm are not affected by the changed in capital structure. The firm's value is determined by its real assets, not by the securities it issues. In other words, capital structure decisions are irrelevant as long as the firm's investment decisions are taken as given.

The Modigliani and Miller (1958) explained the theorem was originally proven under the assumption of no taxes. It is made up of two propositions that are (i) the overall cost of capital and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. (ii) The financial risk increase with more debt content in the capital structure. As a result, cost of equity increases in a manner to offset exactly the low cost advantage of debt. Hence, overall cost of capital remains the same. The assumptions of the MM theory are: 1. There is a perfect capital market. Capital markets are perfect when investors are free to buy and sell securities investors can trade without restrictions and can borrow or lend funds on the same terms as the firms do investors behave rationally investors have an equal access to all relevant information capital markets are efficient no costs of financial distress and liquidation there are no taxes 2. Firms can be classified into homogeneous business risk classes. All the firms in the same risk class will have the

same degree of financial risk. 3. All investors have the same view for the investment, profits and dividends in the future; they have the same expectation of a firm's net operating income. 4. The dividend payout ration is 100%, which means there are no retained earnings. In the absence of tax world, base on MM Proposition I, the value of the firm is unaffected by its capital structure. In other words, regardless of whether a company has liabilities, the total risk of its securities holders will not change even the capital structure is changed. As the weighted average cost of capital unchanged, so must the same as the total value of the company. That is VL = VU = EBIT/ requity where VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity, VU is the value of an unlevered firm = price of buying a firm composed only of equity and EBIT is earnings before interest and tax. Whether or not the company has loans or the loans for high or low, investors are all accessible through the following two kinds of investment on their own to create the desired type of earning. 1. direct invested in the company's stock borrowing 2. if shares of levered firms are priced too high, investors will try to take advantage of borrowing on their own and use the money to buy shares in unlevered firms. The use

of debt by the investors is known as homemade leverage. The investors of homemade leverage can obtain the same return as the levered firms, therefore, for investors; the value of the firm is not affected by debt-equity mix. The MM Proposition I assumptions are quite unrealistic, there have some implications, (i) Capital structure is irrelevant to shareholder wealth maximization. (ii) The value of the firm is determined by the firm's capital budgeting decisions. (iii) Increasing the extent to which a firm relies on debt increases both the risk and the expected return to equity - but not the price per share. (iv) Milton Harris and Artur Raviv (1991) illustrated the asymmetric information that firm managers or insiders are assumed to possess private information about the characteristics of the firm's return stream or investment opportunities. They will know more about their companies' prospects, risks and values than do outside investors. Then it cannot fulfill the assumption of perfect market. Based on the inadequate of MM Proposition I, Franco Modigliani and Merton H.Miller revised their theory in 1963, which is MM Proposition II. The Modigliani-Miller Proposition II Theory (MM II) defines cost of equity is a linear function of the firm's debt/equityratio. According to them, for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital plus a premium for the financial risk, which is equal

to debt/equity ratio times the spread between average cost and cost of debt. Also Modigliani and Miller (1963) recognized the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the value of corporation can be achieved by maximizing debt component in the capital structure. This theory of capital structure for the study provided an important and analytical framework. According to this approach, value of a firm is VL = VU = EBIT (1-T) / requity + TD where TD is tax savings. MM Proposition II is assuming that the tax shield effect of each is the same, and continued in sight. Leverage firms are increased in interest expense due to reduced tax liability, has also increased the allocation to the shareholders and creditors of the cash flow. The above formula can be deduced from the company debt the more the greater the tax saving benefits, the greater the value of the company. The revised capital structure of the MM Proposition II, pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company's value. Therefore, the value and cost of capital of corporation with the capital structure changes in different leverage, the value of the levered firm will exceed the value of the unlevered firm.

MM Proposition theory suggests that the higher the debt ratio is more favorable to corporate, but though borrowing adds an interest tax shield it may lead to costs of financial distress. Financial distress occurs when promises to creditors are broken or honored with difficulty. Financial distress may lead to bankruptcy. The trade-off theory of capital structure theory in MM based on the added risk of bankruptcy and further improves the capital structure theory, to make it more practical significance. Trade-off Theory of capital structure According to Myers (1984), a firm that follows the trade-off theory sets a target debt to value ratio and then gradually moves towards the target. The target is determined by balancing the tax benefits of using debt against costs of financial distress that rise at an increasing rate with the use of leverage. It so predicts moderate amount of debt as optimal. But there is evidence that the most profitable firm in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low. This fact contradicts the theory because if the distress risk is low, an increase of debt has a favorable tax effect. Under the trade-off theory, high profits should mean more debt-servicing capacity and more taxable income to shield and therefore should result in a higher debt ratio. Pecking Order Theory of capital structure The pecking order theory stems from Myers (1984) argues that adverse selection implies that retained earnings are

better than debt and debt is better than equity. Firms prefer internal finance and if external finance is required, firms issue debt first and issue equity only as a last resort. The pecking order explains why the most profitable firms generally borrow less because they have low target debt ratios but they don't need outside money. As in Baskin (1989), asymmetric information affects capital structure by limiting access to outside finance. Managers know more than outside investors about the profitability and prospects of the firm. Information problems are particularly acute with common stock, announcement of stock issue can drive down the stock price. Conclusion The capital structure decision is one of the most fundamental issues in corporate finance. Regardless of which kind of capital structure, to achieve one of the most optimal capital structures, the company should be mixture of equity and debt and it cannot only focus on equity or debt. Equity is a cushion and debt is a sword, debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. In general, there are differences in the capital structures of different industries; they are having their own characteristic. The most important thing is the company's liquidity is sufficient or not. In making the decision of how to allocate the fund in which type of assets, the company has to consider and compare the

different factors such as NPV, IRR and payback period. In evaluating the NPV, IRR and payback period, cash inflow is fund of the vital element. Therefore the company should know how to obtain the financing and how to invest it. They should carefully to allocate their resources to maximize the firm value.