Efficient financial management necessitates the presence of clear objectives or goals. These objectives provide the benchmark for evaluating the efficiency of financial decisions. The two primary objectives of financial management are:
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Profit Maximization
Traditionally, the prevailing argument has been that a company’s ultimate goal is profit. Consequently, financial management’s objective is often framed as profit maximization. However, relying solely on profit maximization poses challenges:
a) Vagueness of Profit: The term “profit” is ambiguous, carrying different meanings for different individuals.
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b) Risk-Return Relationship: Profit maximization, when pursued without considering risks, may lead to acceptance of highly risky proposals.
c) Temporal Oversight: Profit maximization as an objective overlooks the time pattern of returns, neglecting the flow and timing of profits.
d) Social and Moral Obligations: An exclusive focus on profit fails to consider social responsibilities and ethical trade practices, potentially jeopardizing the company’s longevity.
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Wealth Maximization
Companies fixated on profit maximization in the short run may adopt policies detrimental to long-term growth and overall interests. The emphasis, instead, should be on maximizing the company’s value or wealth.
According to Van Horne, a firm’s value is represented by the market price of its common stock. This takes into account present and prospective future earnings, timing and risk of these earnings, dividend policies, and other factors influencing stock market prices. Share prices, in the long term, reflect the value attributed by various parties to the company.
The value is influenced by:
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- Likely Earnings Per Share (EPS): Reflects the company’s future profitability.
- Capitalization Rate: Represents investor preferences based on risk and other qualitative factors.
The market value of a share hinges on EPS and the capitalization rate. As profit maximization faces technical limitations, financial decisions should aim to maximize the market value of the company’s shares in the long run. Wealth maximization, optimizing EPS considering risk and other factors, emerges as a superior objective compared to a narrow focus on return and risk.
While there’s a growing emphasis on social obligations, especially in public sector enterprises, wealth maximization needs to align with these broader responsibilities. Financial decision-making should positively impact business objectives, even if wealth maximization doesn’t always equate to maximizing financial returns, as seen in certain undertakings with specific technological development goals.