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The primary objective of this essay is to explore how finance managers can in practice contribute to maximising long term shareholder wealth. I shall explore how finance managers contribute to this aim, using various theories and with the use of various accounting methods and techniques.
The main focus and objective of every firm and its members should be maximizing value. But whose value should be maximized? It should be the shareholders value.
What is shareholder wealth?
Maximising shareholder wealth means maximising the flow dividends to shareholder through time (long term perspective).
Shareholder wealth is basically the money shareholders get to accrue from their ownership of shares in a firm. Shareholder wealth can increase in two common way; either by increase in share prices that bring about capital gain or an increase in dividend payments. Knowing this fact, a firm can maximize shareholder wealth through this way. However, an optimal point needs to be struck as a firm needs to balance the risk and return involved.
Maximising wealth can be defined as maximising purchasing power. The way in which an enterprise enables its owners to indulge in the pleasures of purchasing and consumption is by paying them a dividend. ‘The promise of a flow of cash in the form of dividends is what prompts investors to sacrifice immediate consumption and hand over their savings to a management team through the purchase of shares'.
‘Profit maximisation is not the same as shareholder wealth maximisation'. There are many reasons why accounting profit may not be a good proxy for shareholder wealth. Two firms with different risk levels can over a certain period of time make the same average profit despite one being high risk and the other low.
Practical reasons for maximising shareholder wealth
If people assume that decision making carried out by finance managers within a firm are acting in the best interests of shareholders, then the decisions made on matters such as which investment projects to commence, or which means of finance to use, can be made much easily.
‘If a firm has multiple objectives, then the difficulty in deciding to introduce new, more efficient and effective machinery to produce the firm's output is increased'. If managers focus solely on the benefits available to shareholders then a clear decision can be made easily. “The range of decision making tools vary from, producing a component in house to whether to buy another company”, (Arnold, p11). However practically, business does not solely focus on shareholder and we have to anticipate stakeholder's interest, therefore for each decision scenario, we have to contemplate a number of different objectives relating to stakeholders, making the task much more complex for finance managers.
Modigliani Theory was introduced by Franco Modigliani (1918 - 2003) and Merton Miller (1923 - 2000). The theory of the cost of capital states that the overall cost of capital remains constant as the financial gearing of a firm increases.
The ‘Modigliani-Miller theorem' of Franco Modigliani, Merton Miller forms the basis for modern thinking on capital structures. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stocks or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.
If we consider two firms which are identical except for their financial structures. The first is financed by equity only and the other is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same. Therefore stating that the capital structure's of firms are irrelevant when valuing different firms.
The capital structure of a company is the particular combination of debt, equity and other sources of finance that it uses to fund its long term financing. ‘The key division in capital structure is between debt and equity'. The proportion of debt funding is measured by gearing. This simple division is somewhat complicated by the existence of other types of capital that do not distinguish the lines between debt and equity, as they are a mixture of the two.
Preference shares are ‘legal shares which have a fixed return that make them closer to debt than equity in their economic effect'. However, changeable debt may be likely to become equity in the future when looking at debentures which are either fully or partly convertible.
Considering the division between debt and equity is sufficient to understand the issues involved. Simple financial theory models show that capital structure does not affect the total value (debt + equity) of a company. This is not completely true, as more sophisticated models show. It is, nonetheless, an important result, also known as capital structure irrelevance.
Dividend Irrelevance and Capital Structures
If a company makes money, in the form of cash inflows, that money belongs to shareholders. It should not matter whether a company keeps money and invests it, or returns the money to shareholders.
It is also possible to show that it should make little difference to investors whether dividends are paid or not, as investors can reproduce the cash flows of different dividend policies. For example, if a company pays out dividends, but an investor would prefer the money to be re-invested, then the investor can simply use the dividends to buy more shares.
However, if a company retains too much profit from a shareholder's point of view, then the share price will be boosted by the company's stronger cash position, and the shareholder can offset that by selling a few shares and regaining capital.
These arguments for dividend irrelevance are closely related to the Modigliani-Miller arguments for capital structure irrelevance. Miller and Modigliani in 1961 stated that ‘dividend policy is irrelevant to share value' (Arnold, p1011). The two theorists go on to say that share prices do not change in accordance to different dividend polices (zero dividend polices or high dividend polices).
Sources of Finance
Traditionally a position exists where an optimal capital structure and financial power affects the value of the firm. On the other hand, there is the Modigliani Miller approach which states that financial leverage does not have any impact on the value of the firm. The increasing complexities of financial markets, the increased education of investors in general, the imperfections of taxes, agency costs, etc. all have a role to play in the selection of debt sources.
Businesses essentially need finance for the short-term and the long-term. The way in which they may raise these funds will differ a great deal.
Two key sources of finance are; internal sources and external sources. 'Internal sources' refers to money they can raise from within the firm. This may include profit, or perhaps better management of existing resources. External sources refer to raising money from outside the firm. (Brealey & Myers, 2003)
Overdrafts provide businesses with the right to withdraw funds they do not currently have, therefore making it a short term source of finance. It provides firms with flexibility with cash flows, and interest is only paid on the amount withdrawn, making this a cheap and effective way to fund the business in the short term. This will not affect shareholder wealth directly, however if a firm has a poor cash flow, then despite profitability levels, the firm will become involved in financial difficulties and may consequently become liquidated, making shareholder wealth reduce.(Brealey & Myers, 2003)
‘A debenture loan is a marketable legal contract, whereby the company promises to pay its owner, a specified rate of interest for a defined period of time and to repay the principal at the specific date of maturity'. Debentures are usually secured by a charge on the immovable properties of the company. The interest of the debenture holders is usually represented by a trustee and this trustee is responsible for ensuring that the borrowing company fulfils the contractual obligations embodied in the contract. (McLaney, 2006)
Debentures can be classified into Non-Convertible Debentures (NCDs), Fully Convertible Debentures (FCDs) and Partly Convertible Debentures (PCDs) (Equity Master, 2008). NCDs cannot be converted into equity shares and are redeemed at the end of the maturity period. FCDs are fully converted into equity shares after a specified period of time, at once or in instalments. PCDs are those where a portion of it is converted into equity shares and the balance redeemed on maturity. NCD's and PCD's can help in increasing and maximising shareholder wealth, due to the increase in value of the firm and the reduction in long term debts. Therefore debenture loans can be advantageous to a firm and its shareholder when considering the main aim (McLaney, 2006).
Other sources of finance include government grants which are non-repayable and can help boost a firm's financial situation. This source of finance will consequently lead to an increase in the value of capital available within the business. If this is the case an increase in capital will lead to a higher rate of return for shareholders, hence maximising shareholder wealth.
Rate of Return
For a given rate of return, businesses with less risk are more valuable to debt and equity investors than businesses with greater risk.
In the pursuit of shareholder value, investments should be evaluated in terms of risk and return. This analysis should extend to existing investments and new investments that do not require external financing. Risk measures are integral to developing useful guidelines that help finance managers to determine how new investments will affect shareholder value. This will help contribute towards the aim, as it will reduce the risk of failure and reduce negative equity.
Corporate finance provides tools for measuring the cost of financing alternatives, measuring the risk and return of new and existing investments, pricing acquisition and divestment candidates and developing integrated strategies that increase shareholder value. Managers have a responsibility to use these tools effectively (McLaney, 2006).
However, we have to take into consideration the opportunity costs of certain investments when considering the rate of return. If the firm decides a certain investment, we have to consider the alternative we have not invested in. This is particularly the case when considering the portfolio theory, due to the comparability in different firms.
Net Present Value Methods
Investment decisions are very important to a business. They tend to involve large sums of money and their impact on the survival and prosperity of the business can be profound.
Once an investment decision has been made, and the funds committed, it is often difficult to abandon the project without significant losses being incurred. It is therefore important that investment proposals are properly evaluated before a final decision is made. In practice, there are three major methods of evaluating investment proposals:
- Accounting rate of return (ARR)
- Net present value (NPV) method
- Internal rate of return (IRR).
The first method is the traditional method of appraising investments and has been around for many years. The NPV method is a more recent development. This method discounts the future cash flows associated with the investment project using the cost of capital as the appropriate discount rate. The decision rule is that if the net present value of the discounted cash flows is positive, we should accept the project.
It is important to be aware of the advantages of this method over the ARR method. The most important advantages of the NPV method are that it:
- Takes account of the time value of money, by discounting the cash flows arising in the future
- Takes account of all relevant cash flows
- Provides a clear decision rule concerning acceptance/rejection of a project
- Is consistent with the objective of maximising shareholder wealth, which is assumed to be the primary objective of a business.
The IRR method is the last method listed above and is similar to the NPV method. It is based on the principle of discounting future cash flows and will normally give the same accept/reject decisions and will rank investment projects in the same way as the NPV method (Value Based Management, 2008).
However, the IRR method has difficulty in handling unconventional cash flows and does not address the issue of wealth maximisation as well as the NPV method. Thus, from a theoretical viewpoint, the IRR method is inferior to the NPV method. However, it seems that managers prefer the IRR method to the NPV method (McLaney, 2006). This is perhaps because it provides an answer that is expressed as a percentage figure, which is easier to understand than present value pounds. Finance managers can in practice incorporate both methods, thus aiding the maximisation of long term shareholder wealth.
To conclude we can see that, if the objective of the business is to maximise the wealth of its shareholders, them the NPV method is theoretically the best method to use. The general principles of the NPV method are fairly straightforward and act in the best interest of everyone one in the firm.
List of References
Arnold, G.; (2005) Corporate Financial Management, 3rd Edition, Essex; Financial Times Prentice Hall
Brealey & Myers, (2003) Principles of Corporate Finance, 7th Ed New York, McGraw-Hill
McLaney, (2006) Business Finance: Theory and Practice (7th ed.), London, Pitman Publishing
Landesman, E.S.; (1997) Corporate Financial Management: Strategies for Maximising Shareholder Wealth, John Wiley & Sons
Peter, D.; (2002) Creating Shareholder Wealth: Answering the Five Critical Questions, American Book Publishing Group
Cost of Capital, (2008). Dictionary by LaborLaw Talk, Available at : http://dictionary.laborlawtalk.com/cost_of_capital [Accessed on 23 February 2008]
Equity Master, (2008). Equity Master [online], Available at: http://www.equitymaster.com [Accessed on 10 March 2008]
Value Based Management, (2008). Value Based Management [online] Available at: http://www.valuebasedmanagement.net [Accessed on 02 March 2008]