Managerial Action to Maximize Shareholder Wealth
Before we describe the actions to be taken to maximize the shareholder wealth we discuss what we mean by shareholder wealth maximization.
Shareholder wealth maximization is an almost universally accepted goal of a firm. According to this goal, the managers should take decisions that maximize the value of the firm. The value of a firm is the total of the market value of equity and the market value of debt. If the value of the firm is maximized, the market value of equity will increase because debt has a fixed claim on the firm. Thus, maximizing a firm’s value is consistent with maximizing shareholder wealth or maximizing stock price. Shareholder wealth is maximized when a decision generates net present value. The net present value is the difference between the present value of the benefits of a project and the present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys the wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted.
We can illustrate the value maximization or shareholder wealth maximization goal with this example. Suppose a firm invests Rs 10,000 now in a project that generates a cash flow of Rs 3,000 each year for five years. The net present value of the project is Rs 1,372 if the firm requires a 10 percent return on its capital (method of calculating net present value can be found in our book Fundamentals of Financial Management) Project like this should be accepted because the net present value accruing from the project belongs to the shareholders, hence increases their wealth. Investors pay higher prices for shares of a company that undertakes projects with positive net present value. As a result, value maximization is reflected in the market price of shares. Based on this logic, stock price maximization is considered equivalent to shareholder wealth maximization as the goal of a company. It is because the market price of a firm’s stock takes into account present and expected earnings per share; the timing, duration, and risk of the earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock.
Shareholder wealth maximization goal as a financial management decision criterion is considered superior goal because it meets the test of fundamentals of financial decision making. For example, it measures benefit in terms of cash flow instead of accounting profit, prefers current rupees to future rupee (considers the time value of money), considers risk by discounting more uncertain cash flows at a higher rate, and reduces the conflict among stakeholders (customers, employees, society) by appropriately addressing their concerns.
Against this backdrop what should the financial managers do to maximize the share holders’ wealth? We can create a long to-do and not-to-do list of activities. But these activities may be summed up in three principles. Adherence to these three principles thus can be said as the managerial actions to maximize shareholders’ wealth. The three principles are as under:
According to this principle, the financial manager should invest in assets and projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and should reflect the financing mix used— owners’ funds (equity) or borrowed money (debt). Return on projects should be measured based on cash flows generated and the timing of these cash flows.
THE FINANCING PRINCIPLE.
This principle suggests managers choose a financing mix (debt and equity) that maximizes the value of the investments made and matches the financing to the nature of the assets being financed.
According to this principle, the firm should have investments that earn the hurdle rate to return the cash to the owners of the business.