Scope and Objectives of Financial Management: formula sheet

Key formulas

Profit maximisation

Goal: maximise profit (earnings) of the firm

Ignores timing, risk and cash flows. It is a short-term, accounting-based goal.

Wealth maximisation

Wealth of shareholders = Number of shares × Market price per share

Value of the firm rises when the market price of equity rises.

Net present value (decision rule)

NPV = Σ [Cash inflow in year t ÷ (1 + k)^t] − Initial outlay

Accept a project if NPV is greater than zero. Here k is the risk-adjusted discount rate. This links wealth maximisation to project decisions.

Earnings per share (EPS)

EPS = (Profit after tax − Preference dividend) ÷ Number of equity shares

EPS maximisation is a version of profit maximisation. It still ignores risk and timing.

Total agency costs

Agency costs = Monitoring costs + Bonding costs + Residual loss

This is the standard three-part classification. There is no numerical formula to compute residual loss; it is usually estimated or given.

Principal-agent relationship

Principal = Shareholders; Agent = Managers

For the creditor conflict, lenders are the other principals. Name both parties clearly in the answer.

Alignment idea (ESOP)

Manager gain from ESOP per share = Market price at exercise − Exercise price

The manager gains only if share price rises above the exercise price. This ties pay to shareholder wealth.

Economics link

Microeconomics → firm-level decisions; Macroeconomics → environment

Micro: pricing, cost, marginal analysis, value maximisation. Macro: interest rates, inflation, taxes, policy, growth.

Accounting vs financial management

Accounting = recording and reporting (accrual, past); Financial management = decision making (cash flow, future)

Use this one-line contrast in any 'differentiate' or 'relationship' question.

Treasurer's functions

Treasurer = funds: raising capital, cash management, banking, investment of surplus, credit and risk handling

Think of the treasurer as looking after money coming in and going out.

Controller's functions

Controller = accounting, financial reporting, budgeting, cost control, internal audit and tax compliance

Think of the controller as looking after the accuracy of records and control of performance.

Quick revision

• Financial management means planning, raising, using and controlling funds efficiently to achieve the firm's goals.
• The three core decisions are investment, financing and dividend.
• Investment decision decides where funds go: which assets and projects to take up.
• Financing decision decides the mix of debt and equity used to fund the investments.
• Dividend decision decides how much profit to pay out and how much to retain.
• Profit maximisation ignores the timing of returns, risk and cash flows.
• Wealth maximisation focuses on increasing the value of the shareholders' stake, taking time value and risk into account.
• Wealth maximisation is the accepted objective because it is more complete and measurable than profit maximisation.
• The agency problem arises when managers (agents) act in their own interest rather than the owners' (principals').
• Agency costs include monitoring costs, bonding costs and the residual loss from decisions that still differ from the owners' interest.
• Aligning managers with owners can use incentives such as performance-linked pay and share-based rewards, along with monitoring.
• Finance draws on economics, accounting, law, taxation, statistics and other fields for theory, data and constraints.

Common mistakes

• Placing working capital management under the financing decision only. Fix: Remember that managing current assets is a use of funds, so it belongs to the investment decision. Arranging the funds for it is financing.
• Reversing the traditional and modern approaches. Fix: Traditional means mainly raising funds, seen from outside the firm. Modern means allocation and use of funds as well, seen from inside.
• Saying profit maximisation considers risk and the time value of money. Fix: Remember the key weakness: it treats a rupee today and a rupee after five years as equal and ignores uncertainty.
• Defining wealth maximisation as maximising the profit of the firm over the long run. Fix: Define wealth as the market value of shareholders' equity, based on the present value of expected cash flows adjusted for risk.
• Treating agency problem as only a shareholder-manager issue. Fix: Write both conflicts in one line each: shareholders versus managers, and shareholders versus creditors.
• Mixing up monitoring and bonding costs. Fix: Remember who is spending. Principal watches the agent: monitoring. Agent assures the principal: bonding.
• Writing that financial management and accounting are the same thing. Fix: State that accounting records and reports past events, while financial management uses that data and cash flows to take future decisions.
• Mixing up treasurer and controller functions. Fix: Remember: treasurer = funds (raising, custody, investment); controller = records and control (accounting, reporting, budgets, audit).

Exam tips

• Questions often ask for scope in 4 to 5 marks. Use definition, three decisions and a linking line.
• In case-based questions, name the decision first, then explain in one line why.
• MCQs often test which decision a given action belongs to or the difference between traditional and modern approaches.
• For finance function or finance manager role, group points under headings instead of writing a long unstructured list.
• Expect both theory and MCQs here. Learn the four comparison bases so you can write a distinguishing answer in under five minutes.
• For MCQs, watch for statements such as 'profit maximisation considers risk'. These are almost always the wrong option.
• In a 'critically examine' question, give merits and limitations of both goals, then a clear conclusion in favour of wealth maximisation.
• Use the words 'time value of money', 'risk', 'cash flows' and 'market value of equity'. These are the keywords examiners look for.