By: Kristy Annely
Every organization regardless of its size and mission may be viewed as a financial entity. Management of an organization, particularly a business firm, is confronted with issues and decisions that have important financial implications. Questions must be answered like:
• What kind of plant and machinery should the firm buy?
• How should the firm raise finances?
• How much should the firm invest in inventories?
• What should the firm’s credit policy be?
• How should the firm gauge and monitor its financial performance?
Business finance is broadly concerned with the acquisition and use of funds by a business firm. Its scope may be defined in terms of the following questions: How large should the firm be and how fast should it grow? What should be the composition of the firm’s assets? What should be the mix of the firm’s financing? How should the firm analyze, plan and control its financial affairs?
In general, business finance rests on the premise that the objective of the firm should be to maximize the value of firm to its equity shareholders. What is the justification for this objective? It appears to provide a rational guide for business decision-making and promote efficient allocation of resources in the economic system. Savings are allocated primarily on the basis of expected return and risk and the market value of a firm’s equity stock reflects the risk-return trade-off of investors in the market place.
Hence when a firm maximizes the market value of its equity stock, it ensures that its decisions are consistent with the risk-return preferences of investors. This suggests that it allocates resources optimally. If a firm does not pursue the goal of shareholder wealth maximization, it implies that its actions result in sub-optimal allocation of resources. This in turn leads to inadequate capital formation and lower rate of economic growth.