Question 1
Profit maximisation as the objective; equal loan instalments and total interest
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 1 · 18.75 marks"The objective of Financial Management should be Profit Maximization," Do you agree? Give reasons.
Mr. Y took a loan of Rs. 85, 00,000 @ 10% p.a. to finance his house, and has paid Rs.18, 00,000 as a down payment. The loan is repayable in 10 equal instalments, the first at the end of the first year. Calculate the amount of the equal annual instalment, and the total interest paid on repayment of the loan.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Should…?Give…Calculate…3 questions in all: answer every one.
- agreeA statement to judge: take a stand on it in your first line, and come back to it at the end.
- CalculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
No mark is printed for the question; the paper asks for any four of six, equal marks. The loan amount is read as the sum borrowed; the down payment is paid separately and does not reduce the loan. The answer states this and shows the other reading.
Write it in this order
A step that gives the answer away stays hidden: tap it to see it.
- Read the data; note exactly what is asked 2 min
- 1 Profit maximisation: position and reasons 8 marks 14 min
- 2 Better objective 2 marks 4 min
- 3 Annual instalment 5 marks 9 min
- 4 Total interest, with the other reading 3.8 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Should the objective be profit maximisation?
I do not agree. Profit maximisation has some merit (profit is a test of efficiency and the source of growth and dividends), but as the objective of financial management it is inadequate:
1Quick cash today: the deal is struck even as the godown behind them crumbles.
Weaknesses of profit maximisationIt ignores the risk of the profits; it ignores the timing of costs and returns.
2Asha weighs time against risk on the scale—and the share price curve climbs behind her.
Strengths of wealth maximisationIts result is visible in the market price of the share.
- Vagueness. "Profit" may mean short-term or long-term profit, total profit or profit per share, before or after tax; the objective gives no clear guide.
- Ignores the timing of returns. A rupee earned in year five counts the same as a rupee earned now; the time value of money is ignored.
- Ignores risk. Two projects with the same expected profit may differ greatly in uncertainty; risk-averse shareholders value the safer one more.
- Ignores dividends and the shareholders' perspective. Profit can be raised by retaining all earnings even when the shareholders would be better off receiving dividends.
- Too narrow. It ignores social responsibility and the interests of employees, customers and society.
The better objective is maximisation of the shareholders' wealth, the market value of the shares: it uses cash flows, discounts them for time and risk, and so gives an operational decision rule (accept proposals with a positive NPV). Profit remains important, but as a means to wealth, not as the objective.
Equal annual instalment and total interest
Reading (paper note): the loan is the ₹85,00,000 borrowed; the down payment of ₹18,00,000 is paid separately and does not reduce it.
The instalment is the loan divided by the present value annuity factor, the instalments being an annuity whose present value equals the loan. PVIFA (10%, 10 years) = 6.145.
| Particulars | ₹ |
|---|---|
| Loan | 85,00,000 |
| Annual instalment (85,00,000 ÷ 6.145) | 13,83,238.41 |
| Total repaid (10 × 13,83,238.41) | 1,38,32,384.05 |
| Total interest (total repaid − loan) | 53,32,384.05 |
The other reading. If the down payment is taken out of the ₹85 lakh, the loan is ₹67,00,000: instalment ₹10,90,317.33 and total interest ₹42,03,173.31.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Profit maximisation: position and reasons | 8 |
| 2 | Better objective | 2 |
| 3 | Annual instalment | 5 |
| 4 | Total interest, with the other reading | 3.75 |
| Total | 18.75 |
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