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TOPICS 1. FINANCIAL DECISIONS, INVESTMENT DECISIONS AND DIVIDEND DECISIONS 2. FINANCIAL MANAGEMENT PROCESS 3. PROFIT MAXIMIZATION AND WEALTH MAXIMIZATION
FINANCIAL DECISIONS • These are decisions concerning financial matters of a business firm. • There aim is to maximize shareholder’s wealth • Examples : - kinds of assets to be acquired, pattern of capitalization, distribution of firm’s income etc. • Financial decisions are of three types : - FINANCIAL DECISIONS INVESTMENT DECISIONS FINANCING DECISIONS DIVIDEND DECISIONS
INVESTMENT DECISIONS v Relates to determination of Ø total amount of assets to be held in the firm Ø composition of these assets Ø business risk complexions of the firm v Most important financial decision as funds available are limited and need to be utilized properly v Further classified into two categories : Ø Long term investment decision or capital budgeting Ø Short term investment decision or working capital management 1. CAPITAL BUDGETING : - It is the process of making investment decisions in capital expenditure, benefits of which are expected over a long period of time exceeding one year. Investment decision should be evaluated in the terms of expected profitability, costs involved and the risks associated. This decision is important for setting new units, expansion of present units, reallocation of funds etc. 2. SHORT TERM INVESTMENT DECISION : - It relates to allocation of funds among cash and equivalents, receivables and inventories. Such decision is influenced by trade off between liquidity and profitability. Proper working capital management policy ensures higher profitability, proper liquidity and sound structural health of the organization.
FINANCING DECISIONS v Firm must decide best means of financing for new assets and best overall mix of financing for the firm v Select such sources which will make optimum capital structure v Important to decide the proportion of various sources in the overall capital mix v Debt-equity ratio should be fixed in such a way that it helps in maximizing the profitability of the concern v More debts will increase the return on equity but will involve fixed interest liability v More equity will bring permanent funds but the shareholders will expect higher rates of earnings v Therefore there must be a proper balance between various sources v If capital structure is able to minimize the risk and raise the profitability then the market prices of the shares will go up maximizing the wealth of shareholders.
Dividend Decisions � Relates to the disbursement of profits back to investors who supplied capital to � � � the firm. The term dividend refers to that part of profits of a company which is distributed by it among its shareholders. It is the reward of shareholders for investments made by them in the share capital of the company. A decision has to be taken whether all the profits are to be distributed, to retain all the profits in business or to keep a part of profits in the business and distribute others among shareholders. The higher rate of dividend may rise the market price of the shares and thus, maximise the wealth of shareholders. The firm should also consider the question of dividend stability, shock dividend (bonus shares) and cash dividend.
� � � Inter-relation of Financial Decision All financial decisions have same objective i. e. maximization of shareholders’ wealth. All financial decisions influence one another and are Inter-dependent. For example, the decision to invest in some proposal cannot be taken in isolation without having necessary finance available for the same. The financing decision in turn is influenced by and also influences the dividend decision. In case the profits are retained for financing of the investment, the profits available for distribution to the shareholders as dividends are reduced. An efficient financial management thus, has to be taken the optimal joint decision by evaluating each of the decision involved in relation to its effect on shareholders’ wealth and by considering the joint impact of these decisions on the market value of the company’s shares. INVESTMENT DECISION FINANCING DECISION DIVIDEND DECISION
Financial Management Is concerned with Financing decision Investment decision Analysis Risk and Return Relationship (trade off) To achieve the goal of Wealth Maximisation Dividend decision
FINANCIAL MANAGEMENT PROCESS • • • It begins with the financial planning and decisions. While implementing these decisions, firm has to acquire certain risk and return characteristics. These characteristics determine the market price of shares and shareholders wealth. The process must include feedback system to enable to take corrective measures, if required. Following figure depicts the process of financial management FINANCIAL MANAGEMENT PROCESS Financial planning and control Feedback Financial decisions 1. Investment decisions 2. Financing decisions 3. Dividend decisions Risk and return Characteristics of the firm Market price of share P 0 Shareholder Wealth W 0 = NP 0
Factors Influencing Financial Decisions � There are number of (both external as well as internal ) factors that influence the financial decisions. � A list of the important external as well as internal factors influencing the decisions as given below: A. External factors: v State of economy v Structure of capital and money markets v Government policy v Taxation policy v Lending policy of financial institutions B. Internal factors: v nature and size of business v Expected return, cost and risk v Composition of assets v Structure of ownership v Trend of earnings v Liquidity position v Working capital requirements v Conditions of debt agreements.
Profit maximization Ø Profit earning is the main aim of every economic activity. Ø It is the measure of efficiency of a business enterprise. Ø It also serve as a protection against risks Ø Accumulated profits enable a business to face risks like fall in prices, competition from other units adverse government policies. Ø Arguments in favour of profit maximization as the objective of business : - a) b) c) d) e) When profit - earning is the aim of business then profit maximization should be the obvious objective. Profitability is a barometer for efficiency and economic prosperity of a business enterprise , thus , profit maximization is justified o the grounds of rationality. Business should aim at maximization of profits for enabling its growth and development. A firm by pursuing the objective of profit maximization socio-economic welfare. A business will be able to survive under unfavourable situation, only if it has some past earnings to rely upon. Therefore a business to try to earn more and more when situation is favorable.
� Profit maximization as an objective of financial management has been considered inadequate. Even as an operational criterion for maximizing owner’s economic welfare, profit maximization has been rejected because of the following drawbacks : a) The term ‘profit’ is vague and it cannot be precisely defined. It means different things for different people. Even if, we take the meaning of profits as earnings per share and maximize the earnings per share, it does not necessarily mean increase in the market value of the shares and the owner’s economic welfare. b) It ignores the time value of money and does not consider the magnitude and timings of earnings. It treats all earnings as equal though they occur in different periods. c) It does not take into consideration the risk of the prospective earnings stream. d) The effect of dividend policy on the market price of the shares is also not considered in this objective. The following elements are involved in profit maximization. q Increase in revenues – all efforts should be made to increase the sales which will increase the revenue receipts. Profits can be increased either by raising the price of products or by increasing the volume of sales. q. Controlling costs – another way of increasing profit is to control or reduce costs. This will increase the margin of profit per unit. The costs may be controlled by controlling material wastages, increasing labour efficiency etc.
WEALTH MAXIMIZATION When the firm maximises the stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. It means that by maximizing the stockholder’s wealth the firm is operating consistently towards maximizing stockholder’s utility. STOCKHOLDER’S CURRENT WEALTH IN A FIRM = MAXIMUM UTILITY NUMBER OF SHARES OWNED MAXIMUM STOCKHOLDER’S WEALTH * CURRENT STOCK PRICE PER SHARE MAXIMUM CURRENT STOCK PRICE PER SHARE Implications of wealth maximization – it serves the interest of suppliers of loaned capital, employes , management and society. It not only serves shareholder’s interests but insures security to lenders also. Productivity and efficiency of employees is the primary consideration in raising company’s wealth. The efficient allocation of productive resources will be essential for raising the wealth of the company. The economic interest of the society are served if various resources are put to economical and efficient use.
CRITICISM OF WEALTH MAXIMIZATION It is a prescriptive idea § It is not necessarily socially desirable § There is controversy whether the objective is to maximize stockholder’s wealth or wealth of the firm § It may face difficulties when ownership and management are seperated. §