CHAPTER 1

Introduction to Advanced Financial Management

1 Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the
enterprise. Financial management refers to the efficient and effective management
of money (funds) in such a manner as to accomplish the objectives of the
organization. It is the specialized function directly associated with the top
management. The significance of this function is not seen in the 'Line' but also in
the capacity of 'Staff' in overall of a company. It has been defined differently by
different experts in the field.
The term typically applies to an organization or company's financial strategy, while
personal finance or financial life management refers to an individual's management
strategy. It includes how to raise the capital and how to allocate capital, i.e. capital
budgeting. Not only for long term budgeting, but also how to allocate the short
term resources like current liabilities. It also deals with the dividend policies of the
share holders.
In fact, finance is the bright thread running through all business activity. It
influences and limits the activities of marketing, production, purchasing and
personnel management. The success of a business is measured largely in financial
terms. The efficient organisation and administration of the finance function is thus
vital to the successful functioning of every business enterprise.

2. Definitions of Financial Management:

According to Joseph Massie financial management can be defined as, "Financial

Management is the Operational Activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient operation.
One needs money to make money. Finance is the life-blood of business and there
must be a continuous flow of funds in and out of a business enterprise. Money
makes the wheels of business run smoothly. Sound plans, efficient production
system and excellent marketing network are all hampered in the absence of an
adequate and timely supply of funds.
Sound financial management is as important in business as production and
marketing. A business firm requires finance to commence its operations, to
continue operations and for expansion or growth. Finance is, therefore, an
important operative function of business.
A large business firm has to raise funds from several sources and has to utilise
those funds in alternative investment opportunities. In order to ensure the most
judicious utilisation of funds and to provide a reasonable rate of return on the
investment, sound financial policies and programmes are required. Unwise
financing can drive a business into bankruptcy just as easily as a poor product,
inept marketing or high production costs.
On the other hand, adequate and economical financing can provide the firm a
differential advantage in the market place. The success of a business enterprise is
largely determined by the way its capital funds are raised, utilised and disbursed. In
the modern money-using economy, the importance of finance has increased further
due to increasing scale of operations and capital intensive techniques of production
and distribution.

3. Functions of Financial Management:

1. Estimation of capital requirements: A finance manager has to make estimation

with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a concern.
Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made,
the capital structure have to be decided. This involves short- term and long- term
debt equity analysis. This will depend upon the proportion of equity capital a
company is possessing and additional funds which have to be raised from outside
parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like:
Issue of shares and debentures.
Loans to be taken from banks and financial institutions.
Public deposits to be drawn like in form of bonds.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to
cash management. Cash is required for many purposes like payment of wages and

salaries, payment of electricity and water bills, payment to creditors, meeting

current liabilities, maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and
utilize the funds but he also has to exercise control over finances. This can be done
through many techniques like ratio analysis, financial forecasting, cost and profit
control, etc.

5. Financial management essentials:

1. Income Statement (Profit and Loss Statement): An Income Statement, also
called a Profit and Loss Statement, shows where and how money goes in an out of
a company for a period of time. Monthly, quarterly, and annual profit and loss
reports show the strength of a business. The format of the Income Statement may
vary, but all include the following:

Revenue (income from normal business activities)

Gross gains (earnings before taxes, expenses, etc.)
Operating expenses and losses
Net income (positive)/net loss (negative).

At each step, you make a deduction for certain costs or other operating expenses
associated with earning the revenue. At the bottom of the stairs, after deducting all
of the expenses, you learn how much the company actually earned or lost during
the accounting period. People often call this "the bottom line."
2. The Cash Flow Statement: A Cash Flow Statement shows how cash is moving
into and out of the business. It is one of the most useful financial management
tools because it shows you:
Net cash flow from operating activities: collections from customers, cash paid to
suppliers and employers, cash paid for interest and taxes, cash revenue from
dividends or interest.
Net cash flow from investing: purchases or sale of equipment.

 Net cash flow from financing activities: funds available from sales of stock,
loan proceeds, both principal and interest received on loans made to others.
Net change in cash and marketable securities: if the cash flow is positive, the
business is generating the cash you need for ongoing operations, with some
cash left over; if the cash flow is negative, the business needs to raise more
cash through the sale of stock, new loan proceeds, or other strategies.
3. The Balance Sheet: Provides a financial snapshot of your business.
A Balance Sheet is a financial snapshot of your business. It shows the overall
financial condition of your company, including all the major assets and liabilities,
as well as net worth, which are referred to as equity.
The "assets" side of the Balance Sheet may include:
Cash: Currency, coins, checking accounts, un deposited checks, etc.
Accounts receivable : A current asset resulting from selling goods or services on
credit.
Prepaid Expenses: The value of business expenses paid in advance, such as
insurance premiums.
Land: The value of real property excluding the value of constructed assets.
Buildings: The value of a building excluding the cost of land.
Intangibles : Copyrights, patents, goodwill, trade names, trademarks, mail lists,
etc.
Other assets: Long-term assets that don't fit any of the categories listed above.
The "liabilities" side of the Balance Sheet may include:
Short-term notes: A loan to be repaid in less than a year.
Long-term debt: Obligations that are not payable within one year.
Accounts payable: The amount owed for items or services purchased on credit.
Accrued expenses: An expense that has been incurred but not yet paid.
5

Taxes payable: The amount of taxes currently due to the federal, state, and local
governments.
Other current liabilities: Obligations that are due within one year.
by a company.
Corporate financial management: Corporate finance is the area of finance
dealing with the sources of funding and the capital structure of corporations and
the actions that managers take to increase the value of the firm to the shareholders,
as well as the tools and analysis used to allocate financial resources. The primary
goal of corporate finance is to maximize or increase shareholder value.[1]
Although it is in principle different from managerial finance which studies the
financial management of all firms, rather than corporations alone, the main
concepts in the study of corporate finance are applicable to the financial problems
of all kinds of firms.
Long term funding: Funding obtained for a time frame exceeding one year in
duration. When a business borrows from a bank using long-term finance methods,
it expects to pay back the loan over more than a one year period. For example, this
might include making payments on a 20 year mortgage. Another long-term finance
example would be issuing stock.
Investment: Investment is time, energy, or matter spent in the hope of future
benefits actualized within a specified date or time frame. This article concerns
investment in finance. In finance, investment is buying or creating an asset with the
expectation of capital appreciation, dividends (profit), interest earnings, rents, or
some combination of these returns. This may or may not be backed by research and
analysis. Most or all forms of investment involve some form of risk, such as
investment in equities, property, and even fixed interest securities which are
subject, among other things, to inflation risk. It is indispensable for project
investors to identify and manage the risks related to the investment.
Types of financial investment:
Alternative investments
Traditional investments.
6

Types of Financial Institution

Commercial Banks:
Commercial banks accept deposits and provide security and convenience to their
customers. Part of the original purpose of banks was to offer customers safe
keeping for their money. By keeping physical cash at home or in a wallet, there are
risks of loss due to theft and accidents, not to mention the loss of possible income
from interest. With banks, consumers no longer need to keep large amounts of
currency on hand; transactions can be handled with checks, debit cards or credit
cards, instead.
Commercial banks also make loans that individuals and businesses use to buy
goods or expand business operations, which in turn leads to more deposited funds
that make their way to banks. If banks can lend money at a higher interest rate than
they have to pay for funds and operating costs, they make money.

Investment Banks:
The stock market crash of 1929 and ensuing Great Depression caused the United
States government to increase financial market regulation. The Glass-Steagall Act
of 1933 resulted in the separation of investment banking from commercial
banking.
While investment banks may be called "banks," their operations are far different
than deposit-gathering commercial banks. An investment bank is a financial
intermediary that performs a variety of services for businesses and some
governments. These services include underwriting debt and equity offerings, acting
as an intermediary between an issuer of securities and the investing public, making
markets, facilitating mergers and other corporate reorganizations, and acting as a
broker for institutional clients. They may also provide research and financial
advisory services to companies. As a general rule, investment banks focus on
initial public offerings (IPOs) and large public and private share offerings.
Traditionally, investment banks do not deal with the general public. However,
some of the big names in investment banking, such as JP Morgan Chase, Bank of
America and Citigroup, also operate commercial banks. Other past and present
7

investment banks you may have heard of include Morgan Stanley, Goldman Sachs,
Lehman Brothers and First Boston.

Insurance Companies:
Insurance companies pool risk by collecting premiums from a large group of
people who want to protect themselves and/or their loved ones against a particular
loss, such as a fire, car accident, illness, lawsuit, disability or death. Insurance
helps individuals and companies manage risk and preserve wealth. By insuring a
large number of people, insurance companies can operate profitably and at the
same time pay for claims that may arise. Insurance companies use statistical
analysis to project what their actual losses will be within a given class. They know
that not all insured individuals will suffer losses at the same time or at all.

Brokerages:
A brokerage acts as an intermediary between buyers and sellers to facilitate
securities transactions. Brokerage companies are compensated via commission
after the transaction has been successfully completed. For example, when a trade
order for a stock is carried out, an individual often pays a transaction fee for the
brokerage company's efforts to execute the trade. A brokerage can be either full
service or discount. A full service brokerage provides investment advice, portfolio
management and trade execution. In exchange for this high level of service,
customers pay significant commissions on each trade. Discount brokers allow
investors to perform their own investment research and make their own decisions.
The brokerage still executes the investor's trades, but since it doesn't provide the
other services of a full-service brokerage, its trade commissions are much smaller.

Unit Investment Trusts (UITs):

A unit investment trust, or UIT, is a company established under an indenture or
similar agreement. It has the following characteristics:
The management of the trust is supervised by a trustee.
Unit investment trusts sell a fixed number of shares to unit holders, who
receive a proportionate share of net income from the underlying trust.

 The UIT security is redeemable and represents an undivided interest in a

specific portfolio of securities.
The portfolio is merely supervised, not managed, as it remains fixed for the
life of the trust. In other words, there is no day-to-day management of the
portfolio.

Management Investment Companies:

The most common type of investment company is the management investment
company, which actively manages a portfolio of securities to achieve its
investment objective. There are two types of management investment company:
closed-end and open-end. The primary differences between the two come down to
where investors buy and sell their shares - in the primary or secondary markets and the type of securities the investment company sells.

Closed-End Investment Companies:

A closed-end investment
company issues shares in a one-time public offering. It does not continually offer
new shares, nor does it redeem its shares like an open-end investment company.
Once shares are issued, an investor may purchase them on the open market and sell
them in the same way. The market value of the closed-end fund's shares will be
based on supply and demand, much like other securities. Instead of selling at net
asset value, the shares can sell at a premium or at a discount to the net asset value.

Open-End Investment Companies:

Open-end investment companies,

also known as mutual funds, continuously issue new shares. These shares may only
be purchased from the investment company and sold back to the investment
company. Mutual funds are discussed in more detail in the Variable Contracts
section.

Savings and Loans:

Savings and loan associations, also known as S&Ls or thrifts, resemble banks in
many respects. Most consumers don't know the differences between commercial
banks and S&Ls. By law, savings and loan companies must have 65% or more of
their lending in residential mortgages, though other types of lending is allowed.
9

S&Ls emerged largely in response to the exclusivity of commercial banks. There

was a time when banks would only accept deposits from people of relatively high
wealth, with references, and would not lend to ordinary workers. Savings and loans
typically offered lower borrowing rates than commercial banks and higher interest
rates on deposits; the narrower profit margin was a byproduct of the fact that such
S&Ls were privately or mutually owned.

Credit Unions:
Credit unions are another alternative to regular commercial banks. Credit unions
are almost always organized as not-for-profit cooperatives. Like banks and S&Ls,
credit unions can be chartered at the federal or state level. Like S&Ls, credit
unions typically offer higher rates on deposits and charge lower rates on loans in
comparison to commercial banks.
In exchange for a little added freedom, there is one particular restriction on credit
unions; membership is not open to the public, but rather restricted to a particular
membership group. In the past, this has meant that employees of certain
companies, members of certain churches, and so on, were the only ones allowed to
join a credit union. In recent years, though, these restrictions have been eased
considerably, very much over the objections of banks.

10

CHAPTER 2
Objectives & Scope of Financial Management

1. Objectives of Financial Management:

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should
be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Profit Maximisation: Very often maximisation of profits is considered to be the
main objective of financial management. Profitability is an operational concept that
signifies economic efficiency. Some writers on finance believe that it leads to
efficient allocation of resources and optimum use of capital.
It is said that profit maximisation is a simple and straightforward objective. It also
ensures the survival and growth of a business firm. But modern authors on
financial management have criticised the goal of profit maximisation.
Wealth Maximisation: Prof. Ezra Solomon has advocated wealth maximisation as
the goal of financial decision-making. Wealth maximisation or net present worth
maximisation is defined as follows: The gross present worth of a course of action
is equal to the capitalised value of the flow of future expected benefits, discounted
(or as capitalised) at a rate which reflects their certainty or uncertainty.
11

Wealth or net present worth is the difference between gross present worth and the
amount of capital investment required to achieve the benefits being discussed. Any
financial action which creates wealth or which has a net present worth above zero
is a desirable one and should be undertaken.
Any financial action which does not meet this test should be rejected. If two or
more desirable courses of action are mutually exclusive (i.e., if only one can be
undertaken), then the decision should be to do that which creates most wealth or
shows the greatest amount of net present worth. In short, the operating objective
for financial management is to maximise wealth or net present worth.
Wealth maximisation is more operationally valid because of the following reasons:
(a) It is a precise and unambiguous concept. The wealth maximisation means
maximising the market value of shares.
(b) It takes into account both the quantity and quality of the expected steam of
future benefits. Adjustments are made for risk (uncertainty of expected returns) and
timing (time value of money) by discounting the cash flows.

2. Scope/Elements:

Investment decisions: It includes investment in fixed assets (called as capital

budgeting). Investment in current assets are also a part of investment decisions
called as working capital decisions. The investment decision involves the
evaluation of risk, measurement of cost of capital and estimation of expected
benefits from a project. Capital budgeting and liquidity are the two major
components of investment decision. Capital budgeting is concerned with the
allocation of capital and commitment of funds in permanent assets which would
yield earnings in future.
Capital budgeting also involves decisions with respect to replacement and
renovation of old assets. The finance manager must maintain an appropriate

12

balance between fixed and current assets in order to maximise profitability and to
maintain desired liquidity in the firm.
Financial decisions : While the investment decision involves decision with
respect to composition or mix of assets, financing decision is concerned with the
financing mix or financial structure of the firm. The raising of funds requires
decisions regarding the methods and sources of finance, relative proportion and
choice between alternative sources, time of floatation of securities, etc. In order to
meet its investment needs, a firm can raise funds from various sources.
The finance manager must develop the best finance mix or optimum capital
structure for the enterprise so as to maximise the long- term market price of the
companys shares. A proper balance between debt and equity is required so that the
return to equity shareholders is high and their risk is low.
Dividend decision : In order to achieve the wealth maximisation objective, an
appropriate dividend policy must be developed. One aspect of dividend policy is to
decide whether to distribute all the profits in the form of dividends or to distribute
a part of the profits and retain the balance. While deciding the optimum dividend
payout ratio (proportion of net profits to be paid out to shareholders).
The finance manager should consider the investment opportunities available to the
firm, plans for expansion and growth, etc. Decisions must also be made with
respect to dividend stability, form of dividends, i.e., cash dividends or stock
dividends, etc.

13

Nature of Financial Statement:

It is very well known that the financial statements basically refer to balance sheets
and Income statements. Of course these two basic statements are supported by a
number of schedules, supplementary statements, explanatory notes, etc. Therefore
all these are financial statements. They show with supporting figures, earn or loss
incurred during an accounting period and also the assets, liabilities and capital at
the end of the last day of the accounting period. These statements reflect a
combination of recorded facts, accounting convention and personal judgments. It is
therefore obvious that the figure included in the financial statements is influenced
by these factors.
They are as follows-

RECORDED FACTS:
Financial statements contain the fact relating to the business transaction already
recorded in the book of accounts. The unrecorded facts, whatever important they
might have not included in financial statements. The examples are human
resources, which are not shown in these statements because they are not recorded
in the books.

ACCOUNTING CONVENTION:
Accounting convention implies certain accounting principle which has been
satisfied by the long user. In other words they refer usages and customary practices
in social and economic life of human being which have been generally accepted in
building up the accounting principles. For examples, on account of convention of
conservation provision is made for expected losses but expected profits are
ignored. It means that the real business position of the firm is better than what is
shown in the financial statements.

14

ACCOUNTING ASSUMPTION OR CONCEPTS

:GAAPs or Generally Accepted Accounting Principles are in the form of guidelines
and rules which are to be used as standard for recording business transaction in the
book of accounts and their fair presentation in the financial statements. Because
their statements have to prepare in conformity with GAAPs, these GAAPs include
principles, concepts and assumption. Consequently the figures recorded in the
financial statements are influenced by GAAP. For examples Inventory valuation
states those year-end inventories are to be valued at lower of cost or market price.
That means the value of year-end inventory which appears in the financial
statements is influenced by these principles.

PERSONAL JUDGMENT:
It is true that Generally Accepted Accounting Principles and concepts are followed
in preparing financial statements but their application in most of the cases depends
on personal judgment of the accountant. For examples, the choice of selecting
methods of depreciation lies on the accountant. Similarly the method of valuing
inventory also depends on the personal judgment of the accountant.

15

Types of Financial Institution

Commercial Banks:
Commercial banks accept deposits and provide security and convenience to their
customers. Part of the original purpose of banks was to offer customers safe
keeping for their money. By keeping physical cash at home or in a wallet, there are
risks of loss due to theft and accidents, not to mention the loss of possible income
from interest. With banks, consumers no longer need to keep large amounts of
currency on hand; transactions can be handled with checks, debit cards or credit
cards, instead.
Commercial banks also make loans that individuals and businesses use to buy
goods or expand business operations, which in turn leads to more deposited funds
that make their way to banks. If banks can lend money at a higher interest rate than
they have to pay for funds and operating costs, they make money.

Investment Banks:
The stock market crash of 1929 and ensuing Great Depression caused the United
States government to increase financial market regulation. The Glass-Steagall Act
of 1933 resulted in the separation of investment banking from commercial
banking.
While investment banks may be called "banks," their operations are far different
than deposit-gathering commercial banks. An investment bank is a financial
intermediary that performs a variety of services for businesses and some
governments. These services include underwriting debt and equity offerings, acting
as an intermediary between an issuer of securities and the investing public, making
markets, facilitating mergers and other corporate reorganizations, and acting as a
broker for institutional clients. They may also provide research and financial
advisory services to companies. As a general rule, investment banks focus on
initial public offerings (IPOs) and large public and private share offerings.
Traditionally, investment banks do not deal with the general public. However,
some of the big names in investment banking, such as JP Morgan Chase, Bank of
America and Citigroup, also operate commercial banks. Other past and present
16

investment banks you may have heard of include Morgan Stanley, Goldman Sachs,
Lehman Brothers and First Boston.

Insurance Companies:
Insurance companies pool risk by collecting premiums from a large group of
people who want to protect themselves and/or their loved ones against a particular
loss, such as a fire, car accident, illness, lawsuit, disability or death. Insurance
helps individuals and companies manage risk and preserve wealth. By insuring a
large number of people, insurance companies can operate profitably and at the
same time pay for claims that may arise. Insurance companies use statistical
analysis to project what their actual losses will be within a given class. They know
that not all insured individuals will suffer losses at the same time or at all.

Brokerages:
A brokerage acts as an intermediary between buyers and sellers to facilitate
securities transactions. Brokerage companies are compensated via commission
after the transaction has been successfully completed. For example, when a trade
order for a stock is carried out, an individual often pays a transaction fee for the
brokerage company's efforts to execute the trade. A brokerage can be either full
service or discount. A full service brokerage provides investment advice, portfolio
management and trade execution. In exchange for this high level of service,
customers pay significant commissions on each trade. Discount brokers allow
investors to perform their own investment research and make their own decisions.
The brokerage still executes the investor's trades, but since it doesn't provide the
other services of a full-service brokerage, its trade commissions are much smaller.

Unit Investment Trusts (UITs):

A unit investment trust, or UIT, is a company established under an indenture or
similar agreement. It has the following characteristics:
The management of the trust is supervised by a trustee.
Unit investment trusts sell a fixed number of shares to unit holders, who
receive a proportionate share of net income from the underlying trust.

17

 The UIT security is redeemable and represents an undivided interest in a

specific portfolio of securities.
The portfolio is merely supervised, not managed, as it remains fixed for the
life of the trust. In other words, there is no day-to-day management of the
portfolio.

Management Investment Companies:

The most common type of investment company is the management investment
company, which actively manages a portfolio of securities to achieve its
investment objective. There are two types of management investment company:
closed-end and open-end. The primary differences between the two come down to
where investors buy and sell their shares - in the primary or secondary markets and the type of securities the investment company sells.

Closed-End Investment Companies:

A closed-end investment
company issues shares in a one-time public offering. It does not continually offer
new shares, nor does it redeem its shares like an open-end investment company.
Once shares are issued, an investor may purchase them on the open market and sell
them in the same way. The market value of the closed-end fund's shares will be
based on supply and demand, much like other securities. Instead of selling at net
asset value, the shares can sell at a premium or at a discount to the net asset value.

Open-End Investment Companies:

Open-end investment companies,

also known as mutual funds, continuously issue new shares. These shares may only
be purchased from the investment company and sold back to the investment
company. Mutual funds are discussed in more detail in the Variable Contracts
section.

Savings and Loans:

Savings and loan associations, also known as S&Ls or thrifts, resemble banks in
many respects. Most consumers don't know the differences between commercial
banks and S&Ls. By law, savings and loan companies must have 65% or more of
their lending in residential mortgages, though other types of lending is allowed.
18

S&Ls emerged largely in response to the exclusivity of commercial banks. There

was a time when banks would only accept deposits from people of relatively high
wealth, with references, and would not lend to ordinary workers. Savings and loans
typically offered lower borrowing rates than commercial banks and higher interest
rates on deposits; the narrower profit margin was a byproduct of the fact that such
S&Ls were privately or mutually owned.

Credit Unions:
Credit unions are another alternative to regular commercial banks. Credit unions
are almost always organized as not-for-profit cooperatives. Like banks and S&Ls,
credit unions can be chartered at the federal or state level. Like S&Ls, credit
unions typically offer higher rates on deposits and charge lower rates on loans in
comparison to commercial banks.
In exchange for a little added freedom, there is one particular restriction on credit
unions; membership is not open to the public, but rather restricted to a particular
membership group. In the past, this has meant that employees of certain
companies, members of certain churches, and so on, were the only ones allowed to
join a credit union. In recent years, though, these restrictions have been eased
considerably, very much over the objections of banks.

19

CHAPTER 3
Introduction to Profit maximization & Valuation
Profit maximization
Profit maximization is the main aim of any business and therefore it is also an
objective of financial management. Profit maximization, in financial management,
represents the process or the approach by which profits (EPS) of the business are
increased. In simple words, all the decisions whether investment, financing, or
dividend etc are focused to maximize the profits to optimum levels.
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
positive effect on the profits, the decision is taken further for implementation.
In economics, 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. There are
several approaches to this problem. The total revenuetotal cost perspective relies
on the fact that profit equals revenue minus cost and focuses on maximizing this
difference, and the marginal revenuemarginal cost perspective is based on the fact
that total profit reaches its maximum point where marginal revenue equals
marginal cost.
A process that companies undergo to determine the best output and price levels in
order to maximize its return. The company will usually adjust
influential factors such as production costs, sale prices, and output levels as a way
of reaching its profit goal. There are two main profit maximization methods used,
and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total
Revenue Method. Profit maximization is a good thing for a company, but can be a
20

bad thing for consumers if the company starts to use cheaper products or decides to
raise prices.
Any costs incurred by a firm may be classed into two groups: fixed
costs and variable costs. Fixed costs, which occur only in the short run, are
incurred by the business at any level of output, including zero output. These may
include equipment maintenance, rent, wages of employees whose numbers cannot
be increased or decreased in the short run, and general upkeep. Variable costs
change with the level of output, increasing as more product is generated. Materials
consumed during production often have the largest impact on this category, which
also includes the wages of employees who can be hired and laid off in the span of
time (long run or short run) under consideration. Fixed cost and variable cost,
combined, equal total cost.
Revenue is the amount of money that a company receives from its normal business
activities, usually from the sale of goods and services (as opposed to monies from
security sales such as equity shares or debt issuances)
Marginal cost and revenue, depending on whether the calculus approach is taken or
not, are defined as either the change in cost or revenue as each additional unit is
produced, or the derivative of cost or revenue with respect to the quantity of
output. For instance, taking the first definition, if it costs a firm 400 USD to
produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is 80
dollars.

The objective of financial management is profit maximisation. It cannot be the sole

objective of a company as there is a directs/relationship between risk and profit. If
profit maximisation is the only goal, then risk factories ignored.

21

Sometimes, higher the risk, higher is the possibility of profits. Hence, risk has to be
balanced with the objective of profit maximisation. In addition, a firm has to take
into account the social considerations, and normal obligations to the interests of
workers, consumers, society, government, as well as ethical trade practices.
However, as profit maximisation ignores risk and uncertainty and timing of returns,
a firm cant solely depend on the objective.

22

Profit Maximization Theory

Profit maximization theory of directing business decisions is encouraged because

of following advantages associated with it.
o

Economic Survival: Profit maximization theory is based on profits and

profits are a must for survival of any business.

Measurement Standard: Profits are the true measurement of viability of a

business model. Without profits, the business losses its primary objective and
therefore has a direct risk on its survival.

Social and Economic Welfare: 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.

23

Limitations of Profit Maximization as an objective of Financial

Management:

Profit maximization is criticized for some of its limitations which are discussed
below:
o

Haziness of the concept Profit: The term Profit is a vague term. It is

because different mindset will have different perception about profit. For e.g.
profits can be the net profit, gross profit, before tax profit, or the rate of profit
etc. There is no clear defined profit maximization rule about the profits.
o gnores Time Value of Money: 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.
o Ignores the Risk: A decision solely based on profit maximization model
would take 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.
o Ignores Quality: 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

24

generating value for a business is not worth ignoring. They indirectly

create assets for the organization.

Profit maximization ruled the traditional business mindset which has gone
through drastic changes. In the modern approach of business and financial
management, much higher importance is assigned to wealth maximization in
comparison of Profit Maximization vs. Wealth Maximization. The loosing
importance of profit maximization is not baseless and it is not only because it
ignores certain important areas such as risk, quality, and time value of money but
also because of the superiority of wealth maximization as an objective of business
or financial management.

25

How Do We Calculate Profit Maximization?

The calculation for profit maximization is: the number of units where MR = MC.
Okay, we definitely need a few definitions before we go any further!
Profit: the money left over once you pay all of your bills out of funds that
come in from your customers. So for example, if you sell 5 necklaces for $5
each, and the cost to purchase the necklaces is $3, you will have revenues
(customer monies in) of 5 necklaces * $5 each = $25, and costs of 5
necklaces * $3 each = $15. Your profit will be $25 revenue - $15 cost = $10
remaining.
MR: This stands for 'marginal revenue,' which means the per-unit selling
price of your item. It is often true that to sell more units you have to reduce
the price, so we will show marginal revenue as a line sloping down to the
right in our graph below.
MC: This stands for 'marginal cost,' which means the per-unit cost of your
item. MC is generally shown as a line that slopes downward and then comes
back up. This is based on the fact that per-unit costs will decrease to a
certain point as you increase the number of units produced at your plant;
then once you reach capacity your costs will increase as you either open a
new plant or outsource production to other companies.

26

I.

The Concept of Profit Maximization

Profit is defined as total revenue minus total cost. = TR TC (We use to stand
for profit because we use P for something else: price.) Total revenue simply means
the total amount of money that the firm receives from sales of its product or other
sources. Total cost means the cost of all factors of production. But and this is
crucial we have to think in terms of opportunity cost, not just explicit monetary
payments. If the owner of the business also works there, we must include the value
of his time. If the firm owns machines or land, we must include the payments those
factors could have earned if the firm had chosen to rent them out instead of using
them. If only explicit monetary costs are considered, we get accounting profit. But
to find economic profit, we need to take into account the opportunity cost, implicit
or explicit of all resources employed. The main constraints faced by the firm are:
technology, as summarized in the cost curves of the last lecture; the prices of
factors of production, also taken into account by the cost curves; and the demand
for its product.

II. Demand Curve Facing the Firm

The firms demand curve tells how much consumers will buy at each price from a
particular firm. (This is distinguished from other kinds of demand curve, such as
the market demand curve, which shows how much consumers will buy at each
price from all firms put together.) The shape of the firms demand curve is related
to the degree of competition in the market. Loosely speaking, more competition
causes the firms demand curve to be more elastic (flatter), because consumers can
respond to price increases by shifting their purchases to other firms. Less
competition, on the other hand, implies a more inelastic (steeper) demand curve.
Perfect competition and monopoly turn out to be the extreme ends of the spectrum:
a perfectly competitive firm faces a perfectly horizontal demand curve; a
monopoly faces the whole market demand curve.
27

III. Total and Marginal Revenue

Total revenue (TR) is the total amount of money the firm collects in sales. Thus,
TR = pq if p is the price and q is the quantity the firm sells. Notice that Im using a
small q, because this is just one firm (Q is reserved for the market as a whole). If
the firm faces a downward-sloping demand curve, picking a quantity q
automatically implies picking a price p. Why? Because the firm must be operating
on the demand curve. Any chosen price corresponds to a specific quantity that
consumers will buy at that price, and any chosen quantity corresponds to a specific
price that will induce consumers to buy the chosen quantity. To sell more, the firm
must lower its price. Graphically, TR is represented the rectangle created by p and
q. Marginal revenue is the change in total revenue from increasing quantity by one
unit. That is, MR = TR/q, where the change in q is usually one. Now, you might
think that MR must be equal to the price, p, because thats how much you get paid
for selling one more unit. But this is not true in general. Why not? Because if you
face a downward-sloping demand curve, you have to lower your price to sell more.
So if you increase your quantity, youre also lowering your price for all the
previous units of the good. Example: Suppose youre currently selling 10 units at
$20 each. To sell an 11th unit, youll have to lower the price to $19. So, you gain
$19 from the additional unit. But you also lose $1 each on the previous ten units
that you could have sold at $20 each. So your marginal revenue from the 11th unit
is not $19, but rather $9. You can see this from looking at the total revenue: before,
TR = 20(10) = 200, but now TR = 19(11) = 209. Thus, TR rose by only $9. This
analysis leads to the following general conclusion: that MR is always below the
demand curve. Why? At any quantity, the demand curve tells us the price
corresponding to that quantity. But weve just shown that the MR must be less than
the price, and hence below the demand curve. The only place MR and the demand
curve are equal is the point where the cross the vertical axis. In general, any time a
firm lowers its price, there are two effects: the people buy more units effect, and
the people pay less per unit effect. Which effect is larger determines whether MR
is positive or negative. It turns out this is closely related to the price elasticity of
demand.

28

Advantages & Disadvantages of Profit Maximization

When a firm applies profit maximization, it is basically saying that its primary
focus is on profits, and it will use its resources solely to get the biggest profits
possible, regardless of the consequences or the risk involved. Profit maximization
is a generally short-term concept. Application usually lasts less than one year,
although some companies employ this strategy exclusively, constantly jumping on
the next big trend.
Risk
Pursuing a profit maximization strategy comes with the obvious risk that the
company may be so entrenched in the singular strategy meant to maximize its
profits that it loses everything if the market takes a sudden turn. For example, a
company may find that it gets the most profit selling the Wii gaming system, so
instead of keeping a balanced inventory, it invests solely in buying Wiis to sell. If
the Wii goes out of favor or the makers of the Wii begin to limit the price that can
be charged for the system, the company that relied solely on its investment in Wiis
could lose everything. Similarly, if a company focuses only on maximizing its
profit, it may miss opportunities for investment and expansion.
Expectation and Goodwill
You also need to consider consequences of profit maximization. If a company
pursues a profit maximization strategy, it creates an environment where price is a
premium and cutting costs is a primary goal. This, in turn, creates a perception of
the company that could lead to a loss of goodwill with customers and suppliers; for
instance, a company may win subsequent contracts with a client by bidding the
first job low. It also creates an expectation of shareholders to see immediate gains,
rather than realizing profits over time.

29

Cash Flow
For all its drawbacks, profit maximization carries the big advantage of creating
cash flow. When maximizing profit is the primary consideration, investments,
reinvestments and expansions are typically tabled. The company simply makes do
on what it has. This can create a more cost-efficient environment. In the mean
time, the profits keep building, producing a healthy bottom line and increasing the
firms amount of available cash. Sometimes profit maximization is used entirely to
create an influx of cash so the firm can reduce its debt or save up for expansion.
Financing and Investors
Some degree of profit maximization is always present. The goal of a company is to
create profits. It has to profit from its business to stay in business. Moreover,
investors and financiers in the company may require a certain level of profits to
secure funds for expansion. Further, a company has to perform well for its
shareholders; they expect a return on their investments. As such, maximizing that
profit is always a consideration to some extent.

30

CHAPTER 4
Conclusions
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. There are several
approaches to this problem. The total revenuetotal cost perspective relies on the
fact that profit equals revenue minus cost and focuses on maximizing this
difference, and the marginal revenuemarginal cost perspective is based on the fact
that total profit reaches its maximum point where marginal revenue equals
marginal cost.
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. There are several
approaches to this problem. The total revenuetotal cost perspective relies on the
fact that profit equals revenue minus cost and focuses on maximizing this
difference, and the marginal revenuemarginal cost perspective is based on the fact
that total profit reaches its maximum point where marginal revenue equals
marginal cost.

31

Bibliography

1. https://en.wikipedia.org/wiki/Financial_management
2. http://www.managementstudyguide.com/financialmanagement.htm
3. http://searchfinancialapplications.techtarget.com/definit
ion/financial-management-system
4. http://www.wd-deo.gc.ca/eng/10896.asp
5. https://en.wikipedia.org/wiki/Profit_maximization
6. http://study.com/academy/lesson/profit-maximizationdefinition-equation-theory.html
7. http://www.investorwords.com/7690/profit_maximizatio
n.html

32

33