Page 10 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 2. Profit maximization, as an objective does not take into account time pattern of return.

Example: Proposal A may give a higher amount of profits compared to proposal B,
yet if the returns begin to flow say, 10 years later, proposal B may be preferred,
which may have lower overall profits but the returns flow is more early and
quick.
3. Profit maximization, as an objective is too narrow. It fails to take into account the social
considerations as also the obligations to various interests of workers, consumers, society
as well as ethical trade practices. Further, most business leaders believe that adoption of
ethical standards strengthen their competitive positions.
4. Profits do not necessarily result in cash flows available to the stockholder. Owners receive
cash flow in the form of either cash dividends paid to them or proceeds from selling their
shares for a higher price than paid initially.

Modern Approach—Wealth Maximization
The alternative to profit maximization is wealth maximization. This is also known as Value
Maximization or Net Present Worth Maximization. Value is represented by the market price of
the company’s equity shares. Prices in the share market at a given point of time, are the result of
many factors like general economic outlook, particularly if the companies are under
consideration, technical factors and even mass psychology. However, taken on a long-term
basis, the share market prices of a company’s shares do reflect the value, which the various
parties put on a company. Normally, the value is a function of two factors:
1. The likely rate of earnings per share (EPS) of a company and

2. The capitalization rate
EPS are calculated by dividing the periods total earnings available for the firm’s common shares
by the number of shares of common shares outstanding. The likely rate of earnings per share
(EPS) depends on the assessment as to how profitably a company is going to operate in the
future.

!
Caution The capitalisation rate reflects the liking of the investors for a company.
If the company earns a higher rate of earning per share through risky operations or risky
financing pattern, the investors will not look upon its shares with favour. To that extent, the
market value of the shares of such a company will be low. If a company invests its fund in risky
ventures, the investors will put in their money if they get higher return as compared to that
from a low risk share.
The market value of a firm is a function of the earning per share and the capitalisation rate.

Example: Suppose the earning per share is expected to be 7 for a share, and the
capitalisation rate expected by the shareholder is 20 per cent, the market value of the share is
likely to be

7 7 100
  35
20% 20
This is so because at this price, the investors have an earning of 20%, something they expect from
a company with this degree of risk.

4 LOVELY PROFESSIONAL UNIVERSITY