Profit Maximization Approach

FINANCE 2

The company must take the investment and the decisions of financing on a basis of continuation. To take the wise optimum and the decision, a clear arrangement of the objectives is a need. There are two approaches broad-discussed concerning objectives financial management. One is approach of maximization of benefit and second is approach of maximization of richness.

In this article we are discussing on Profit Maximization Approach

The objectives are employed in the direction of a criterion of goal or decision for the decision implied in financial management.

Profit maximization approach

The economists believes that one long period that the maximum benefit of income is the single goal of any organization of businesses, because that will also lead to the optimum allocation of resources. Actions which increase the benefit of companies are undertaken and those which decrease the benefit are avoided. Thus, of the prospect for the economic theory, the maximization of benefit is simple a criterion of economic efficiency. There is also an extensive agreement which under the perfect competition, where all the prices reflect true values exactly and consume them are quite informed, benefit maximizing the behavior by companies leads to the effective allocation of resources and the maximum good social being.

The rationale behind profit maximization objectives is simple. A business firm is s profit seeking organization. Profit is a test of economic efficiency, It is assumed to lead to efficient allocation of resources, It ensure maximum social welfare

Limitation of profit maximization objectives

The concept of the benefit is vague

The definition of the benefit of limit is vague and ambiguous. Does it refer to the gross profit or profits after tax? Total benefit or benefit by share? The benefit is interpreted by various people in various manners.

Ignores time value of money

The fact that one rupee received today is of more than value than one rupee received later. This concept is to lead been unaware of to the errors in decision making.

It ignores risk

The future advantages can have various degrees of certainty. The more certain the return envisaged is, the more is its high value or reciprocally more is the return envisaged dubious. More is its lower value. This concept is also completely ignored. It also arranges the two proposals implying various degrees of risk.

A system based on the private property and the maximization of benefit could be effective, but it carries out it leads to the serious inequality of the income and the richness among various groups. Naturally, the contrary argument is that the company as a whole is clearly easier because it leads to the optimum allowance of the resources of the company.

The financial management 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 fulfill objective of earning profit but may not help in creating wealth. It is because wealth creation needs a longer term horizon Therefore, Finance Management or 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 business. For e.g., under wealth maximization, more importance is given to cash flows rather than profitability. As it is said that profit is a relative term, it can be a figure in some currency, it can be in percentage etc. For e.g. a profit of say $10,000 cannot be judged as good or bad for a business, till it is compared 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 under 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 and also use discounting technique to find out worth of a project. Thus, maximization of wealth approach believes that money has time value.

An obvious question that arises now is that how can we measure wealth. Well, a basic principle is that ultimately wealth maximization should be discovered in increased net worth or value of business. So, to measure the