How to Maximise Shareholder Wealth - Essay Example

How to Maximise Shareholder Wealth We explore the different ways managers can influence the magnitude, timing, and risk of the cash flows expected tobe generated by the firm to maximise shareholder wealth. We begin with a brief discussion of what shareholder wealth is and how it is measured, and then proceed with a discussion of how managers influence the means by which shareholder wealth is maximised. As this essay integrates key introductory lessons on corporate finance and financial management from various sources, we listed down our classified bibliography to avoid clutter from multiple references. "Shareholders" are legal persons (humans or corporations) that own a business. Ownership is derived by investing funds or assets, or buying stakes from previous owners. Shareholdings represent a limited legal claim on the ownership of a business, its assets and liabilities. Such claims are limited by the proportion of ownership derived from the amount of the investment. Shareholders who invest have one common goal: maximise the value of invested wealth. Every investment decision is made with the expectation that its value would increase over time. Shareholders do not necessarily manage the business, so they hire managers as their agents to increase the value of their (shareholders') wealth such that there would be enough profits for everybody. A portion of these profits is given back to owners through dividends whilst the balance may be re-invested to create more wealth. The agency theory describes the dynamics of the relationship and potential conflicts of interest between shareholder-owners and manager-agents. How shareholder wealth is measured indicates how managers can maximise it. For any business with more than one shareholder, the ultimate measure of shareholder wealth is the share price, the value of one share of ownership in the business. Share valuation follows a systematic process based on the value of the corporation's assets, which equal its liabilities plus stockholders' equity, all information available from the balance sheet. At start-up, the value of a share is derived from dividing equity by the number of shares offered. Once the business generates profits, cash can be distributed as dividends to shareholders or re-invested in the business. Profits increase assets and the value of the shareholders' equity, thereby increasing each share's value. Or, assets can increase with debt, but it does not automatically follow that stockholders' equity would stay the same, decrease, or increase. The effects of debt depend on what managers do with it, and whether or not borrowing allows the corporation to generate more cash. At some future time, when a shareholder decides to sell the shares, both buyer and seller only need to analyse the balance sheet to agree on the price. However, a single share of stock is not only a claim on the assets the corporation owns today, or the value of the shareholders' equity now. It is also a claim on future profits and the future selling price of the share. Neither is the investment totally risk-free, since the share's value could drop because of mismanagement and bankruptcy. Risk is part of valuation because of the risk-return relationship. Therefore, a share's value today is calculated by getting the present value of: 1) Cash dividends until the shares are sold; 2) Proceeds from selling the shares; or if the corporation ceases operations, 3) The firm's break-up value after selling assets to pay off liabilities. Financial analysts simplify share valuation by focusing on the present value of cash dividends, making the convenient assumptions that shares would not be sold and the business would not be closed. Since cash dividends are equivalent to the free cash flow (FCF), the value of a share now is the present value of the FCF stream discounted at the rate of return investors expect to receive on comparable investments. FCF is not profits, which can be re-invested or given out as dividends. Rather, FCF is the cash not retained nor re-invested in the business. It can be calculated by subtracting costs and investments from revenues: FCF = revenues - costs - investment. The present value of a cash flow stream is based on the principle that money today is worth more than money in the future because of the opportunity cost of capital. This means that in one year, the value of money would be reduced by a discount factor: Discount factor = 1 . (1 + r) n The variable r is the rate of return corresponding to the opportunity cost of capital. Any acceptable investment today must give either the same or a greater sum in the future. The rate of return is determined by looking at: 1) The return on government securities, which is the risk-free rate; 2) The corporation's Weighted Average Cost of Capital (WACC), which is a weight-adjusted rate depending on the corporation's mix of debt and equity funds; and 3) Other potential investments and their returns. If the share is owned over several n years, the discount factor is adjusted by the factor n, and the cash flow for each period n is discounted (multiplied by the discount factor) and summed up to arrive at the present value. The rate of return r may change each year due to fluctuations in inflation, interest rates or the WACC, or it may remain constant. Another factor to consider is market sentiment, or how investors perceive the effects of the economy, management performance, and business prospects. These affect the price of the stock, a phenomenon defined by the Efficient Markets Hypothesis (EMH), whose supporters (Fama, French, etc.) classify information (weak, semi-strong, and strong) and study their effects on stock prices. According to EMH, equity markets are efficient and stock prices reflect available information. Others disagree who think markets are inefficient and prices are affected more by irrational investor behaviour. EMH and behavioural finance proponents (Shiller, Kahnemann, etc.) are engaged in a continuing debate, each side citing empirical evidence supporting their theories. Risk is included in share valuation based on the observation that the expected return from risky activity must be proportional to the level of risk. An investor expects a risky investment to offer higher returns. Financial risk, the probability that the expected return would not be realised, is present in the corporation (goods won't sell) and in the market (all stock prices collapse). How risk gets into share valuation is covered by the Capital Asset Pricing Model (CAPM). CAPM states that the value of a share is affected by two types of risk: risk in the market, which is affected by investor or economic behaviour, and risk to which the company is exposed. This second risk can be eliminated by diversification, but the market risk, which affects all companies, cannot be eliminated. CAPM calculates how the stock moves with the market, a factor captured by beta (providing investors with an idea of a stock's risk level. The beta affects share valuation because it is the starting point in calculating the expected rate of return, r, used in the discount factor: r = rf + (rm - rf) This means that the share's expected return r is the sum of the risk-free rate rf and the market risk premium, which is the difference between the market's rate of return rm and the risk-free rate rf multiplied by the of the stock. All variables are known and based on historical data. Would it matter if a corporation has more debt than equity Offhand, piling more debt may look riskier. And besides, paying interest would mean foregoing a share of profits that could be given to shareholders as dividends. According to Modigliani and Miller, it does not matter as long as the cash flows generated by the firm's assets are unchanged. They argued that share value is independent of capital structure and paying debt and interest instead of giving dividends may leave shareholders better off. There are many reasons for this, such as tax laws, tax shields and the effects of gearing on management. Lastly, there are two types of shares issued: preferred and common. Preferred stocks are like debt equity: they give out fixed regular dividends. In exchange, they rarely possess full voting privileges, whilst common stockholders do. Preferred stocks are useful in financing mergers and in other special situations. Now, we can answer our main question: how do managers maximise shareholder wealth They do so by increasing the share price. The most obvious method is to increase FCF, which is affected by raising revenues by increasing prices and the variety and number of goods or services sold. They may also cut down expenses such as salaries, cost of raw materials, marketing, etc., and invest in new businesses or equipment to enter new markets or increase productivity. Another is to manage the firm's working capital and inventory more efficiently. Minimising working capital and inventory will maximise FCF. There are several methods: buying materials only when needed, using Just-in-Time inventory systems, or selling finished products quickly to generate cash. Negotiating generous terms on payables and cutting down receivables also decreases working capital requirements, freeing up cash and increasing FCF. As Modigliani and Miller argued, the discounted value of future cash flows may not necessarily increase by decreasing the rate of return variable in the discount factor equation, e.g., by decreasing WACC, since CAPM predicts that an increase in risk would lead stockholders to demand higher expected returns. What this means is that the best way to maximise shareholder value is not by manipulating the firm's capital structure but by increasing FCF, unless gearing increases FCF through tax breaks or decreased financing costs. Lastly, managers can increase the share price by facilitating the flow of positive information on the company, such as communicating to financial analysts their profits expectations, strategic plans, growth objectives, and other positive developments. Any information that improves the market's confidence in management helps increase share prices and would increase shareholder wealth if they so decide to take advantage and sell their shares. 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