Wealth Maximization and the NPV Method

2122 words (8 pages) Essay in Finance

25/04/17 Finance Reference this

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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.

2. 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

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3.0. Shareholder’s Wealth Maximization Concept

The maximization of shareholders wealth is a significant objective of management. According to Dr.R.Srinivasan,(2010)”Any action which results wealth or which has a net present value is a preferable one and should be undertaken”. The wealth of the company is based on the maximization of the present value of the entity. i.e., the present worth of the entity, This wealth may be measured if the organization has shares that are traded by the public, this because the market price of the share is indicative of the value of the organization. And to a shareholder, the word ‘wealth’ is based upon the amount of shareholder’s current dividends and the market price of share.

Ezra Solomon has described a wealth maximization goal in these 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.”

On the other hand a public sector company which it’s equity stock is fully owned by the government, and also not traded in stock market? In such companies, the objective 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, and must use the most appropriate discount rate. A same observation may be made with regarding to other entities which their equity shares are either not traded or very rarely traded.

In the above definition, one thing is for sure 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 appraise 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 faces with the uncertainty problems by considering the trade-off between the different returns and their associated levels of risks. It also considers the dividends payment to shareholders. All these components of the wealth maximization goal are the outcome of the investment, financing and dividend decisions of the company.


4.0. The Agency Problem Theory

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 by placing their own interests above those of the shareholders. For example, the managers may multiple their personal wealth by doubling 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 individual wealth, but may trade off other considerations, such as perquisites and leisure, against individual wealth. If the owner-manager forgoes a portion of his or her ownership by selling some of the entity’s stock to external investors, a potential conflict of interest may arise, called an agency problem. E.g. 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 external 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 objective of maximization of shareholder wealth. Although the shareholders recognize managers to manage the company’s assets, a potential conflict of interest may exist between these two groups.

According to Jensen/Meckling (1976) an agency relationship exists when “one or more persons (the shareholders or the principles) negotiate another person (the agent) to do some service on their behalf which involves delegation of some authority to make decision.” If both parties maximize their own utility there is good proof to consider that the management (agent) will not always act in the best interest of the shareholders (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 agent’s 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 agent’s 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

5.0. NPV Method of Investment Appraisal

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).

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As clarified by Averkampt H. (d.t) who defined NPV” as the acronym for net present value. Net present value is a computation that differentiates the amount invested today to the present value of the future cash receipts from the investment. In other words, the amount invested is compared to the future cash amounts after they are discounted by a specified rate of return”.

5.1. Advantages and disadvantages of NPV method

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.

5.2. Recommendations

Finally, at the starting of an NPV analysis it is very significant to identify the objective of the project. If the goal is to reduce the costs of operations and also prices. As to enhance the organization’s revenues, the forecasted increase in revenues needs to be evaluated and included as a positive cash flow in the computation. But if the objective in mind is to survival then a negative NPV might be reasonable if the negative financial impact of the investment is influenced by the potential financial losses that may be related with the ignored project. In some cases, the analysis led to the conclusion that mobilizing the capital required implementing the core lab project is in keeping with a strategy to maximize potential returns.

The NPV method evaluates the present value of the future cash flows that a project will have. A positive NPV is that the investment should appreciate the value of the company and also promote to maximizing shareholder wealth. A positive NPV project gives a return that is more than enough to compensate for the required return on the investment. Thus, using NPV as a guideline for capital investment decisions is consistent with the goal of creating wealth.

Moreover the NPV of the future benefits is the difference between net present value of the benefits and the investment required to achieve those benefits. A financial action resulting negative NPV should be rejected, because this will not generate a wealth to the shareholders. Therefore the organization should take a course of financial action e.g. invest in a project where there is a increase in the wealth of the firm or a project which have a positive NPV.

6.0. 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 time framework 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 investor’s wants to put 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.

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