Financial management of any business firm has to set goals for itself and to interpret them in relation to the objective of the firm. Broadly, there are only two alternative objectives a business firm can pursue viz.
(a) Profit maximization;
(b) Shareholder Wealth maximization.
(a) Profit Maximisation
According to Solomon, the Price system directs managerial efforts towards more profitable goods or services. Prices are determined by the demand and supply conditions as well as the competitive forces, and they guide the allocation of resources for various productive activities.
In economic theory, the behavior of the firm is analyzed in terms of profit maximization. The classical economic view of the firm, as put forward by Hayek (1950) and Fredman (1970), is that it should be operated in a manner that maximizes its profit. This occurs, in economic terms, when marginal revenue equals marginal cost. Profit maximization means that a firm either produces maximum output for a given amount of input or uses minimum input for producing a given output. The underlying rationale of profit maximization is efficiency. It is assumed that profit maximization causes the efficient allocation of resources under the competitive market condition, and profit is considered as the most appropriate measure of a firm’s performance.
Thus, profit maximization is considered an important goal in financial decision-making in an organization. It ensures that a firm utilizes its available resources most efficiently under conditions of competitive markets.
But in recent years, under the changing corporate environment, profit maximization is regarded as an unrealistic difficult, inappropriate, and socially not a much-preferred goal for a business organization. It is argued that profit maximization assumes perfect competition, and in the face of imperfect modern markets, it cannot be a legitimate objective of the firm. It is also argued that the objective of profit maximization as a business objective developed in the 19th century when the business activity was self-financing and based on the assumption of private property and single entrepreneurship. The only aim of the entrepreneur then was to maximize his profit and enhance his own wealth, this objective could be easily satisfied by profit maximization objective. The modern business environment is characterized by limited liability and a distinction between management and ownership. The various stakeholders of the firm are shareholders, lenders, customers, employees, government, and society. In practice, the objectives of all these stakeholders may differ and may even conflict with each other. The manager has the difficult task of reconciling and balancing these conflicting objectives. The goal of profit maximization overlooks the interest of other parties than the shareholders and is therefore criticized and considered as unrealistic, inappropriate, and immoral.
Profit maximization as the corporate goal is criticized by scholars mainly on the following grounds:
(i) It is vague conceptually.
(ii) It ignores the timing of returns.
(iii) It ignores the risk factor.
(iv) It may tempt to make such decisions which may, in the long run, prove disastrous.
(v) Its emphasis is generally on short-run projects.
(vi) It may cause decreasing share prices.
(vii) The profit is only one of the many objectives and variables that a firm considers.
(b) Shareholder Wealth Maximisation
According to Solomon, shareholder wealth maximization means maximizing the net present value of a course of action to shareholders. Net present value (NPV) or wealth of a course of action is the difference between the present value of its benefit and the present value of its costs.
Presently, maximization of present value (or wealth) of a course of action is considered appropriate operationally the flexible goal for financial decision-making in an organization.
The management of an organization tries to maximize the present value not only for shareholders but for all including employees, customers, suppliers, and the community at large. This goal for the maximum present value is generally justified on the following grounds:
(i) It is consistent with the object of maximizing owners’ economic welfare.
(ii) It focuses on the long-run picture.
(iii) It considers risk.
(iv) It recognizes the value of regular dividend payments.
(v) It takes into account the time value of money.
(vi) It maintains the market price of its shares.
(vii) It seeks growth in sales and earnings.
However, profit maximization can be part of a wealth maximization strategy. Quite often two objectives can be pursued simultaneously but the maximization of profit should never be permitted to overshadow the objectives of wealth maximization.
The objective of the firm provides a framework for optimal decision making in the area of business management. The term ‘objective’ should be used in the sense of ‘decision criteria’ for taking decisions involved in financial management. It means that what is relevant is not the overall objective of the business but an operationally useful criterion against which the investment, financing, and dividend policy decisions are to be judged. The objective of shareholder wealth maximization is an appropriate and operationally feasible criterion to choose among the alternative financial actions.
It provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions on behalf of shareholders. Another point to note in this context is that objectively provides a ‘normative’ framework. In other words, it implies that the focus is on what a firm should try to achieve and on policies that it should follow if the objectives are to be achieved.