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Q1. “Value maximization is preferred objective of financial management than profit maximization.” Justify the statement.
Ans: Profit maximization helps in producing maximum output with the minimum utilization of resources. It is the foremost objective of the company. Earlier, it has been recommended that motive of any organization is to earn profit. Profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest Profit
Wealth maximization is a process that increases the current net value of business or shareholder capital gains, with the objective of bringing in the highest possible return. The wealth maximization strategy generally involves making sound financial investment decisions which take into consideration any risk factors that would compromise or outweigh the anticipated benefits.
Profit Maximization vs. Wealth Maximization
The financial management has come a long way by shifting its focus from traditional approach to modern approach. The modern approach focuses on wealth maximization rather than profit maximization. This gives a longer term horizon for assessment, making way for sustainable performance by businesses.
A myopic person or business is mostly concerned about short term benefits. A short term horizon can fulfil objective of earning profit but may not help in creating wealth. It is because wealth creation needs a longer term horizon Therefore, financial management emphasizes on wealth maximization rather than profit maximization. For a business, it is not necessary that profit should be the only objective; it may concentrate on various other aspects like increasing sales, capturing more market share etc, which will take care of profitability. So, we can say that profit maximization is a subset of wealth and being a subset, it will facilitate wealth creation.
Giving priority to value creation, managers have now shifted from traditional approach to modern approach of financial management that focuses on wealth maximization. This leads to better and true evaluation of the business.
For e.g.: Under wealth maximization, cash flows are more important than profitability. As we know, profit is a relative term, it can be a figure in some currency, a percentage etc. For e.g. we cannot judge a profit of say $10,000 as good or bad for a business, till we compare it with investment, sales etc. Similarly, duration of earning the profit is also important i.e. whether it is earned in short term or long term.
In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate various alternatives for decision making, cash flows are taken into consideration. For e.g. to measure the worth of a project, criteria like: “present value of its cash inflow – present value of cash outflows” (net present value) is taken. This approach considers cash flows rather than profits into consideration. It also use discounting technique to find out the worth of a project. Thus, maximization of wealth approach believes that money has time value.
The goal of wealth maximization a better operative criterion than profit maximization as-
- Wealth Maximization ensures fair return to the shareholders and their interests are equally taken care of whereas no such thing is thought of, under Profit Maximization.
- Profit Maximization has a traditional way of completing tasks which is inappropriate and unrealistic whereas Wealth Maximization is a modern approach so is also quite compatible with the Financial Management.
- Wealth maximization main aim is to improve the market value where as in profit maximization it is making large amount of profit.
- In wealth maximization strategy for making sound financial investment which considers the risk factor while in profit maximization it is not required.
- The criterion of profit maximization ignores time value factor. It considers the total benefits or profits into account while considering a project whereas the length of the time in earning that profit is not considered at all, whereas wealth maximization concept fully confirms the time value factor in evaluating cash flows.
Q2. What are prerequisites of working capital requirement of a firm? Illustrate.
Ans: In case of a firm, the important factors determining the requirements of working capital are as follows:
1. Sales:
is capital- intensive, the enterprise will have to make less payment for expenses like wages. As a result, enterprise will require less working capital.
8. Contingencies:
If the demand for and price of the products of small- scale enterprises are subject to wide variations or fluctuations, the contingency provisions will have to be made for meeting the fluctuations. This will obviously increase the requirements for working capital of the small enterprises. While one can add certain other factors to this list, the said factors appear to be the major ones in determining the requirement of working capital of a small-scale enterprise
Q3. Discuss in detail the theory of relevance in dividend policy decision of a firm. Illustrate with hypothetical data.
Ans: Walter and Gordon suggested that shareholders prefer current dividends and hence a positive relation ship exists between dividend and market value. The logic put behind this argument is that investors are generally risk-averse and that they prefer current dividend, attaching lesser importance to future dividends or capital gains.
Walter Valuation Model:
Professor, James, E. Walter’s model suggests that dividend policy and investment policy of a firm cannot be isolated rather they are interlinked as such, choice of the former affects the value of a firm. His proposition clearly states the relationship between the firms’ (i) internal rate of return (i.e., r) and its cost of capital or the required rate of return (i.e., k).
That is, in other words, an optimum dividend policy will have to be determined by the relationship of r and k. In short, a firm should retain its earnings it the return on investment exceeds the cost of capital and in the opposite case, it should distribute its earnings to the shareholders.
Walter’s model is based on the following assumptions:
(i) All financing through retained earnings is done by the firm, i.e., external sources of funds, like, debt or new equity capital is not being used;
(ii) It assumes that the internal rate of return (r) and cost of capital (k) are constant;
(iii) It assumes that key variables do not change, viz., beginning earnings per share, E, and dividend per share, D, may be changed in the model in order to determine results, but any given value of E and D are assumed to remain constant in determining a given value;
(iv) All earnings are either re-invested internally immediately or distributed by way of dividends;
(v) The firm has perpetual or very long life.
Illustration with hypothetical data
Cost of Capital (k) = 10% Earnings per share (E) = Rs. 10. Assume Internal Rate of Return (r):
(i) 15%; (ii) 10%; and (iii) 8% respectively
Assuming that the D/P ratios are: 0%; 40%; 76% and 100% i.e., dividend share is (a) Rs. 0, (b) Rs. 4, (c) Rs. 7.5 and (d) Rs. 10, the effect of different dividend policies for three alternatives of r may be shown as under:
(i) Purchase of fixed assets,
(ii) Meeting working capital requirements, and
(iii) Modernisation and expansion of business.
The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure:
Once the requirement of capital funds has been determined, a decision regarding the kind and proportion of various sources of funds has to be taken. For this, financial manager has to determine the proper mix of equity and debt and short-term and long-term debt ratio. This is done to achieve minimum cost of capital and maximise shareholders wealth.
3. Choice of Sources of Funds:
Before the actual procurement of funds, the finance manager has to decide the sources from which the funds are to be raised. The management can raise finance from various sources like equity shareholders, preference shareholders, debenture- holders, banks and other financial institutions, public deposits, etc.
4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the business. It might require negotiation with creditors and financial institutions, issue of prospectus, etc. The procurement of funds is dependent not only upon cost of raising funds but also on other factors like general market conditions, choice of investors, government policy, etc.
5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in various assets so as to maximise the return on investment: While taking investment decisions, management should be guided by three important principles, viz., safety, profitability, and liquidity.
6. Disposal of Profits or Surplus:
The financial manager has to decide how much to retain for ploughing back and how much to distribute as dividend to shareholders out of the profits of the company. The factors which influence these decisions include the trend of earnings of the company, the trend of the market price of its shares, the requirements of funds for self- financing the future programmes and so on.
7. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It involves forecasting the cash inflows and outflows to ensure that there is neither shortage nor surplus of cash with the firm. Sufficient funds must be available for purchase of materials, payment of wages and meeting day-to-day expenses.
8. Financial Control:
Evaluation of financial performance is also an important function of financial manager. The overall measure of evaluation is Return on Investment (ROI). The other techniques of financial control and evaluation include budgetary control, cost control, internal audit, break- even analysis and ratio analysis. The financial manager must lay emphasis on financial planning as well.
For the sake of smooth running of the activities of a business enterprise these are divided into certain groups. And each group is put under the executive control of a director or manager. Designations of the head of the group or the functional department do vary from company to company but work or functions are well defined.
Q2. Differentiate the terms risk and return. Collect real two years data of share prices of two SENSEX companies of BSE from the web site and calculate their risks and returns.
Ans: Return on Investment is the annual return of an asset over several years. Research analysts and professional investors use historical returns, along with industry and economic data, to estimate future rates of return. You can use actual results and estimated returns to evaluate various assets, such as stocks and bonds, as well as different securities within each asset category. This evaluation process helps you pick the right mix of securities to maximize returns during your investment time horizon.
Risk is the likelihood that actual returns will be less than historical and expected returns. Risk factors include market volatility, inflation and deteriorating business fundamentals. Financial market downturns affect asset prices, even if the fundamentals remain sound. Inflation leads to a loss of buying power for your investments and higher expenses and lower profits for companies. Business fundamentals could suffer from increased competitive pressures, higher interest expenses, quality problems and management inability to execute on strategic and
Q3. Explain various factors affecting capital structure of a firm.
Ans: Under the capital structure, decision the proportion of long-term sources of capital is determined. Most favourable proportion determines the optimum capital structure. That happens to be the need of the company because EPS happens to be the maximum on it. Some of the chief factors affecting the choice of the capital structure are the following:
(1) Cash Flow Position:
While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.
(2) Interest Coverage Ratio-ICR:
With the help of this ratio an effort is made to find out how many times the EBIT is available to the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio.
It is possible that in spite of better ICR the cash flow position of the company may be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to pay interest. It is equally important to take into consideration the cash flow position.
(3) Debt Service Coverage Ratio-DSCR:
This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.
(4) Return on Investment-ROI:
The greater return on investment of a company increases its capacity to utilise more debt capital.
(5) Cost of Debt:
The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilised and vice versa.
(6) Tax Rate:
The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.
(7) Cost of Equity Capital:
Cost of equity capital (it means the expectations of the equity shareholders from the company) is affected by the use of debt capital. If the debt capital is utilised more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity shareholders.
Therefore, the use of the debt capital can be made only to a limited level. If even after this level the debt capital is used further, the cost of equity capital starts increasing rapidly. It adversely affects the market value of the shares. This is not a good situation. Efforts should be made to avoid it.
(8) Floatation Costs:
Floatation costs are those expenses which are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.). These include commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the share capital. This attracts the company towards debt capital.
(9) Flexibility:
According to this principle, capital structure should be fairly flexible. Flexibility means that, if need be, amount of capital in the business could be increased or decreased easily. Reducing the amount of capital in business is possible only in case of debt capital or preference share capital.
If at any given time company has more capital than as necessary then both the above- mentioned capitals can be repaid. On the other hand, repayment of equity share capital is not possible by the company during its lifetime. Thus, from the viewpoint of flexibility to issue debt capital and preference share capital is the best.
(10) Control:
According to this factor, at the time of preparing capital structure, it should be ensured that the control of the existing shareholders (owners) over the affairs of the company is not adversely affected.
