BUSINESS FINANCE ASSIGNMENT 1

QUESTION 1

Although profit maximization has been long been considered as the main goal of a firm, shareholder wealth maximization is gaining acceptance amongst most companies as the key goal of the firm: a) Distinguish between the goals of profit maximization and shareholder wealth maximization:
Profit is the difference between the sales price and the costs. So profit maximization can be done by getting the maximum sales price and by spending the least amount of money. Wealth Maximization-It means maximizing the net present value of a course of action.Net present value = Net present value of benefits- net present value of costs. The financial action which generates positive net present value adds to the wealth of the firm and thus is desirable.

b) Explain three limitations of the goal of profit maximization :

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. Ignores 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. Ignores the Risk: A decision solely based on profit maximization model would take decision in favour 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. 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 generating value for a business is not worth ignoring. They indirectly create assets for the organization.

c) Explain three key roles of a capital markets regulator in your country:

Mobilization of Savings: Capital market is an important source for mobilizing idle savings from the economy. It mobilizes funds from people for further investments in the productive channels of an economy. In that sense it activates the ideal monetary resources and puts them in proper investments.

Capital Formation: Capital market helps in capital formation. Capital formation is net addition to the existing stock of capital in the economy. Through mobilization of ideal resources it generates savings; the mobilized savings are made available to various segments such as agriculture, industry, etc. This helps in increasing capital formation. Provision of Investment Avenue: Capital market raises resources for longer periods of time. Thus it provides an investment avenue for people who wish to invest resources for a long period of time. It provides suitable interest rate returns also to investors. Instruments such as bonds, equities, units of mutual funds, insurance policies, etc. definitely provides diverse investment avenue for the public. Speed up Economic Growth and Development: Capital market enhances production and productivity in the national economy. As it makes funds available for long period of time, the financial requirements of business houses are met by the capital market. It helps in research and development. This helps in, increasing production and productivity in economy by generation of employment and development of infrastructure. Proper Regulation of Funds: Capital markets not only helps in fund mobilization, but it also helps in proper allocation of these resources. It can have regulation over the resources so that it can direct funds in a qualitative manner.

d) Highlight the importance of the following terms in investment appraisal: -Internal rate of return (IRR):
The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. It can also be defined as the discount rate at which the present value of all future cash flow is equal to the initial investment or in other words the rate at which an investment breaks even. In more specific terms, the IRR of an investment is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first. A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.

-Payback period:
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite the recognized limitations.