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Objectives of Corporate Finance:: Rationality of These Model

The objectives of corporate finance are profit maximization, wealth maximization, and value maximization. Profit maximization focuses on increasing profits and considers decisions based on their impact on profits. Wealth maximization aims to increase shareholder wealth by maximizing the net worth and share price of the company. Value maximization seeks to increase shareholder value by maximizing the present value of expected future profits of the firm.

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Zahed Ibrahim
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301 views

Objectives of Corporate Finance:: Rationality of These Model

The objectives of corporate finance are profit maximization, wealth maximization, and value maximization. Profit maximization focuses on increasing profits and considers decisions based on their impact on profits. Wealth maximization aims to increase shareholder wealth by maximizing the net worth and share price of the company. Value maximization seeks to increase shareholder value by maximizing the present value of expected future profits of the firm.

Uploaded by

Zahed Ibrahim
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Objectives of Corporate Finance:

Corporate finance consists of the financial activities related to running a corporation, usually
with a division or department set up to oversee the financial activities. Corporate finance is
primarily concerned with maximizing shareholder value through long-term and short-term
financial planning and the implementation of various strategies. Everything from capital
investment decisions to investment banking falls under the domain of corporate finance.

The objectives of corporate finance are:

a. Profit Maximization

b. Wealth Maximization

c. Value Maximization.

Now, these have been described below:

a. Profit Maximization:
Profit maximization is the traditional approach and the primary objective of financial
management. It implies that every decision relating to business is evaluated in the light of
profits. All the decision with respect to new projects, acquisition of assets, raising capital,
distributing dividends etc are studied for their impact on profits and profitability. If the result
of a decision is perceived to have a positive effect on the profits, the decision is taken further
for implementation.

Rationality of these Model:

1. Profit maximization theory is based on profits and profits are a must for survival of any
business.

2. Profits are the true measurement of the viability of a business model. Without profits, the
business losses its primary objective and therefore has a direct risk to its survival.

3. The profit maximization objective indirectly caters to social welfare. In a business, profits
prove efficient utilization and allocation of resources. Resource allocation and payments for
land, labor, capital, and organization takes care of social and economic welfare.
Limitation:

1. The term “Profit” is a vague term. It is because different mindset will have a different
perception of profit. For e.g. profits can be the net profit, gross profit, before tax profit, or the
rate of profit etc. There is no clearly defined profit maximization rule about the profits.

2. The profit maximization formula simply suggests “higher the profit better is the proposal”.
In essence, it is considering the naked profits without considering the timing of them.
Another important dictum of finance says “a dollar today is not equal to a dollar a year later”.
So, the time value of money is completely ignored.

3. A decision solely based on profit maximization model would take a decision in favor of
profits. In the pursuit of profits, the risk involved is ignored which may prove unaffordable at
times simply because higher risks directly questions the survival of a business.

4. the most problematic aspect of profit maximization as an objective is that it ignores the
intangible benefits such as quality, image, technological advancements etc. The contribution
of intangible assets in generating value for a business is not worth ignoring. They indirectly
create assets for the organization.

Example:

Reducing cost of goods sold, reducing fixed cost, lowering payables etc.

b. Wealth Maximization:
It simply means maximization of shareholder’s wealth. It is a combination of two words viz.
wealth and maximization. A wealth of a shareholder maximizes when the net worth of a
company maximizes. To be even more meticulous, a shareholder holds share in the
company/business and his wealth will improve if the share price in the market increases
which in turn is a function of net worth. This is because wealth maximization is also known
as net worth maximization. Finance managers are the agents of shareholders and their job is
to look after the interest of the shareholders. The objective of any shareholder or investor
would be a good return on their capital and safety of their capital.

Both these objectives are well served by wealth maximization as a decision criterion for
business
Calculation of Wealth:

Wealth is said to be generated by any financial decision if the present value of future cash
flows relevant to that decision is greater than the costs incurred to undertake that activity.
Wealth is equal to the present value of all future cash flows less the cost. In essence, it is
the net present value of a financial decision.

Wealth = Present Value of cash inflows – Cost.

Advantages:

Wealth maximization model is a superior model because it obviates all the drawbacks of
profit maximization as a goal of a financial decision.

 Firstly, the wealth maximization is based on cash flows and not profits. Unlike the
profits, cash flows are exact and definite and therefore avoid any ambiguity associated
with accounting profits.
 Secondly, profit maximization presents a shorter term view as compared to wealth
maximization. Short-term profit maximization can be achieved by the managers at the
cost of long-term sustainability of the business.
 Thirdly, wealth maximization considers the time value of money. It is important as
we all know that a dollar today and a dollar one-year latter do not have the same
value. In wealth maximization, the future cash flows are discounted at an appropriate
discounted rate to represent their present value.
 Fourthly, the wealth-maximization criterion considers the risk and uncertainty
factor while considering the discounting rate. The discounting rate reflects both time
and risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

Example:

Capital investment decisions of a firm have a direct relation with wealth maximization. All
capital investment projects with an internal rate of return (IRR) greater than 1 or having
positive NPV creates value for the firm. These projects earn more than the ‘required rate of
return’ of the firm. In other words, these projects maximize the wealth of the shareholders
because they are earning more than what they can earn by investing themselves.
c. Value Maximization:
It refers, increases in owners' wealth achieved by maximizing of the value of a
firm's common stock.

Value of the firm = Present value of expected future profits

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