Financial management revision question and answer

(a) Although profit maximization has long been considered as the main goal of a firm, shareholder wealth maximization is gaining acceptance amongst most companies as the key goal of a firm.

Required:
(i) Distinguish between the goals of profit maximization and shareholder wealth maximization.
(ii) Explain three limitations of the goal of profit maximization.

(b) Explain three key roles of a capital markets regulator in your country.

(c) Highlight the importance of the following terms in investment appraisal:

(i) Internal rate of return (IRR)
(ii) Payback period.
ANSWER
i) The goal of profits maximization involves maximizing the accounting profits either increasing sales (selling price) or reducing costs
– Profits = Sales revenue – Costs
– In a competitive environment, firms are operating at 100% capacity hence volume/ production cannot be increased thus sales revenue can be increased through increase in selling price
• Shareholding wealth maximization includes maximizing the share price undertaking all projects yielding the highest net present value (N.P.V)

– The focus is to maximize the P.V of Cash flow where
(ii) Limitations of profit maximization goal
– It‟s vague or unclear: does it refer to gross profits, operating profits, net profits,long term or short term profits e.t.c
– It ignores the time value of money
– It ignores risk and uncertainty of benefits/ profits received in future
– It ignores the plight of other stakeholders such as consumers and employees and only consider the owners
– It is a short term goal e.g. cost reduction or increase in selling price is short term measure

(b) The capital markets regulator in Kenya is Capital Market Authority which performs the following roles:
• To remove bottlenecks and create awareness for investment in long term securities •
To serve as efficient bridge between the public and private sectors
• Create an environment which will encourage local companies to go public •
To grant approvals and licenses to brokers
• To operate a compensation fund to protect investors from financial losses should licensed brokers fail to meet their contractual obligation
• Act as a watchdog for the entire capital market system
• To establish operational rules and regulations on placement of securities
• To implement government programs and policies with respect to the capital markets

(c) Importance of
(i) Internal rate of return (I.R.R)
– A discounted cash flow project appraisal technique which indicates the % yield/ rate of return of an individual project independent of other projects
– It equates N.P.V to zero so that at I.R.R, Total P.V of cash flows = Initial capital

Payback period (PBP)

(ii) – A non-discounted cash flow project appraisal technique indicating the number of years within which initial capital can be recovered from cash flows generated the project
– It indicates the projects liquidity so that the shorter the PBP the better the project

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