finance

The finance essay below has been submitted to us by a student in order to help you with your studies.

Usefulness Of Net Present Value Finance Essay

It has long been an accepted perception that the objective of management is the maximization of shareholder wealth. As we know the corporate objective of a firm is to maximization share holders wealth in order to achieve this corporate goal there is a problem arising called agency problem. The corporate firms are managed by professional managers these managers do not own a 100% share so managers may not work to ward’s the best of firms goal of maximizing shareholders wealth because of the conflicting interests, in this assignment we will examine the firm’s corporate goal.

The this study contends that it is to evaluate the usefulness of Net Present Value but also taking to the account the effect of agency problem inside the company.

Introduction

Owners are primarily interested in the wealth creation ability of an entity, and they typically monitor their investments by the valuating of the investment’s financial return. Shareholders tend to prefer that all long-term corporate decisions to be evaluated based on the investment’s contribution to the maximization of shareholder wealth. Dean (1994) suggests that “the primary objective of the modern corporation should be to maximize the present worth at the company’s cost of capital of the future stream of benefits to the stockholder. All other objectives ... should be either intermediate or subsidiary to this overriding company’s financial objective

Question1

WEALTH MAXIMISATION

The maximization of shareholders wealth is a significant objective of management. According to Dr.R.Srinivasan, (2010). The same goal, if defined in other words, would convey the idea of net present value maximization. Any action which results wealth or which has a net present value is a desirable one and should be undertaken. Wealth of the company is reflected in the maximization of the present value of the company i.e., the present worth of the company. This value may be readily measured if the organization has shares that are held by the public, because the market price of the share is indicative of the value of the company. And to a shareholder, the term ‘wealth’ is reflected in the amount of his current dividends   and the market price of share.

Ezra Solomon has defined wealth maximization objective in the following terms: “The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefits, discounted (or capitalized) at a rate which reflects the uncertainty or certainty. Wealth or net present worth is the difference between gross present worth and   the amount of capital investment required to achieve the benefits.”

What about a public sector firm the equity stock of which, being fully owned by the government, is not traded on stock market? In such a case, the goal of management should be to maximize the present value of the stream of equity returns. Of course in determining the present value of stream of equity returns, an appropriate discount rate has to be applied. A similar observation may be made with respect to other companies whose equity shares are either not traded or very thinly traded.

From the above defination, one thing is certain that the wealth maximization is a long-term strategy that emphasizes raising the net present value of the owner’s investment in a company   and the   implementation of this objective that will increase the market value of the company’s securities. This concept, if applied, meets the briars raised against the old concept of profit maximization. The manager also deals with the uncertainty problems by taking into account the trade-off between the different returns and associated levels of risks. It also considers the dividends payment to shareholders. All these components of the wealth maximization objective are the result of the financing, investment and dividend decisions of the company.

Question2

Agency problems exist in large companies because of the conflicting of interests which sometimes arise between shareholders and managements. In most large organizations, managers only own a small percentage of the stock. They may consider to place their interests above those of the shareholders. For example, managers may increase their personal wealth by increasing 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 shareholders. Shareholders may take actions through their company’s managers that affect the riskiness of the company like investing in more risky assets. Increasing a company’s riskiness can negatively affect the safety of its debt.

A potential agency conflict comes whenever the manager of a company owns less than 100 percent of the company's common stock. If a company is a sole proprietorship company and managed by its owner, the owner-manager will always consider maximizing his or her own wealth. The owner-manager will carefully control cost by personal wealth, but may trade off other considerations, such as perquisites and leisure, against personal wealth. If the owner-manager forgoes a portion of his or her ownership by selling some of the firm's stock to outside investors, a potential conflict of interest may arise, called an agency problem. For example, the owner-manager may prefer a more leisurely lifestyle and not work as to maximize shareholder wealth, because less of the wealth will now accrue to the owner-manager. In addition, the owner-manager may decide to consume more perquisites, because some of the cost of the consumption of benefits will now be borne by the outside shareholders.

As defined by Robert T. Kleiman. Agency theory raises a fundamental problem in company, self-interested behavior. A corporation's managers may have their own personal objectives that challenges with the owner's goal of maximization of shareholder wealth. Since the shareholders authorize managers to manage the company's assets, a potential conflict of interest exists between these two groups.

According to Jensen/Meckling (1976) an agency relationship exists when “one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.” If both parties maximize their own utility there is good reason to believe that the agent will not always act in the best interest of the principal. As a result the principal will try to limit the divergence from his interests by monitoring the agent. The dilemma is, that the cost of monitoring the agents actions (monitoring expenditures) can be significant and can in fact exceed the loss due to the agency relationship. The principal will therefore try to establish incentives for the agent in a contract so that the agents actions are in the interest of the principal without costly monitoring. Additionally there will be situations where it will pay for the agent to expend resources on actions to guarantee that he will act in the sense of the principal (bonding expenditures) or to ensure that the principal will be compensated in such cases. As a result it is impossible for the principal and the agent to ensure at zero cost that the agent will make optimal decisions from the viewpoint of the principal. Given the complex structure of agency relationships these costs will be pecuniary and no pecuniary as well. In general, the principal and the agent will have positive monitoring and bonding costs and there will still be some divergence between the agents decisions, subject to the optimal monitoring and bonding activities, and those decisions that would maximize the welfare of the principal. The value (in money terms) of this divergence is often referred to as the residual loss. According to Jensen/Meckling (1976) agency costs could therefore be defined as the amount of:

• The evaluating expenditures by the principal,

• The bonding expenditures by the management and

• The residual loss

Question3

The net present value (NPV) is described very fully both in principle and application and in how the decision rules are derived. Different sets of circumstances are introduced to show how the NPV approach can cope with the situations met in an imperfect world, (e.g. taxation, inflation, different interest rates, repeat investments, mutually exclusive investments, capital rationing).

The NPV method has pros and cons I mean negative and positive sides. First, the NPV method makes more appropriate adjustments for the time value of money. Second, the NPV rule focuses on cash flow, not accounting earnings. Third, the decision rule to invest when NPVs are positive and to refrain when from investing when NPVs are negative reflects the firm’s need to compete for funds in the marketplace rather than an arbitrary judgment. Fourth, the NPV approach offers a relatively straight forward way to control for differences in risk among alternative investments. Cash flows on riskier investments should be discounted at higher at higher rates. Fifth, the NPV method incorporates all the cash flows that a project generates over its life, not just those that occur in the project’s early years. Sixth, the NPV gives a direct estimate of the change in shareholder wealth resulting from a given investment.

Although we are enthusiastic supporters of the NPV approach, especially when compared with the other decision methods, we must acknowledge that the NPV suffers from a few weaknesses. Relative to alternative capital budgeting tools, the NPV rule seems less intuitive to many users.

Conclusion

The efficiency of management is assessed by the success in achieving the company’s objective. The shareholder wealth maximization objective as defined that management should work towards maximizing the net present value of the expected future cash flows to the shareholders of the company. Net present value is the 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 generated from sales, are cash inflows. Net cash flows are obtained the different between cash outflows and cash inflows. The discount rate considers 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 receiving a future cash flow, the lower the value investors place on that cash flow.

Also sharelhoders wealth can be maximized if the company


Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay


More from UK Essays