Financial management

May 17, 2018 Management

What are the goals of financial management? Ans. Goal of financial management Financial management means maximization of economic welfare of its shareholders. Maximization of economic welfare means maximization of wealth of its shareholder’s wealth maximizations reflected in the market value of the firm’s shares. Experts believe that, the goal of financial management is attained when it maximizes the market value of shares.

There are two versions of the goal of financial management of the firm-Profit Maximization and Wealth maximization. Let us now discuss the goals of financial management in datial. Profit maximization Profit maximization is based on the cardinal rule of efficiency. Its goal is to maximize the returns with the best output and price levels. A firm’s performance is evaluated in terms of profitability. Profit maximization is the traditional and narrow approach, which aims at maximizing the profit of the concern.

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Allocation of resources and investor’s perception of the company’s performance can be traced to the goal of profit maximization. Profit maximization has been criticized on many accounts: • The concept of profit lacks clacks clarity. 1. Is it profit after tax or before tax? 2. Is it operating profit or net profit available to shareholders? • Profit maximization neither considers the time value of money nor the net present value of the cash inflow. It does not differentiate between profit of current year with the profits to be earned in later years. The concept of profit maximization apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Profit maximization as a concept, even though has the above-mentioned drawbacks, is still given importance as profit do matter for any kind of business. Ensuring continued profits ensure maximization of shareholder’s wealth. Wealth Maximization The term wealth means shareholder’s wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization.

This objective is an universally accepted concept in the field of business. Wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance manager as it overcomes the limitations of profit maximization. Q2. Calculate the PV of an annuity of Rupees 500 received annually for four years when discounting factor is 10%. Ans. Annuity Refers to the periodic flows of equal amounts. Given the interest rate, compounding technique can be used to compare the cash flows separated by more than one time period.

The present value of a sum to be received at a future date is determined by discount the future value at the interest rate that the money could earn over the period. This process is known as discounting. Q3. Suraj Metals are expected to declare a dividend of Rupees 5 per share and the growth rate in dividends is expected to grow @ 10% p. a. The price of one share is currently at Rupees 110 in the market. What is the cost of equity capital to the company? Ans. Ke + (D1/Pe) + g = (5/110) + 0. 10 = 0. 1454 Or 14. 54% Cost of equity capital is 14. 54% Ke is the cost of external equity is the constant growth rate of dividends According to dividend forecast approach, the intrinsic value of an equity share is the sum of present values of dividends associated with it. Dividends cannot be accurately forecasted as they may sometimes be nil or have a constant growth or sometimes have supernormal growth periods. Hence, it is not possible to arrive at the price per equity share on the basis of forecast of future streams of dividends. The following is a simplified from the equation, Pe = {D1/Ke-g}. This equation is arrived at with the assumption that there is a constant growth in dividends.

If the current market price of the share is given (Pe), and the values of D1 and `g` are known, the equation is then rewritten as Ke = (D1/Pe) + g. Under the case of earnings price ratio approach, the cost of equity can be calculated as: Ke = E1/P Where E1 = expected EPS for the next year P = current market price per share Ke is the cost of external equity E1 is calculated by multiplying the present EPS with (1 + Growth rate). This ratio assumes that the EPS will remain constant from the next year onward. some people are of the option that equity capital is free of cost as a ompany is not legally bound to pay dividends . This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore, equity capital is not free of cost. As we have just learnt that if retained earnings are reinvested in business for growth activities, the shareholders expect the same amount of returns and therefore Ke = Kr However, it should be borne in mind by the policy makers that floating of a new issue and people subscribing to the new issue will involve huge amounts of money towards floating costs.

This need not be incurred if retained earnings are utilized towards funding activities. Q4. What are the assumptions of MM approach? Ans. The MM approach to irrelevance of dividend is based on the following assumptions: The capital markets are perfect and the investors behave rationally. All information is freely available to all the investors. There is no transaction cost. Securities are divisible and can be split into any fraction. No investor can affect the market price. There are no taxes and no flotation cost. The firm has a defined investment policy and the future profits are known with certainty.

The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted. The model Under the assumptions stated above, MM argue that neither the firm paying dividends nor the shareholders receiving the dividends will be adversely affected by firms paying either too little or too much dividends. They have used the arbitrage process to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders.

They have shown that given the investment opportunities, a firm will finance these either by plugging back profits of if pays dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally. In order to satisfy their model, MM has started with the following valuation model. P0= 1* (D1+P1)/ (1+ke) Where, P0 = Present market price of the share Ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 P1 = Expected market price of the share at the end of year 1

With the help of this valuation model we will create a arbitrage process, i. e. , replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are: • Payment of dividend by the firm • Rising of fresh capital. With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralized by the decrease in terminal value of the share.


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