MODULE 1: THE FIRM AND ITS FINANCIAL OBJECTIVES

Introduction

A firm is organisation that provides goods and services. There are two major organizational types
namely business organisation and governmental organisation. While business organisations are
private entities providing goods and services, governmental organisations provide public
services. Discussions in this and subsequent modules will focus on business organisations. The
major characteristics and objectives of these groups will be discussed. All these are required to
fully understand the ‘firm’, its functions and objectives.

Learning Outcome

This topic introduces the students to the fundamentals of financial management. At the end of
this module, students should be able to differentiate among the different types of firms and the
rationale for setting up the business organisations.

Background

Finance can be referred to as the art and science of the management of money. Finance is the
study of concepts, applications, and systems that affect the value (or wealth) of individuals,
companies, and countries over the short and long term. It is the management of the flows of
money through an organization (whether it is a private or governmental organization) and claims
against money. Finance is very vital to the management of any organization. The functional
activities of companies such as marketing, production, purchasing etc. require the use of money.
The activities of government organization also require the use of money.

Financial management is an applied field of management. It borrows knowledge from the

various fields of management such as marketing, economics etc. in the management of money.
Today, finance can also be applied to other fields and to the problem of money management. We
refer to persons responsible for finance function as financial managers.

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Types of finance

Finance is one of the important and integral parts of business concerns, hence it plays major roles
in every part of the business activities. It is used in all areas of the activities of any organization
under different names.

Finance can be classified into two major parts: Private and Public

Fig. 1.1 – Types of Finance

Finance

Private Finance Public Finance

Individual Partnership Business/ Federal State Local

Finance Finance Corporate Finance Government Government Government

Private Finance includes the individual, firms, business or corporate financial activities to meet
the requirements.

Public finance concerns revenue and disbursement of government such as Federal, State and
Local government financial matters.

Firm and its financial objectives

Firms/organizations can be classified into two broad categories which are: business organization
and governmental organization. Business organizations engage in economic activities to make
profit while governmental organization includes central, state, local governments and
nationalised industries which provide public services at those levels. Governmental organizations

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are run in public interest and their activities do not necessarily result in profit. Business
organization on the other hand takes three forms: sole proprietorship, partnership and companies.

• Sole proprietorship: this is a business organization that is owned by one person. The owner
of the business has all rights to the business assets and liabilities. The single owner receives
all profits from the business and also suffers all losses incurred by the business. It is the most
common form of business and it is easy to set up.

Characteristics of sole proprietorship

o It is easy to establish and form.

o No financial security is required as a proof of business ownership and a sole proprietor
can issue debt securities.
o The liabilities of a sole proprietor are unlimited.
o It’s the easiest means of maintaining control over an organization.
o The business may not have perpetual existence.

• Partnership: a partnership is a business firm carried on by two or more persons with a view
of making profit. The maximum number of partners in a partnership business is twenty
excluding solicitors, accountants and surveyors. In most cases, the activities of partners in the
business are regulated by partnership deed. Partnership deed is a written agreement stating
the responsibilities of each partner, profit and loss sharing ratio among partners, interest on
capital, interest on drawing etc. There are two broad types of partnership:
• General partnership: it is the most common form of partnership business and all partners are
liable for the debt of the partnership.
• Limited partnership: this is a partnership in which the liabilities of some partners are limited
to the amount stated in the partnership agreement. In this type of partnership, there will be
one or two general partners.

Characteristics of Partnership Business

o No financial security is required as evidence of ownership of the business.
o The liabilities of all partners in the business are unlimited except the limited partner.

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 o The business may not have a perpetual existence.
o Profit and loss are shared among partners.

• Limited Companies: a limited company is an artificial legal entity incorporated by

registration under the law. A company is a person distinct from the persons who have
proprietary interest in it or who are the owners of the business. It can sue and be sued in its
corporate name. It has the ability to own properties. In Nigeria the relevant law that regulates
limited companies is the Companies and Allied Matters Act 1990 (CAMA) as amended. In
order to form a company in Nigeria, CAMA requires the promoters to file memorandum and
articles of association and also form a board of directors consisting of at least two directors.
The memorandum and articles of association both represent the constitution of the company.

Types of company: there are majorly three types of companies:

 Company limited by shares: this is a company that has the liability of its
members limited by the memorandum to the amount, if any that is unpaid on the
shares respectively held by them.
 Company limited by guarantee: this is a company that has the liability of its
members limited by memorandum to such amount as the members may
respectively thereby undertake to contribute to the assets of the company in the
event of its being wound up.
 Unlimited company: this is the type of company where the liability of its
members does not have any limit.

Characteristics of limited companies o Legal entity: the

company is distinct from its owners.
o Limited liability: the liability of the owners is limited to an unpaid amount on the
shares they have purchased.
o Perpetual existence: the death of a shareholder does not affect the existence of the
company.
o Shares represent ownership in the company: the shareholders are owners of the
business and they have a voting right in the company.

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 o Transferability of shares: ownership in a company can be transfer from one person
to another easily.
o Directors of the company are appointed at annual general meetings.

Objectives of the firm

The starting point for developing a good financial management for any organization is the
definition of achievable objectives. Clearly defined and understood objectives are the keys to
moving the firm to a future desired position. Business firms are profit seekers; thus, their
objectives need to be stated in monetary terms. The following are the frequently encountered
financial objectives of the firm:

I. Profit maximization
II. Shareholders’ wealth maximization

I. Profit maximization
Profit maximization is the main objective of a business enterprise. Most businesses believe as
long as they are increasing revenue while keeping down cost, they are achieving this objective.
Maximization of profit is an easily understood and measurable rational objective for any
business since it focuses the firm’s efforts toward making money. One can ask whose profits the
firm is trying to maximize. Since ordinary shareholders are the suppliers of risk funds, the firm is
actually trying to maximize profit for the ordinary shareholders. Profit maximization consists of
the following important features:
1. Profit maximization is also called “cashing per share” maximization. It leads to the
maximization of the business operations for profit maximization.
2. Ultimate aim of the business concern is to 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 objective helps to reduce the risk of the business.

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Arguments for Profit Maximization
The following important points are in support of the profit maximization objective of the
business concern:
(i) Main aim is the earning of 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.

Arguments against Profit Maximization

The following important points are against the objective 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 objective leads to inequalities among the stakeholders such
as customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization Profit Maximization Objective

Profit maximization objective has been criticized on the following grounds:
o There are many interest groups in modern day organization compared with owner-
managed organization that was in existence in ancient days. The interest groups
such as customers and the general public have varying objectives which have to
be reconciled with the financial objectives of a firm.
o The definition of profit which is the major objective of the firm is vague. The
definition of profit is not clear. Is the firm maximizing short- or long-term profit?
Are they maximizing profit before tax or profit after tax? Operating profit or gross
profit? For instance, if an organization is seeking profit without maintenance or
planning for replacement of its machinery, it is pursuing short term profit. In the
long term such firms may not survive. Profit could also be earnings per share or
return on capital employed.

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 o It ignores timing of returns: money received today has a higher value than money
to be received tomorrow. This is because N1 today can be invested to yield more
than N1 tomorrow, N1 million profit this year is different from N1 million next
year.
o It ignores risk or uncertainty of future earnings: the future profits might be risky.
o It does not consider the qualitative aspects of future activities: some non-financial
objectives such as growth and diversification might result in short term profits but
will ensure a firm’s stability in the long term.
o Profits do not necessarily translate into cash flows for the firm or shareholders.
II. Maximization of Shareholder’s wealth
The theory of company finance is based on the assumption that the objective of the firm
is to create value (or wealth) for the shareholders. This objective is considered more
credible since all residual earnings of a business belong to the legal owners of the
company, i.e. ordinary shareholders and retained earnings are undistributed wealth of
these equity shareholders. Thus, if the objective of the firm is to maximize its value, any
extra wealth created will belong to the equity (ordinary) shareholders. Thus, maximizing
the value of a firm means also maximizing the wealth of shareholders. The wealth of the
shareholders will be maximized if the market price of a company’s shares goes up.
Market price of a company’s shares represents the value placed on the company by
market participants. This is a reflection of the company’s investment, financing and
dividend decisions. If a firm embarks on an investment decision that yields a positive net
present value, the amount of positive net present value will increase the wealth of the
shareholders. The increase in wealth of the shareholders will also make the market price
of the company’s shares to go up if it is quoted on the stock Exchange.

Arguments for Wealth Maximization

(i) Wealth maximization is superior to profit maximization because the main aim of
the business concern under this concept is to improve the value or wealth of the
shareholders.

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 (ii) Wealth maximization considers the comparison of the value to cost associated
with the business concern i.e. it considers timing of returns as the net present
value of an investment is obtained by discounting the present value of cash flows
at the opportunity cost of capital.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
(vi) It balances short- and long-term benefits, in a way that profit maximization
objective cannot.

Arguments against 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 in an indirect way.
(iii)Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoys 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.

Shareholder’s Wealth Maximization and Social Responsibility

The shareholders’ wealth maximization objective provides a guide for efficient allocation of
society’s economic resources. Any other objective will lead to sub-optimal allocation of
resources that will have implication on the growth of an economy. However, pursuing wealth
maximization objective does not necessarily imply fulfilment of social responsibility of a firm.
The social responsibilities of the firm include such things as protecting consumers (e.g. supply
of quality goods at low price), maintaining sound industrial relations, paying fair remuneration
to employees, maintaining fair recruitment practices and safe working condition, supporting
education and sports, supporting the government in the provision of clean water etc. Some
social actions are compatible with the objective of shareholders’ wealth maximization e.g.

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capital investment for the welfare of customers and employees while some others (e.g.
investment in education) conflicts with the objective of shareholders’ wealth maximization (it
might reduce shareholders’ wealth). Since shareholders’ wealth maximization objective has
implication on the efficient allocation of society’s economic resources, there is a tradeoff
between social goals and economic efficiency.

Assessment
1. Provide a brief summary of the nature and types of finance
2. What are the key differences between sole proprietorships, partnerships and corporations?

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