Maximization a Goal of Financial Management †MyAssignmenthelp.com

Question: Discuss about the Maximization a Goal of Financial Management. Answer: Introduction: Shareholders are the owners of the company as they have invested their money in the form of shares in the company. Maximization of shareholders wealth is a modern concept which emphasizes in increasing the value of shareholder's money in the company, in other words, providing higher and higher return on shareholder's investment. Maximization of shareholder's wealth can be achieved by increasing the value of the company. The increased value of the company can be achieved by increasing the net worth of the business i.e. either by making higher profits or by purchasing assets having future benefits in terms of generating higher cash flows or reducing its liabilities. The shareholders wealth is calculated or is evident by the market prices of the shares of the company as higher the share price, the higher the value of the company and vice-versa. The net worth of the company is calculated as below: Total assets Outsiders Liabilities or Total funds attributable to the shareholders So, the maximization of shareholder's wealth is somewhat related to the maximization of profit concept. As the concept of maximization of profit asks the management to increase the profits of the company by reducing its expenses or making higher sales and increase in profits will lead to increase in net worth of the business thereby increasing the shareholders wealth. However, there are some differences between the two concepts. The profit maximization has a short term horizon whereas wealth maximization is a long term goal. Wealth maximization is not only concerned with the profits but also with the cash flows to be generated in the future. On the other hand, profit maximization just emphasizes on creating profits whereas wealth maximization emphasizes on creating the value to the business. This includes increasing sales, capturing more market shares, more customer satisfaction, building goodwill for the business and so on. Creation of value of business is a slow and steady process which takes years for a business to develop. So, we can say that profit maximization is a sub concept or sub ordinate to wealth maximization. However, the concept of maximization of shareholder's wealth is criticized by some people, because this concept emphasizes on creating more and more wealth to the shareholder's by increasing profits or reducing expenses. In order to reduce expenses, sometimes management cut down the necessary expenses, which have negative long term impacts. For example, to reduce expenses, management decides not to buy sufficient safety equipment for the workers, thereby putting workers health at risk. Hence, from the above we can conclude that since shareholder's are the owners of the company and they will always want to increase the returns on their money, so it becomes utmost important for the management to keep their shareholder's happy by making their will true. So that, the shareholders invests their money in the business as and when required. Further, the management should try to make a trade-off between its objectives so that the ultimate objective of financial management i.e. to maximize the shareholders wealth can be achieved. That's why maximization of shareholder's wealth is an important concept in any business or in the field of finance. Evaluating mutually exclusive projects using the IRR and NPV approaches can be problematic. Discuss this statement. In the business, many times there comes a situation in which more than one projects / offers are available with the company and the company needs to select the projects / offer which best suits the company. These types of projects are known as mutually exclusive projects. This means that out of 2 projects the company can only accept one project and has to reject the second project. In such a situation, proper evaluation of the projects becomes mandatory. To evaluate the projects, capital budgeting techniques are used. Two such popular and commonly used techniques are NPV and IRR. NPV refers to net present value. This technique calculates the net present value of cash flows to be generated by the given projects during their life span. It ranks the projects according to their NPVs. The higher the NPV the better the project is and vice-versa. Under this method, the present value of all the cash outflows (i.e. the investment required for the project) and the present value of all the cash inflows are calculated and the difference between the present value of cash inflow and present value of cash outflow is termed as net present value. If the NPV is zero then it means that the project is at a position of no profit and no loss meaning thereby all the money invested will be received back. The other popular and effective technique is IRR. IRR refers to internal rate of return. This method involves finding a discount rate at which NPV becomes zero. It is expressed as a percentage. This method states that if the resultant IRR is greater than the cost of capital or required rate of return than the project should be taken or if the IRR is less than the cost of capital or required rate of return than the project should be rejected. Similar to NPV, the higher the IRR, the better it is and vice-versa. But sometimes, the evaluation of mutually exclusive projects using the IRR and NPV provides conflict results. This can be due to unequal cash flows or relative higher or small size of the projects. This can be better understood with the help of an example. The two mutually exclusive projects are there, Project A and Project B. The cash flows from these projects are as below: Particulars Project A Project B Initial Investment 10,000,000 1,000,000 Cash inflow at the end of Year 1 10,000,000 2,000,000 Cash inflow at the end of Year 2 10,000,000 1,000,000 Now, when we compute NPV and IRR of these two projects the results will be like this. Particulars Project A Project B NPV 7,355,371.90 1,644,628.10 IRR 61.80% 141.42% From above results, we can see that as per NPV method, the Project A should be accepted whereas as per IRR method Project B should be accepted. This conflict is due to relative different size of the projects. This is because the IRR method assumes that the cash flows generated will be again invested at the given internal rate of return. But this assumption will not always be true. On the other hand, the NPV follows the conservative approach and assumes that the generated cash flows will be invested at the cost of capital only. Further, if the project has irregular cash flows than the IRR method will result in multiple IRRs and will not even display the true picture whereas the NPV method will provide true and correct picture irrespective of the fact that whether the projects have regular cash flows or irregular cash flows. So, to conclude it is advised to follow the NPV approach in mutually exclusive projects. Further, the IRR method can be additionally used to complement the results generated by NPV method. References eFinanceManagement.com. (2018). Profit vs Wealth Maximization as a Goal of Financial Management. Retrieved from https://efinancemanagement.com/financial-management/profit-vs-wealth-maximization eFinanceManagement.com. (2018). Wealth Maximization - Definition, Calculate, Advantages, How to Create it. Retrieved from https://efinancemanagement.com/financial-management/wealth-maximization eFinanceManagement.com. (2018). Profit Maximization. Retrieved from https://efinancemanagement.com/financial-management/profit-maximization AccountingExplained.com. (2018). NPV vs IRR. Retrieved from https://accountingexplained.com/managerial/capital-budgeting/npv-vs-irr Keylogic.com. (2018). Which financial evaluation technique, NPV or IRR, is better to use when selecting the best project among a number of mutually exclusive projects, and why?. Retrieved from https://www.keylogic.com/blog/blog/2013/08/27/which-financial-evaluation-technique-npv-or-irr-is-better-to-use-when-selecting-the-best-project-among-a-number-of-mutually-exclusive-projects-and-why- Indiainfoline.com. (2018). What is IRR how to calculate it?. Retrieved from https://www.indiainfoline.com/article/research-articles-personal-finance/what-is-irr-how-to-calculate-it-113111500082_1.html