The methods finance managers take to maximize wealth
Wealth maximization has been accepted by the finance managers, because it overcomes the limitations of profit maximization. it means maximizing the net wealth of the company share holders ,maximization is possible only of the company ,management ‘s goal should be to maximize share holder wealth, which means maximizing the value of the stock.
Maximizing shareholder value (the total market value of all the firm’s capital owners) is the appropriate decision-making criterion for corporate management.
(Harri , M and A. Ravi) in the theory ,managers should operate in the best interests of the owners who are the stockholders within corporations. in practice the interest of managers and owners may differ. this can create a principal-agent problem involving conflicts of interest.
Most academics agree that shareholder wealth maximization should be a firms primary goal, wealth maximization is based on the concept of cash flows .cash flows are a reality and not based on subjective elements in the concept of profit maximization.
It considers time value of money translates cash flows occurring of different periods into a comparable value of cash flows in considered critically in all decisions as it incorporates the risk associated with the cash flow stream.(Kalpana Rashiwala, February 2001,business times).
All though CEOs and directors are ultimately responsible for maximizing share holders value, they seldom if ever are exposed to valuation models, or even to data that focuses on long –term levels of stock prices as a reflection of future economic reruns and reinvestment rates. Managements and boards, by and large ,do not have an adequate understanding of either the forecasting efficiency of the market, or the knowledgeable investors attentiveness to the long-term wealth creation or dissipation potential of their management decisions. in particular, management should adhere to making decisions to maximize long-term shareholder value regardless of the near-term effect on quarterly earnings.
Maximization of wealth and it relevant to companies financial objectives
The financial goal of the firm is to maximize shareholder wealth as reflected in the market price of the stock. Investors generally prefer more wealth to less wealth .shareholders wealth maximization is consistent with the long-run interests of stakeholders and society.
The corporate objective of maximizing shareholder wealth assumes that managers operate in the best interests of stockholders, not themselves, and do not attempt to expropriate wealth from lenders to benefit stockholders. Stockholder wealth maximization also assumes that managers do not take action to deceive financial markets in order to boost the price of the firm’s stock. Another assumption is that managers act in a responsible manner and do not create unreasonable costs to society in pursuit of stockholder wealth maximization.
(Kalpana Rashiwala, February 2001,business times) assume that when financial manager assess potential to investment into a new product, they examine the risks and potential benefits and cost ,if the risk-adjusted benefits don’t outweigh the costs, they will not invest. similarly, managers assess current investment for the same purpose ;if benefits don’t continue to outweigh the cost, they don’t continue to invest the product but they will shift their investment elsewhere this is consistent shareholders wealth maximization and with the allocative efficiency of the market economy.
Material in the capital (that is conventional financial capital) dominated the era of industrial economy ,to maximize shareholder wealth enterprises often become the main objective of financial management ,because material capital investors are only investors are the only investors enterprises to meet the material capital investors desire to maximize wealth,. Along with the development of material knowledge economy ,the scope of capital, there is a change in the new capital structure ,material, capital and human capital (intellectual capital) go hand in hand, the decision to change the enterprise of financial management objectives is no longer just attributable to shareholders, and shall be vested in a “main stakeholders” such as shareholders ,human capital investors, creditors, customers and so on, they are dedicated to the business of invested capital, the remaining enterprises have made contributions and thus have to share the remaining enterprises rights. Clearly the interests of all enterprises involved in the operation of enterprises are the interests of all and not just the interests of shareholders. in addition ,business survival the more social circumstances, enterprises cannot do without the support of the community, enforce social responsibility must also be the duty of the enterprise. therefore, enterprises must be innovative financial management objectives, must be from a single-to multi-oriented shareholder interests, by the maximization of shareholder wealth to meet objectives of the main interests of goals, experts ion financial management have endorsed the view the goal of financial management of the firms is maximization of economic welfare of its shareholder .
Shareholders wealth maximization is reflected in the market value of the firm’s shares. A firm’s contribution to society is maximized when it maximizes its value. there are two versions of the goals of financial management of the firm which are profit maximization and wealth maximization.
Agency problem and measures that helps companies to solve it
An Agent relationship is a relationship between the principal and agent, in which agency acts with the principal, in corporation the principal are the shareholders and the agents are the managers, there is a lot of problems with agency relationship that resulted with different interests between the shareholders and managers. for example
1.Agency may not expend with their best efforts
2.Agency may act with their own self interest
3.Agency may consume excessive perquisite.
Agency problem resulted by direct and indirect cost, monitoring cost ,bonding cost, and residual losses.
Monitoring cost: are cost incurred by principal to monitor the actions of agents,e.g. annual report of share holders.
Bonding cost: are cost incurred by agents to insure they will act in the best interest of the principal.eg Building employment contract.
Residual losses: is the implicit cost when management and share holders cannot be aligned even when monitoring and bonding occurred.
Agency problems exist in large organizations because conflicts of interest sometimes arise between stockholders and managers. In most large corporations ,managers only own a small percentage of stock. they may take action to place their interests above those of the stockholders. As measured in (Jensen, C,M, American Economic Review ) for example ,managers may increase their personal wealth by raising their salaries ,bonuses ,or option grants as high as possible and by increasing their perquisites including luxurious offices ,corporate jets ,generous retirement plans ,and the like at the expense of outside stockholders. Agency problem can also exists between stockholders and creditors. stockholders may take action through their firms managers that affect the riskiness of the firm such as investing in more risky assets, and also increasing a firms riskiness can negatively affect the safety of its debt.
Stockholders incur agency costs to reduce agency conflicts by instituting incentives, constraints and punishments. direct agency cost often result from corporate expenditures that benefit management but involve a cost to the stakeholders. incentives such as bonuses ,stock options, and perquisites (fringe benefits ) are example of such costs. Monitoring cost, which are cost borne by stockholders to monitor or limit the action of the managers ,are another type of direct agency cost. One example is the cost of having a board of directors whose job is to make sure that the decisions are in the best of shareholders. An indirect agency cost could result from managements failure to make a profitable investment because of its aversion to risk.
Mechanism of alignin the interst of managers and stockholders:
Managerial compension: incentive compensation sytems serve as one means of aligning the interests of shareholders and mangewrs.these sytems can take many forms and include providing salries,bonuses,performance shares,and stock option to reward superior performance and to penalize porr performance.turning managers into substantial owners is likely to reduce the incident of agency conflicts.
Direct shareholders intervention: utside investors ,especially those holding a large proportion of the firms shares,can use their voting power to influence the companys action and the composition.
Threat of dismissal: top managers are subject to achieving certain performance standards.if they unable reach those standards,the board of directors ar other executives can dismiss these managers.their replacements may be more effective in acting in the best interests of the stockholders than are the existing managers.
Shareholder wealth maximization and net present value
The shareholder wealth maximization goal states that management should endeavour to maximize the net present (or current) value of the expected future cash flows to the shareholders of the firm.net present value refers to discounted sum of the expected net cash flows .some of the cash flows, such as capital outlays, are cash outflows, while some, such as cash proceeds from sales, are cash inflows.net cash flows are obtained by subtracting a given periods cash outflow from that periods cash inflows. The discount rate takes into account the timing and risk of the future cash flows that are available from an investment. the longer it takes to receive a cash flow, the lower the value investors place on that cash flow now. The greater the risk associated with the cash flows expected to be received in the future cash flow, the lower the value investors place on that cash flow.
The shareholders wealth maximization goal, thus; reflects the magnitude, timing and risk associated with the cash flows expected to be received in the future by shareholders. in terms of the firms objective, shareholder wealth maximization has been emphasized because this book has a corporate focus.
(Peter Goldstein) measured that a simplified case where there is only one capital outlay which occurs at the beginning of the first year of the project, the net present value of the annual net operating cash flows (and the net terminal cash flows). If the capital outlay occurs only at the beginning of the first year of the project then it is already a present value and it is not necessary to discount it any further, so the shareholder value is maximized if only if the firm makes only those decisions that generate positive net present values.
The goal of the firm might well be expressed in terms of a truly inspiring mission statement to produce uniquely valuable benefits to particular consumers. Achieving its stated goal in an efficient manner maximazes shareholders value.
In other words how a firm maximazes shareholder value invariably rest with efficiency in using resources in fulfilling customers wants over time .that the expected eefects of activities on shareholder value are often difficult to quantify does not diminish the importance of this crucial economic compass ,and its shareholder value is maximized if .
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