FINANCIAL MANAGEMENT - 3

1. Comment on Profit maximization V/s Wealth maximization.
Ans
P PROFIT MAXIMIZATION

It is a term which donates the maximum profit to be earned by an organization in a given time period. The profit - maximization goal implies that the investment, financing and dividend policy decision of the enterprise should be oriented to profit maximization.
The term "Profit" can be used in two senses - one as the owner-oriented concept and the other as the operational concept.
Profit as the owner-oriented concept; refer to the amount of net profit, which goes in their form of dividend to the shareholders. Profit as the operational concept means profitability, which is an indicator of economics efficiency of enterprise.
Profitability-maximization implies that the enterprise should select assets projects and decision, which are profitable and reject those which are not profitable. It is in this sense that the term Profit - Maximization is used in financial management.

P MERITS OF THE PROFIT - MAXIMIZATION

1. Best criterion of decision-making
The goal of profit maximization is regarded as the best criterion of the decision making as it provides a yard-stick to jungle the economic performance of enterprise.
2. Efficient allocation of resources
It leads to efficient allocation of scarce as they tend to diverted to those uses which, in term of profitability, are the most desirable
3. Optimum utilization
Optimum utilization of available resource is possible.
4. Maximum social welfare
It ensures maximum social welfare in the form of maximum dividend to shareholders, timely payments to creditors, higher wages, better quality and lower prices, more employment opportunities to the society and maximization of capital to the owners.

P DRAWBACKS OF PROFIT - MAXIMIZATION
1. Time factor ignored
The term "Profit" does not speak anything about the period of Profit-whether it is short-term profit or long-term profit.
2. It is value
The term "Profit" is very vague. It is not clear in what exact sense the term profit is used. Whether it is Accounting profit or Economic profit or profit after tax or profit before tax.
3. The term maximum is also ambiguous
The term "maximum" is not clear. The concept of profit is also not clear. It is therefore, not possible to maximize what cannot be known.
4. It ignores time value
It fails to provide any idea regarding the timing of expected cash earnings. The choice of a more worthy project lies in the study of time value of future inflows of cash earnings. It ignores the fact that the rupee earned to day is more valuable than a rupee earned later.
5. It ignores the risk factor
According to economists, profit is reward for risk and uncertainty bearing. It is also dynamic surplus or profit is a reward for innovation. But when can the organization maximum profit? Profit - Maximization objectives does not make this clear.

P WEALTH MAXIMIZATION

It is now widely and universally accepted that the objective of the enterprise should be4 suitable and operationally feasible, precise and clear cut and should give weightage too time value and risk factors. Owing to the various drawbacks of the Profit - Maximization objectives, Professor Ezra Solomon rejected it as inappropriate and unsuitable and suggested the adoption of wealth maximization objective, which removes all the drawbacks of the Profit - Maximization objectives.
Wealth maximization is also called value maximization. Wealth or "net present worth" of the course of action is the difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present-worth represents the present value of expected cash benefits.
In simple, wealth maximization means maximizing the present value of course of action. Any financial action, which results in positive NPV, creates and adds to the existing wealth of the organization and the course of action, which has a negative NPV, reduces the existing wealth and hence be given up. All positive actions can be adopted as they add to the existing wealth and help in wealth maximization.

 Significance of wealth -maximization

The Company although it cares more for the economic welfare of the shareholders, it cannot forget the others who directly or indirectly work for the overall development of the company. Thus wealth maximization takes care of
• Lenders or creditors
• Workers or Employees
• Public or society
• Management or Employer.

2. Differentiate between NPV and IRR method.

Ans

Comparison of NPV and IRR Methods


NPV IRR Method

1. Interest rate is a known factor.
1. Interest rate is an unknown factor.

2. It involves computation of the amount that can be invested in a given project so that the anticipated earnings will be from sufficient to repay this amount with market rate of interest.
2. It attempts to find out the maximum rate of interest at which funds are invested in the project. Earnings the project in the form of cash flow will help us to get back the funds already invested.
3. It assumes that the cash inflows can be inflow reinvested at the discounting rate in the discounting new projects. 3. It also assumes that the cash can be reinvested at the rate in the new projects.

4. Reinvestment is assumed to be at cut-off assumed to rate.
4. Reinvestment of funds is be at the IRR



3. Briefly explain the approaches for determining the financial mix.

Ans:

 Matching Approach or Hedging Approach
When the firm follows matching approach, long term financing will be used to finance permanent working capital. Temporary working capital should be financed out of short term funds. The rationale underlying matching approach is that the maturity of source of funds should match the assets to be financed.
 Conservative Approach
According to this approach all requirements of funds should be met from long-term sources. Short-term sources should be used only for emergency requirements. Under a conservative plan, a firm finances its permanent current assets and a part of the temporary current assets with a long term financing. In periods when the firm has no temporary current assets, it stores liquidity by investing surplus funds in marketable securities. Conservative approach is risky but more costly as compared to matching approach.
 Aggressive Approach
Under an aggressive policy firm uses more short term financing than warranted by the matching plan, i.e. the firm finances a part of its permanent current assets with short term financing. On the other hand more use of short term financing makes the firm more risky.


4. "Cost of equity is zero" - Do u agree? Why?
Ans
Cost of equity is the minimum rate of return expected by the shareholders. Unlike dept or preference capital, dividends on equity share are not fixed, nor it is a compulsory payment. Dividend on equity shares has to be paid only when the company earns profit. It also depends on the decision of the Board of Directors. So sometimes it is argued that there is no cost for the equity capital. But it is not true. Even if there is no compulsory payment to equity shareholders, they invest their money in the company with an expectation of earning some return, which is at least equal to their opportunity cost.


5. Explain the reasons for mergers and acquisitions.

Ans The following are important reasons for mergers and acquisition of firms:

 Economics of scale
The combined firms can have larger volume of operations than the individual firms. Thus combined firm can enjoy economics of scale. The optimum utilization of palnt capacity is possible to combined entity resulting in fall in the average cost of the output. The mergers and acquisitions help the company to produce the good more economically through the full utilization of plant capacities.
 Synergy
Synergy is simply defined as 2+2 = 5 phenomenon. The value of the company formed through merger will be more than the sum of the value of the individual companies just merged.
V(A) + V(B) < V(AB)
V(B) = value for A ltd.
V(AB) = value for merged company.
 Diversification of risk
Company's profits and cash flows fluctuate widely when it produces a single product. This increases the risk of a firm. So company experiencing wide fluctuations in the earning may merge with another company whose earnings are of different nature. The merger of companies whose earning are negatively correlated will bring stability in the earnings of the combined firms. So diversification reduces the risk of firm.
 Growth
Growth is possible in 2 ways i.e. internal expansion of Greenfield ventures or external expansion through mergers and acquisitions. Internal expansion is slow and takes time and also involves a lot of risk. Mergers and acquisition help the company to grow quickly without gestation period.
 Reduction in tax liability
In some cases tax shields may be the motivating factor for mergers. Under Income Tax Act there is a provision for set off and carry forward of losses. A Sick Company may not be in a position to earn sufficient profits in future to take advantage of carry forward provision. So a sick company with accumulated losses may like some profitable company to merge with it to take advantage of tax benefits. Even the sick company with accumulated losses may be merged with a profitable company and take advantage of income tax benefits with approval of government.
 To increase market power and to kill competition
The merger can increase the market share to merged firm. This increase the market power and makes the demand for the product of the firm less elastic. Mergers also help the company to reduce competition in the market place. Many mergers have been intended to kill the competition and to increase the market power.
 Financial synergy
The following are the financial synergy available in the case of merger
 Better credit worthiness
This helps the company to purchase the goods on credit, obtain bank loan and raise in the market easily.
 Reduce the cost of capital
The investors consider big firms as safe and they expect lower rate of return for the capital supplied by them. So the cost of capital reduces after merger.
 Increase the dept capacity
After the merger the earnings and cash flows become more stable than before. The increases the capacity of the company to borrow more funds.
 Low floatation cost
Small companies have to spend higher percentage of issued capital as floatation cost when compared to big firm.
 Rising of capital
After the merger due to increase in the size of the company and better credit worthiness and reputation, the company can easily raise the capital at any time.
 Managerial motives
After the merger manager's benefit in rank, status and perquisite. This is another motivation for mergers.