Financial Goals & Cost of Capital: Maximizing Business Value

Financial Goals: Profit vs. Wealth Maximization

The basic dictum of financial planning is “the earlier, the better.” According to this principle, Project ‘B’ is often preferable in investment scenarios.

Profit Maximization: Limitations

The profit maximization goal often overlooks critical factors, including the time value of money and the quality of benefits. If predicted earnings are more assured, the quality is high because the range of fluctuation is small. Profit maximization ignores the true value of benefits and does not consider the risks associated with profits.

The following table demonstrates the concept of Quality of Benefits based on Profit per Annum:

Project ‘A’ has higher quality earnings because its range is small [Rs 11,000 - Rs 9,000 = Rs 2,000]. In contrast, Project ‘B’ has a larger range [Rs 20,000 - 0 = Rs 20,000], suggesting lower quality profits. Therefore, the profit maximization goal is often unable to differentiate effectively between various ventures based on risk and quality.

Wealth Maximization

The firm's most widely accepted goal is to maximize the value of the company for its shareholders. Maximizing shareholder wealth serves as a reasonable guide for conducting business. According to the wealth maximization goal, managers should strive to maximize the present value of the firm's expected profits.

The discount rate (or cost of capital) is crucial for assessing the present value of future rewards, as it inherently considers both time and risk. The goal of financial management, according to the modern approach, is to maximize the firm's wealth.

The goal of wealth maximization can also be symbolically defined using a short-cut method:

PV = (A1 / (1+k)^1) + (A2 / (1+k)^2) + ... + (An / (1+k)^n) - C0

Where:

• A1, A2, ..., An represent the stream of benefits (cash inflows) expected to occur in the investment project.
• C0 is the initial cost of the project.
• k is the discount factor/capitalization rate used to calculate the present value of expected cash flows.

Implications of Wealth Maximization

Wealth maximization offers several significant implications for a company:

• It aims at the prosperity and perpetuity of a company.
• It helps in measuring the performance of a company.
• It aids in the efficient allocation and reallocation of scarce resources.
• It assists the company in discharging its other responsibilities effectively, such as:
  • Consumer protection
  • Payment of fair wages
  • Provision of safe working conditions
  • Environmental protection
  • Support for social problems
• It leads to efficient use of scarce and precious resources.
• It considers associated risks.

Cost of Capital

As explained earlier, Cost of Capital is the rate of compensation paid for the money invested in a business. This capital might be supplied by the promoter from their own savings or resources, or it might be borrowed.

In finance terminology, the term Cost of Capital refers to the minimum rate of return that a firm must earn on its investments to keep the value of the enterprise intact. It represents the rate of return which the firm must pay to the suppliers of capital for the use of their funds.

Characteristics of Cost of Capital

The following are the basic characteristics of the Cost of Capital:

1. Cost of capital is a rate of return, not expressed in absolute amounts.
2. A firm’s cost of capital represents the minimum rate of return that will result in at least maintaining (if not increasing) the value of the firm.
3. Cost of Capital, as a rate of return, is calculated based on the actual cost of different components of capital.
4. It is usually related to long-term capital funds.

In operational terms, Cost of Capital, in terms of a rate of return, is used as a discount rate. It is applied to discount future cash inflows to determine their present value and compare it with the investment outlay.

Assessment of the Cost of Capital is always related to risk. Different kinds of investments involve diverse risk levels. For example:

• Putting money in a bank yields some return at zero risk.
• Investing money in a Debenture/Bond of a company carries some risk.
• Investing in Equity Shares of a company, whose share prices fluctuate, is considered riskier.

Computing Cost of Capital for Individual Components

Computation of the cost of capital from each source of funds helps in determining the overall cost of capital for the firm. There are four basic sources of long-term funds for a business firm:

1. Long-term Debt and Debentures
2. Preference Share Capital
3. Equity Share Capital
4. Retained Earnings

Though all of these sources may not be tapped by the firm for funding its activities at any single point in time, each firm will typically have some of these sources in its capital structure. The specific cost of each source of funds is the after-tax cost of financing.