In this unit, we will be shown the financial goal of a firm which is shareholders’ wealth maximization as reflected in the market value of business equity – owners’ contributions/shares.
At the end of this unit, you should be able to:
- identify financial goal of a business firm
- discuss profit maximization
- Explain wealth maximization.
3.0 MAIN CONTENT
3.1 Profit Maximization
In the market economy of a country, prices of goods and services are determined by the forces of demand and supply. Firms produce goods and services desired by the community in which they serve as efficiently as possible. It is worthy of note that a business organisation’s financing and investment decisions remain continuous in response to the business activities and circumstances around them.
Price mechanism (system) is a vital organ of a market economy, showing the goods and services required in the community. When the goods and services are in high demand, their prices will rise. This will give rise to higher profit margin. Other Firm with similar or complementary goods and services will intensify competition in order to have a share of the market. The equilibrium price will eventually be reached where demand and supply match. Business firms are frequently profit oriented with maximization of profit as the proper objective.
What is Profit?
It may be expressed as the amount a business can spend in a period and be as “well off” at the end of the period than as at the beginning. In this statement, there are limitations and complications like:
- What determines the “well off” of a business (the size and magnitude of activities)?
- Is it maximising total profit or rate of profit?
- Other problems are risk associated with a project
- Profit maximization neglects differences in the degree of risk associated with different income streams.
Risk is the expected variability of the income flow.
This is why Pandey (2005) summarised profit maximization limitations as follows:
- It is vague
- It ignores the timing of returns
- It ignores risk.
Profit maximization objective is not always clear. It may not specify period – short, medium or long term profit – profit before or after tax; total or relative profit; total operating profit or accruing profit.
SELF ASSESSMENT EXERCISE 1
What is profit maximization limitation?
3.2 Wealth Maximization
This is one of the financial goals of a business enterprise. Yes! You should recall in our previous study that Firm’s management controls the firm, but the shareholders/entrepreneur are the owners of the business Firm. It is then incumbent on the owners to specify the business concern’s primary objective to maximize the utility of the entrepreneurs/owners. Apart from profit making and maximization, the investors (the contributors to the capital base) wealth should be maximized through the manner of profit sharing.
The finance manager should use it as a basis for making decisions concerning:
- Growth of the business and the owners’ delight too.
The financial thrust should correspond with business owners / entrepreneurs primary goal. It is pertinent, at this point, to note that the best primary financial goal to meet the above stated criteria is to maximise the business organisation’s value to the existing owners/entrepreneurs.
Market value assessment of the appropriate prices of a business is considered thus:
- Current and expected income
- Uncertainty and timing of income streams
- Dividend policy
- Other factors the market considers relevant
The market price hereby reflects the markets’ view of management’s activity record of business investment, financing and dividend decisions. Invariably, the market’s view is largely based upon information provided by management in the business’s annual and other reports.
A brief consideration of whether the goal of maximizing the business’s value to existing shareholders meets the three criteria earlier specified.
- Consider if the objective is operational: Finance Officer can evaluate alternative courses of action and choose which will increase the business value to the owners by the largest amount.
- This objective overcomes the problems inherent in the profit maximization objective in that the market price of a business’s contribution/shares is an unambiguous concept and its determination takes account of the time value of money and risk.
- Finally, it is reasonable to assume that the objective is reasonable and consistent with owners/entrepreneurs’ interests.
To sum it up then, we should note that the goal of the firm and that of managers and employees are to maximize the wealth of the owners for who the business is being managed, which in turn, is measured by the value of contribution by owner(s). Therefore, when the finance manager is considering each financial decision, alternative or realistic action, in the light of impact on the firm’s contribution, value/ price, he should accept only those actions that are expected to increase contributor’s price.
SELF ASSESSMENT EXERCISE 2
In your own words, highlight the limitations of profit maximization.
3.3 Financial Goal and firm’s Mission/Objectives
Pandey (2005) stated that the basis of the theory of financial management is the same as that of maximisation of owners’ welfare (classical theory of the firm). Every corporate business Firm states categorically their vision, mission and values in broad terms and is also concerned about technology, leadership, productivity, market standing, image, profitability, financial resources, employee satisfaction etc.
- Objectives and decision criteria should be distinct.
- Goals or objectives are missions or basic purposes of a business’s existence. They direct the firm’s actions.
- The strategies are designed on these basic objectives.
- Defines its markets, products and technology.
- Policies are laid down in areas of production, purchase, marketing, technology, finance etc.
SELF ASSESSMENT EXERCISE 3
Picture yourself as an entrepreneur.
On this basis, develop a typical mission and objectives of your business.
We have attempted a simplified approach to understanding financial goal of a business firm which we have seen as not being simply profit maximization but considering the well being of the investors too. The two have to be balance by the finance officer in-charge to impact positively on the society.
This unit is summarized thus:
- The identification of financial goals of a firm seen through profit maximization and wealth maximization.
- The blend of the two effectively and efficiently by the financial manager gives the society a good turnaround of the business performance.
- Each firm produces a mission and objectives to synchronize with the financial goals to produce goal befitting the entrepreneurs own.
6.0 TUTOR-MARKED ASSIGNMENT
- Identify main financial goal of a business concern.
- Explain financial goal based on firm mission and objectives fulfilment.