Profit Maximization :

Main aim of any kind of economic activity is

earning profit. A business concern is also functioning mainly for
the purpose of earning profit. Profit is the measuring techniques
to understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach, which
aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share
maximization. It leads to maximize the business operation for
profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it
considers all the possible ways to increase the profitability of the
concern
3. Profit is the parameter of measuring the efficiency of the
business concern. So it shows the entire position of the business
concern.
4. Profit maximization objectives help to reduce the risk of the
business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit
maximization objectives of the business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.

(v) Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit
maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt
practice, unfair trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among
the sake holders such as customers, suppliers, public
shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or
correctly. It creates some unnecessary opinion regarding earning
habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does
not consider the time value of money or the net present value of
the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of
the business concern. Risks may be internal or external which will
affect the overall operation of the business concern.

Wealth Maximization
Wealth maximization is one of the modern approaches, which
involves latest innovations and improvements in the field of the

business concern. The term wealth means shareholder wealth or

the wealth of the persons those who are involved in the business
concern. Wealth maximization is also known as value
maximization or net present worth maximization. This objective is
an universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
(1) Wealth maximization is superior to the profit maximization
because the main aim of the business concern under this concept
is to improve the value or wealth of the shareholders.
(2) Wealth maximization considers both time and risk of the
business concern.
(3) Wealth maximization provides efficient allocation of
resources.
(4) It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the
business concern but it may not be suitable to present day
business activities.
(ii) Wealth maximization is nothing, it is also profit maximization,
it is the indirect name of the profit maximization.
(iii) Wealth maximization creates ownership-management
controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is
to maximize the profit.
(vi) Wealth maximization can be activated only with the help of
the profitable position of the business concern

SOURCES OF FINANCE
A business might have access to various sources of financing its needs. These sources of finance can be
classified as:

Internal and external

Internal: this is money raised from inside the business. It includes

Sales of assets: Business might sell off old, obsolete assets which are no longer used by the
business to raise additional cash for the business.

Advantag Disadvantage
e
Better use of capital

A new business might not have any old

or obsolete assets

Retained profits: Businesses (especially limited companies) usually keep some part of the profit
every year for future use. This is also known as ploughed back profit. Over a period of time it can total up
to a huge amount which can be used for financing the business.

Advantage Disadvanta
ge
Does not increase liabilities
No need to pay interest

Not available to new businesses

Reduction in working capital: Cutting the stock levels can also help the business to raise
additional cash.

Advantag Disadvanta

e
Costs related to storage of
stock is reduced

ge
May lead to shortage of stock and
loss of sales

External: This is the money raised from outside the business. It includes

Short Term
Bank overdraft: Bank overdraft is a facility given by banks to its business customers, people having
current accounts. Through this facility the customers can overdraw their accounts to a greater value than
the balance in the account. To overdrawn amount is agreed in advance with the bank manager. The bank
assigns a limit to overdraw from the account and the business can meet its short term liabilities by writing
cheques to the extent of limit allowed.

Advantage

Disadvantage

No need for collaterals or

security.

Interest rates are usually variable

and higher than bank loans.

More flexible and the overdraft

amount can be adjusted every month
according to needs.

Cash flow problems can arise if

the bank asks for the overdraft to be repaid
at a short notice.

Trade Credit: Usually in business dealing supplier give a grace period to their customers to pay for the
purchases. This can range from 1 week to 90 days depending upon the type of business and industry.

Advantage
No interest has to be paid.

Disadvantage
The business may not get cash discounts.

By delaying the payment of bills for goods or services received, a business is, in effect, obtaining finance
which can be used for more important expenditures.
Factoring of debts: It involves the business selling its bills receivable to a debt factoring company at a
discounted price. In this way the business get access to instant cash.
Click on these links to know more about debt factoring
Factoring of debts
Advantages and Disadvantages of debt factoring

Medium Term
Hire purchase: It involves purchasing an asset paying for it over a period of time. Usually a percentage
of the price is paid as down payment and the rest is paid in installments for the period of time agreed
upon. The business has to pay an interest on these installments.
Leasing: Leasing involves using an asset, but the ownership does not pass to the user. Business can
lease a building or machinery and a periodic payment is made as rent, till the time the business uses the
assets. The business does not need to purchase the asset.

Advantage
The business can benefit from the
asset without purchasing it.

Disadvantage
The total cost of leasing may end up
higher than the purchasing of asset

Usually the maintenance of the asset

is done by the leasing firm.

Medium term bank loan: A bank loan for 1 year to 5 years.

Long term
Long term Bank loan: borrowing from bank for a limited period of time. The business has to pay an
interest on the borrowing. This interest may be fixed or variable. Businesses taking loan will often have to
provide security or collateral for the loan.
Issue of share: It is a permanent source of finance but only available to limited companies. Public limited
companies can sell further shares up to the limit of their authorized share capital. Private limited
companies can sell further shares to existing shareholders.

Advantage
Permanent source of capital.
In case of ordinary shares business will only
pay dividends if there is a profit.

Disadvantage
Dividends have to be paid to the shareholders.

Debentures: A debenture is defined as a certificate of acceptance of loans which is given under the
company's stamp and carries an undertaking that the debenture holder will get a fixed return (fixed on the
basis of interest rates) and the principal amount whenever the debenture matures. It is issued for a long
periods of time. Debentures are generally freely transferrable by the debenture holder. Debenture holders
have no voting rights and the interest given to them is a charge against profit.
Sales and lease back: this involves a firm selling its assets or property to an investment company and
then leasing it back over a long period of time. The business thus can use the asset without purchasing it
and can use the revenue earned from its sale for other purposes.
Next >

DEFINITION of 'Direct Tax '

A tax that is paid directly by an individual or organization to the imposing entity. A taxpayer
pays a direct tax to a government for different purposes, including real property tax,
personal property tax, income tax or taxes on assets. Direct taxes are different from indirect

taxes, where the tax is levied on one entity, such as a seller, and paid by another, such a
sales tax paid by the buyer in a retail setting.

INVESTOPEDIA EXPLAINS 'Direct Tax '

A direct tax cannot be shifted to another individual or entity. The individual or organization
upon which the tax is levied is responsible for the fulfillment of the tax payment. Indirect
taxes, on the other hand, can be shifted from one taxpayer to another.
Direct and Indirect Taxes
The most fundamental classification of taxes is based on who collects the taxes from the tax payer.
Direct Taxes, as the name suggests, are taxes that are directly paid to the government by the
taxpayer. It is a tax applied on individuals and organizations directly by the government e.g. income
tax, corporation tax, wealth tax etc.
Indirect Taxes are applied on the manufacture or sale of goods and services. These are initially
paid to the government by an intermediary, who then adds the amount of the tax paid to the value of
the goods / services and passes on the total amount to the end user.
Examples of these are sales tax, service tax, excise duty etc.

Also See: Five things to know about direct taxes

Five things to know about direct taxes

Important Direct and Indirect Taxes

Direct Taxes
1.

Income Tax

Income Tax is paid by an individual based on his/her taxable income in a given financial year. Under
the Income Tax Act, the term individual also includes Hindu Undivided Families (HUFs), Cooperative Societies, Trusts and any artificial judicial person. Taxable income refers to total income
minus applicable deductions and exemptions.
Tax is payable if the taxable is above the minimum taxable limit and is paid as per the differing rates
announced for each tax slab for the financial year.

1.

Corporation Tax

Corporation Tax is paid by Companies and Businesses operating in India on the income earned
worldwide in a given financial year. The rates of taxation vary based on whether the company is
incorporated in India or abroad.

1.

Wealth Tax

Wealth tax is applicable on individuals, HUFs or companies on the value of their assets in a given
financial year on the date of valuation. It is taxed at the rate of 1% of the net wealth of any assesse
exceeding Rs 30,00,000.
Net wealth here includes, unproductive assets like cash in hand above Rs 50,000, second residential
property not rented out, cars, gold jewellery or bullion, boats, yachts, aircrafts or urban land. It does
not include productive assets like commercial property, stocks, bonds, fixed deposits, mutual funds
etc.

1.

Capital Gains Tax

The profits made on sale of property are taxable under Capital Gains Tax. Property here includes
stocks, bonds, residential property, precious metals etc. It is taxed at two different rates based on
how long the property was owned by the taxpayer Short Term Capital Gains Tax and Long Term
Capital Gains Tax. This deciding period of ownership varies greatly for different classes of property.

Indirect Taxes
1.

Sales Tax

Sales Tax is charged on the sale of movable goods. It is collected by the Central Government in case
of inter-state sales (Central Sales Tax or CST) and by the State Government for intra-state sales
(Value Added Tax or VAT). The rates of taxation vary depending on the product type.

1.

Service Tax

Service tax is applicable on all services provided in India except a specified negative list of services
that are exempt. It is paid by the service provider to the government who in turn collects it from the
end user by the service provider at the time of provision of such service.

1.

Excise Duty

Excise duty is applicable on the manufacture of goods sold in India. Once goods are manufactured, it
is originally paid by the manufacturer directly to the Central Government. When the goods change
hands from the manufacturer to the buyer, this tax is bundled by the manufacturer along with the
cost of goods and passed on to the buyer.

Operating Cycle
Operating cycle is the number of days a company takes in realizing its inventories in cash. It equals
the time taken in selling inventories plus the time taken in recovering cash from trade receivables. It is
called operating cycle because this process of producing/purchasing inventories, selling them,
recovering cash from customers, using that cash to purchase/produce inventories and so on is
repeated as long as the company is in operations.
Operating cycle is a measure of the operating efficiency and working capital management of a
company. A short operating cycle is good as it tells that the company's cash is tied up for a shorter
period.
Another useful measure used to assess the operating efficiency of a company is the cash cycle (also
called the cash conversion cycle).

Formula
Operating Cycle = Days' Sales of Inventory + Days Sales Outstanding
Days sales of inventory equals the average number of days in which a company sells its inventory.
Days sales outstanding on the other hand, is the period in which receivables are realized in cash.
An alternate expanded formula for operating income is as follows:

Operating Cycle
=

365
Average Inventories
Purchase +
s

Application of funds
The Application (where the money has gone)
This arises either from: A decrease in Liabilities OR
An increase in Assets
Application of Funds originate from:
Losses to be met by the company
The purchase of fixed assets
The full or partial payment of loans
The granting of loans
Liability for taxes
Dividends paid and proposed
Any increase in net Working Capital

365
Credit
Sales

Average Accounts
Receivable

Accounting vs Financial
Management
Financial Management is a relatively new branch of accounting, that manages the finances
of a particular individual, business, or organization. The main aim of the discipline is to
achieve various financial objectives. It also involves the companys financial resources for
management purposes.
Its key objectives are to create or improve the financial health of the organization, either by
generating cash, or by adding related resources. It should study and devise plans for
implementation, in order to provide a satisfactory return on investment. Financial
management considers all factors, such as risks, of which it tries to manage, and how many
resources are invested. Basically, financial management makes plans to ensure a
productive cash flow. It governs and maintains the financial assets of a certain body.
Apparently, the main concern is not the techniques of quantifying finances, but the
assessment thereof. Financial management is often referred to as the science of money
management.
The three elements of financial management are: Financial planning, Financial Control, and
Financial Decision-making. Planning often deals with funding as any management should,
ensuring that adequate funding is available at the right moment. Financial control, on the
other hand, ensures that the individuals assets, or companys assets, are secure, and being
utilized efficiently. Obviously, financial management deals with various financial decisions,
particularly the things relating to financing, dividends, and investments.
According to the American Institute of Certified Public Accountants (AICPA), accounting is
defined as: The art of recording, classifying, and summarizing in a significant manner, and
in terms of money, transactions, and events, which are, in part at least, of financial
character, and interpreting the results thereof.
The practice is, in fact, ancient. Archaic accounting records have been found, and they are
more than 7,000 years old. Not surprisingly, the methods of accounting used then were
primitive, and they were mainly done to record the development of crops, or the increase of
herds. Nowadays, accounting has evolved, and become an important part of businesses.

Accounting, nowadays, is considered as the language of business. It is means to report

financial data or information about a particular business entity or individual. There are two
main types of accounting management accounting and financial accounting. If an
accounting report is focused on individuals within the organization, it is considered as
management accounting. In management accounting, information is provided to employees,
auditors, owners, managers, etc. The report is used as a basis for making managerial or
operational decisions.
The other type of accounting is financial accounting, in which the information provided is for
people outside of the organization or business, such as, creditors, potential shareholders,
economists, government agencies, and analysts.
Summary:
1. Accounting is more about reporting the financial information of a particular individual, or
business entity.
2. Financial management encompasses everything that involves finances, assets, and
resources. It takes part in financial planning, control, and decision-making.
3. Fundamentally, Financial Management is a relatively new branch of accounting, and more
about business applications, accounting data, and reports.

Dividends - Dividend Policy

Dividend policy is the set of guidelines a company uses to decide how much of its earnings
it will pay out to shareholders. Some evidence suggests that investors are not concerned
with a company's dividend policy since they can sell a portion of their portfolio of equities if
they want cash. This evidence is called the "dividend irrelevance theory," and it essentially
indicates that an issuance of dividends should have little to no impact on stock price. That
being said, many companies do pay dividends, so let's look at how they do it.
There are three main approaches to dividends: residual, stability or a hybrid of the two.
Residual Dividend Policy
Companies using the residual dividend policy choose to rely on internally
generated equity to finance any new projects. As a result, dividend payments can come out
of the residual or leftover equity only after all project capital requirements are met. These

companies usually attempt to maintain balance in their debt/equity ratios before making any
dividend distributions, deciding on dividends only if there is enough money left over after all
operating and expansion expenses are met.
For example, let's suppose that a company named CBC has recently earned $1,000 and
has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of
equity). Now, suppose this company has a project with a capital requirement of $900. In
order to maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this
project by using debt ($300) and two-thirds ($600) by using equity. In other words, the
company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio,
leaving a residual amount of $400 ($1,000 - $600) for dividends. On the other hand, if the
project had a capital requirement of $1,500, the debt requirement would be $500 and the
equity requirement would be $1,000, leaving zero ($1,000 - $1,000) for dividends. If any
project required an equity portion that was greater than the company's available levels, the
company would issue new stock.
Typically, this method of dividend payment creates volatility in the dividend payments that
some investors find undesirable.

The residual-dividend model is based on three key pieces: an investment opportunity

schedule (IOS), a target capital structure and a cost of external capital.
1. The first step in the residual dividend model to set a target dividend payout ratio to
determine the optimal capital budget.
2. Then, management must determine the equity amount needed to finance the optimal
capital budget. This should be done primarily through retained earnings.
3. The dividends are then paid out with the leftover, or residual, earnings. Given the use of
residual earnings, the model is known as the "residual-dividend model."
A primary advantage of the dividend-residual model is that with capital-projects budgeting,
the residual-dividend model is useful in setting longer-term dividend policy. A significant
disadvantage is that dividends may be unstable. Earnings from year to year can vary
depending on business situations. As such, it is difficult to maintain stable earnings and thus
a stable dividend. While the residual-dividend model is useful for longer-term planning,

many firms do not use the model in calculating dividends each quarter.
Dividend Stability Policy
The fluctuation of dividends created by the residual policy significantly contrasts with the
certainty of the dividend stability policy. With the stability policy, quarterly dividends are set
at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides
them with income.
Suppose our imaginary company, CBC, earned $1,000 for the year (with quarterly earnings
of $300, $200, $100 and $400). If CBC decided on a stable policy of 10% of yearly earnings
($1,000 x 10%), it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if
CBC decided on a cyclical policy, the dividend payments would adjust every quarter to be
$30, $20, $10 and $40, respectively. In either instance, companies following this policy are
always attempting to share earnings with shareholders rather than searching for projects in
which to invest excess cash.
Hybrid Dividend Policy
The final approach is a combination between the residual and stable dividend policy. Using
this approach, companies tend to view the debt/equity ratio as a long-term rather than a
short-term goal. In today's markets, this approach is commonly used by companies that pay
dividends. As these companies will generally experience business cycle fluctuations, they
will generally have one set dividend, which is set as a relatively small portion of yearly
income and can be easily maintained. On top of this set dividend, these companies will offer
another extra dividend paid only when income exceeds general levels.

Cost Of Capital
DEFINITION OF 'COST OF CAPITAL'
The cost of funds used for financing a business. Cost of capital depends on the
mode of financing used it refers to the cost of equity if the business is financed
solely through equity, or to the cost of debt if it is financed solely through debt.
Many companies use a combination of debt and equity to finance their
businesses, and for such companies, their overall cost of capital is derived from a
weighted average of all capital sources, widely known as the weighted average
cost of capital (WACC). Since the cost of capital represents a hurdle rate that a

company must overcome before it can generate value, it is extensively used in

the capital budgeting process to determine whether the company should proceed
with a project.

INVESTOPEDIA EXPLAINS 'COST OF CAPITAL'

The cost of various capital sources varies from company to company, and
depends on factors such as its operating history, profitability, credit worthiness,
etc. In general, newer enterprises with limited operating histories will have higher
costs of capital than established companies with a solid track record, since
lenders and investors will demand a higher risk premium for the former.
Every company has to chart out its game plan for financing the business at an
early stage. The cost of capital thus becomes a critical factor in deciding which
financing track to follow debt, equity or a combination of the two. Early-stage
companies seldom have sizable assets to pledge as collateral for debt financing,
so equity financing becomes the default mode of funding for most of them.
The cost of debt is merely the interest rate paid by the company on such debt.
However, since interest expense is tax-deductible, the after-tax cost of debt is
calculated as: Yield to maturity of debt x (1 - T) where T is the companys
marginal tax rate.
The cost of equity is more complicated, since the rate of return demanded by
equity investors is not as clearly defined as it is by lenders. Theoretically, the cost
of equity is approximated by the Capital Asset Pricing Model (CAPM) = Risk-free
rate + (Companys Beta x Risk Premium).
The firms overall cost of capital is based on the weighted average of these costs.
For example, consider an enterprise with a capital structure consisting of 70%
equity and 30% debt; its cost of equity is 10% and after-tax cost of debt is 7%.
Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%. This is the cost
of capital that would be used to discount future cash flows from potential projects
and other opportunities to estimate their Net Present Value (NPV) and ability to
generate value.

Companies strive to attain the optimal financing mix, based on the cost of capital
for various funding sources. Debt financing has the advantage of being more taxefficient than equity financing, since interest expenses are tax-deductible and
dividends on common shares have to be paid with after-tax dollars. However, too
much debt can result in dangerously high leverage, resulting in higher interest
rates sought by lenders to offset the higher default risk.