OBJECTIVES OF FINANCIAL MANAGEMENT:

Financial theory, in general, rests on the premise that the objective of the firm should be to maximise
the value of the firm to its equity shareholders. However, different goals of financial management may
also be identified. These are (i) Profit maximisation, (ii) EPS maximisation and (iii) Maximisation of
return on equity.
Before going to examine different objectives, let us identify four major and crucial functions of financial
management. These are given below along with their impact on firm’s market value.

SOURCE: Capital Structure Decision Return

Direct Impact

Capital Budgeting Decision MV of

Trade-off firm
APPLICATION: Dividend Decision
Inverse Impact

Working Capital Decision Risk

Now, let us examine different goals –

1. Profit Maximization: It is true that a firm is established to earn profit because it serves the basic
objective of the owner. On the other hand, there is no denying the fact that it must have some social
responsibilities also. Profit is a usual concept and it may be considered as the yardstick of measuring
efficiency. It also measures the productivity of capital invested in the business. However, it suffers from
following limitations -

a) The term profit has no definite meaning. It may mean Gross Profit or Net Profit; short-term or long-
term; before tax or after tax etc.
b) Profit in absolute term is not a proper guide for decision-making. Relative measure will give
better idea.
c) It leaves consideration of timing and duration undefined.
d) It glosses over the risk factor. It fails to distinguish between certainty and uncertainty.
e) Profit maximization leads to unhygienic competition and hence fails to satisfy social responsibilities.
f) It may, at best, act as a short term goal, but will not work for the long term sustainability of the firm.

2. EPS and Return on Equity maximization: although the concepts give relative measures, they suffer

from the limitations as mentioned in c, d & e above.

3. Wealth maximization: The objective of the firm should be to maximize the value of the firm to its

equity shareholders. It means maximization of the net present value (NPV) of a course of action. NPV is

the excess of P.V. of future cash inflows over cash outflows. It considers cash inflows instead of profit.

This objective appears to provide a rational guide for business decision-making and promote efficient
allocation of resources in the economic system. Funds are invested primarily on the basis of expected
return and risk and the market value of a firm’s equity stock reflects the risk-return trade-off of
investors as shown by the diagram. This suggests that it allocates resources optimally.
Further, equity shareholders provide the capital and appoint the management and hence it is the
responsibility of corporate management to promote the welfare of equity shareholders.
Value of firm also increases in the long-run when higher customer satisfaction is achieved. Even
efforts towards solving social problems may further (promote) the interest of shareholders in the long-
run by improving the image of the firm. When these other goals seem to conflict, a trade-off between
cost and benefit is required. The maximization of wealth of equity shareholders constitutes the
principal guarantee for efficient allocation of resources in the economy and hence is to be regarded as
the normative goal from financial point of view.

Risk-return relationship of different securities:

Return
Equity Share Capital

Pref. share capital

Risk premium
Bonds and Debentures

Public sector bonds

Govt. securities
Risk-free rate

Risk
Capital Asset Pricing Model (CAPM)-:
According to CAPM, there is a linear relationship between expected return and risk. The
higher the risk, the higher is the expected return. What shareholders expect should be earned
by the company; otherwise, it shall not be able to obtain capital from the shareholders. Thus
the shareholders’ expected rate of return on equity is also the firm’s cost of equity.

 Expected rate of return = Risk-free rate + Risk premium.

OR, ke = Rf + ( Rm – Rf ) , where,
Rm = expected market return
Rf = risk-free return
 = degree of responsiveness of rate of return of
company’s share due to a change in market rate of return
OR relative risk indicator.
Cov. R A , RM 
 ; RA = rate of return in share A & RM = rate of return on the market
M
2

portfolio

This method is considered as the most scientific method and it takes into account investor’s
expectation. However, the method is based on following assumptions –
(i) Investors are risk-averse
(ii) Efficient capital market
(iii) All investors have the same expectation about risk and return
(iv) Lending and borrowing rate is at par with risk free interest rate
(v) All investor’s decisions are based on a single-period horizon
Risk and Return:
Return of a security or investment refers to the additional inflow derived from such investment. For
example, suppose a man invested ₹ 1,00,000 at the beginning of the year in a security or project. He
received ₹ 12,000 during the year from such investment and at the end of the year the value of his
investment goes up to ₹ 1,05,000. In this case his return from the investment is 12,000 + (1,05,000 –
1,00,000) = ₹ 12,000+5,000 = ₹ 17,000. Now if we calculate the rate for a year it will be
17,000*100/1,00,000 = 17%. Thus, total return consists of realized return (12,000) and unrealized
return (5,000). However, return may have different meanings depending upon investors’ perception. It
is sometimes expressed as NP margin or ROI or IRR or Cash inflows.
Risk is the likelihood that actual return from investment may be lesser than the expected return. It
refers to the possibility of loss in future and arises due to the variability in expected return from
investment. Uncertainty is the main cause of risk. The more the uncertainty, the greater is the risk.
Thus, risk can be defined as the cost of information imperfection or information asymmetry. In other
words risk reflects the chance that the actual returns of an investment may be different (lesser) from
the expected return. The degree of risk can be judged by the variability of expected return from the
project. Objectively, it can be measured using standard deviation.
Risks are of two types: systematic (market) and unsystematic (Unique) risk.
Systematic risk arises on account of the economy-wide uncertainties and the tendency of individual
securities to move together with changes in the market. This part of the risk cannot be avoided even
by diversification.
Unsystematic risk arises from the unique uncertainties of individual firm. This part of the risk can be
avoided by appropriate diversification. Such risk can be of two types – Operating or Business risk and
Financial risk.
Examples:
Systematic risk Unsystematic risk

 Government changes interest rate policy  Company workers declare strikes

 The inflation rate increases  The R & D experts leave the company
 The government changes the tax policy  Several competitors enter the market
 Government relaxes the foreign  Existence of high operating fixed cost
exchange controls in cost structure
 Use of huge debt capital in capital
structure