Why is it more important to get the maximization of value (\"value maximization\

Question

Why is it more important to get the maximization of value ("value maximization") that the maximization of profit ("profit maximization") as a goal of enterprise management?

By exposing your answer you should:

Indicate which are the three fundamental decisions the finance manager should take and how they affect the financial statements of the company.

Explain what is the appropriate decision criteria used by financial managers when selecting a capital project.

Justify your answer with an example to the main question.

Explanation / Answer

Solution:

Part A.In enterprise management, value of an enterprise is known as the sum of all sources for capital raise, thus all sources which have supplied capital to the firm constitute the value of the firm. Also known as enterprise value, it is calculated as:

         Enterprise value = Market Capitalization + Preferred equity + Net debt
Here, all three components of the enterprise value supply capital to the firm for their functioning.
Market Capitalization is the product of common equity shares outstanding in the market with the share price.
Preferred equity is the value of all preferred equity holders of the company
Net Debt is the difference between all short term-long term borrowings and the cash available with the company
Now, when we talk about the 'Value Maximization', it means that the sum of all these components should maximize but when we talk about 'Profit maximization', it means maximising the net income of the company.

Now it is quite possible that the firm is making huge profits but that profit is not being invested properly or utilized prudently for the future growth, so the shareholders' sentiments for the company will not improve and the share price of the company will not rise. If the share price will not rise,then the value of the firm will not increase if the other components are fixed. This will affect company in the long run in raising capital either from shareholders or from debt sources and without capital, the company's growth would not happen and its net income will slowly start to decline.

Hence, high profits and low value is not the right way for any enterprise looking for a future growth and that is why value maximization should be the goal of the management and not the profit maximization.

Part B. Three fundamental decisions a finance manager should take are:
1. Investment decision
2. Financing decision
3. Dividend decision

Their affect on company's statements are as follow:

Investment decision helps the finance manager to decide the areas of investing company's money for future profits. Some of the common investments decisions are type of assets to buy, when to buy, mergers or acquisitions to do and how much to invest. These decisions not only affect the cash flow statement but also the balance sheet of the statement

Financing decision involves the areas of sourcing capital for the investment. Through debt or common equity or preferred equity are some of the common financing decisions taken by the manager. These decisions affect the cash flow statement, liabilities part and also shareholder's equity part of balance sheet.

Dividend decision involves the amount of dividend to be distributed to shareholders and when to distribute. It impacts the cash flow statement and also the balance sheet, since it reduces the cash and increase shareholder's worth.

Part C. When selecting a capital project, financial managers should consider the 'Net present value' (NPV) of the project, which includes discounting future cash flows from the project and subtracting capital invested from them. Higher the NPV, better the project

As discussed earlier, a manager should consider maximizing the value of the firm and not the profits, similarly, in projects, NPV should be maximised and not the future cash flows

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