The Finance Function and its Objectives

Financial Management

Financial Management (FM) is the managerial activity concerned with the planning, organizing, directing, and controlling of the financial resources of an enterprise. It focuses on the efficient acquisition and utilization of funds to achieve business objectives.

• Key Decisions of FM (The Three Pillars):

• Investment Decisions (Long-Term/Capital Budgeting): Deciding where the firm’s funds will be invested, i.e., in fixed assets (land, machinery) or current assets (inventory, cash).
  • Example: Should a company buy a new, automated machine for $50,000, which is expected to save $10,000 per year for 8 years? (This involves techniques like Net Present Value – NPV).
• Financing Decisions (Capital Structure): Deciding on the optimal mix of debt (loans, debentures) and equity (share capital, retained earnings) to finance the firm’s investments.
  • Example: Should the company raise $1 Million by issuing 50% Equity and 50% Debt, or 70% Equity and 30% Debt?
• Dividend Decisions: Deciding how much of the net profit should be distributed to shareholders as dividends and how much should be retained for re-investment (retained earnings).
  • Example: Out of a net profit of $10,000, should the firm declare a 60% dividend ($6,000) or a 40% dividend ($4,000)?

. Wealth Maximization (The Superior Objective)

• Goal: Maximizing the Net Present Value (NPV) of the course of action, which translates to maximizing the market value of the company’s equity shares.

• Shareholder Wealth=Number of Shares×Market Price per Share

• Focus: Long-term.
• Pros:

• Considers Risk: The market price of a share inherently discounts the future cash flows by a rate that reflects the project’s risk. Higher risk leads to a lower share price, all else being equal.
• Considers Time Value of Money: It uses the concept of NPV and discounted cash flows.
• Focuses on Cash Flows: It is based on future cash flows, which are more relevant than accounting profit.

Conclusion: Wealth maximization is the universally accepted operational goal of financial management as it considers both the timing and risk associated with expected returns.

. Profit Maximization

• Goal: Maximizing the total profit or Earnings Per Share (EPS) of the company.
• Focus: Short-term.
• Pros: Simple, clear cut, easy to calculate (e.g., maximizing revenue over cost).
• Cons (Why it’s generally rejected as the sole objective):
  1. Ignores Timing of Returns: A high profit now is generally preferred to an equal profit later, but profit maximization doesn’t account for the Time Value of Money.
  2. Ignores Risk: It promotes projects with the highest absolute profit, even if they are extremely risky. A risky project that yields $10 Million is preferred over a less risky project that yields $9 Million.
  3. Vague Term: Profit is ambiguous (Net Profit, Profit Before Tax, etc.).

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