How Finance Managers Can Contribute to the Maximization of Shareholder Wealth - Assignment Example

Critically assess how finance managers can, in practice, contribute to the maximization of shareholder wealth The relationship between the corporate management and the shareholders’ wealth is close. More specifically, the decisions taken by the corporate managers have an extensive influence on the level of share prices while on the long term the level of the firm’s equity can be also differentiated. As of the first issue, the study of LeRoy et al. (1981) and Shiller (1981) showed that the decisions of the corporate managers regarding the level of stock prices can affect the level of dividends distributed to shareholders alternating the shareholder value. Moreover, in accordance with the above two researchers ‘under the assumption of a constant discount factor, stock prices were too volatile to be consistent with movements in future dividends: this conclusion, known as the excess volatility hypothesis, argues that stock prices exhibit too much volatility to be justified by fundamental variables’ (Balke et al., 2006, 55). Another area of investment which – if chosen by the finance managers – can increase the shareholders’ value is the real estate. Towards this direction Quan et al. (1999, 183) supported that ‘a number of authors have argued that commercial real estate offers diversification benefits to institutional investors because of its low correlation with commonly used stock price indexes; for example, using annual U.S. data from 1947 to 1982, Ibbotson et al. (1984) found real estates correlation with SP stocks to be -.06, whereas Hartzell (1986), using quarterly data from 1977 to 1986, estimated the correlation to be -.25’. As of the type of financing preferred by the finance managers, there are no specific indications for preferences of particular type. In fact, it seems that finance managers can use a series of methods to increase the shareholder value. The increase of the firm’s profits is a primary stage. However, because the increase in shareholder value cannot be achieved without the increase of the firm’s equity or its profits on a long term basis, the finance managers have to concentrate at a first level to the retrieval of the amount required for the firm’s current operational activities putting the increase of the shareholder value as a secondary target. In this context the study of Carey et al. (1998, 845) which was focused on the types of loans available to corporations revealed that ‘both the corporate loans made by banks and by finance companies are equally likely to finance information – problematic firms’. The above study does not refer to the maximization of the shareholders’ value, however it refers to the types of supplementary financing available to corporations in case that they face a financial pressure – the survival of a corporation under difficult conditions is considered as necessary in order to proceed to a development of its activities and an increase in the firm’s value (as a result to an increase of its shareholders’ value as well). Towards the above direction, Carpenter et al. (2002, 54) tested the effectiveness of new equity financing as a tool of increase the firm’s equity and found that ‘new equity financing has several advantages over debt, but may be costly compared to internal finance’. More specifically, the above authors examined a series of ‘over 2,400 publicly traded US high-tech companies over the period 1981–98’ and found that ‘new equity financing, in the form of the initial public offering, is very important and permits a major increase in firm size; after going public, comparatively few firms make heavy use of external financing’. Because the above study refers to medium size firms it could be equally used by the finance managers in large corporations, at least in cases that external financing is not available within a short period of time. The factors affecting capital structure choice have been the main objective of the study of Norton (1991) who examined the above issue through a survey among companies listed in the Fortune 500. The above survey led to the conclusion that ‘tax implications, managements desire for flexibility, and market concerns affect capital structure decisions while little indication is provided on the importance of agency costs, signalling, or asymmetric information’ (Norton, 1991, 431). Regarding specifically the international firms, it has been found that a common method of raising funds is the venture finance. More specifically, the study of Cumming (2006, 155) showed that ‘venture capitalists (VCs) in all non-U.S. countries around the world have consistently reported the use of a variety of securities, including common equity, preferred equity, convertible preferred equity, debt, convertible debt, and combinations (in the U.S., VCs typically use convertible preferred equity, and there is a tax bias in favor of that instrument in the U.S.)’. However, the venture finance is not available to firms of all types and sizes. It is necessary that a company has a series of specific characteristics and have achieved a particular level of development. Moreover, the venture finance cannot produce the same results for all international firms. In fact they are the decisions of the finance managers that can lead to a success or failure the relevant effort. More specifically, the study of Wang et al. (2002, 59) showed that ‘differences in internal management mechanisms and staff backgrounds lead to external performance differences’. The above assumptions are based on the thorough examination of a series of venture capital based companies listed in Singapore. The results of the above study showed that ‘there are significant differences among VCFs in accordance wit the industry preference, investment duration, VCF syndication, number of board seats, initial underpricing, and long-term market returns; independent VCFs add more value to their portfolios and for this reason they should be preferred as a ‘vehicle’ of investment in a foreign market’ (Wang et al. 2002, 59). The raising of funds for the cover of the various needs of corporation activities is the primary role of finance managers in firms around the world. A common ‘vehicle’ for the achievement of the above task is the use of corporate bonds. Indeed, as the study of Damodaran (1999, 28) has proved ‘the last two decades have seen a stream of innovation in financial markets, especially in corporate bonds; some of these innovations—notably, hybrid debt—have provided firms with more flexibility in designing cash flows on borrowings, allowing them to match cash flows on financing more closely to cash flows on assets; in so doing, the use of such innovative securities has increased corporate debt capacity and hence firm value’. The above ‘tool’ of corporate financing can be used alone or combined with the venture capital ‘scheme’ as described above in order to increase the firm’s value (and the shareholder value as well). On the other hand, James et al. (2000) have examined the role of bankers in ‘providing commitment-based financing to corporations’. More specifically as the above researchers support ‘this type of lending is important not only for small firms that lack access to public debt markets but for large and medium-size companies as well; for such companies, commitment-based financing provides access to debt capital that becomes valuable when the firm has an immediate need for funding but interest rates in public debt markets are prohibitively high, or the firm is undervalued by the market’ (James et al., 2000, 52). The above assumptions are also supporting by a reference to specific market reactions regarding the commitment-based financing. More specifically, it is stated by James et al. (2000, 52) that ‘the fact that commitment-based financing is used by larger companies when they believe themselves to be undervalued in the market is probably the best explanation of why announcements of these types of loans elicit a positive stock price reaction’. The use of the above ‘tools’ – i.e. of the venture capital, the corporate bonds or the bank borrowing - for covering the financial needs of a particular corporation is decided and formulated by the firm’s finance managers. In these terms, the role of finance managers to the increase of firm’s value (directly related with the shareholder value) is crucial. Another issue that needs to be examined is the basis used by the finance managers in order to proceed to a particular investment decision. In this context, risk management has a primary role in examining all the parameters of a potential choice and highlighting the possible risks related with it. Regarding specifically the risk management sector, Nielson et al. (2005, 279) have divided the risk management process into three generations which are described as following: accepted that ‘the first generation of risk management dealt primarily with risks inside a company creating a need for internal risk communication; the second generation, which arose with the growth in third-party liability claims, involved many more stakeholders external to the company and forced the risk management function to deal with communications to these external parties; the third generation, which began as an expansion of the external risks that firms are exposed to, involves the board and senior management in the risk communication function’. Risk management is proved therefore a corporate activity which has significant importance. The appropriate structure of the plans used during this activity is necessary in order for the finance managers to develop a realistic and feasible investment project. Moreover, it seems that there is a preference by finance managers for specific types of investment projects. In this context the study of Brands et al. (2006) which examined ‘the stock characteristic preferences of institutional Australian equity managers’ revealed that ‘active managers exhibit preferences for stocks exhibiting high-price variance, large market capitalization, low transaction costs, value-oriented characteristics, greater levels of analyst coverage, lower variability in analyst earnings forecasts, higher volatility, value stocks and wider analyst coverage among smaller stocks’ (Brands et al., 2002, 169). It was also revealed that ‘smaller investment managers prefer securities with higher market capitalization and analyst coverage (including low variation in the forecasts of these analysts)’ (Brands et al., 2002, 169). The above assumptions are indicative of the importance of finance managers’ decisions for the increase of shareholders’ value. More specifically, the finance managers as responsible for all investment decisions made within a particular corporation have the power to alternate the firm’s value (either positively or negatively) and in this way they have a strong and direct influence on the level of shareholders’ value. In order to evaluate the role of finance managers to the maximization of shareholder wealth, we should primarily present the criteria on which this wealth is measured. In accordance with Damodaran (2001, 12) in private firms shareholder wealth ‘has to be estimated based on assumptions made about a firm’s future prospects while in a publicly traded company, the stock price is an observable and real measure of shareholder wealth’. At the same time, the increase of the shareholder value is being considered by Damodaran as a priority for the finance managers. More specifically, in accordance with the above researcher: ‘although a firm includes both equity investors and lenders, we could argue that the lenders can protect themselves contractually and that managers should therefore focus on maximizing the wealth of those who hired them in the first place – the stockholders’ (Damodaran, 2001, 12). In accordance with the above, the maximization of the shareholder value should be a priority for all finance managers. Moreover, as it has been proved by the issues developed above, a series of ‘financing tools’ are available to finance managers towards the achievement of the above target. The evaluation of these managers’ role regarding this mission is however a challenging task especially in case of the international enterprises. The high volume of daily transactions occurred within these enterprises combined with the cultural and organizational dysfunctions related with the extension of these firms in the global commercial community, makes the control over the finance managers’ progress almost impossible. In fact, it is just after the release of the firm’s financial statements that its shareholders can have a general view on the development of their investment (or the loss involved). However, the progress made in the area of legal rules related with the monitoring and the evaluation of finance managers’ activities can ensure the protection of shareholders’ investment in a particular firm – at a least up to a point. (words: 2026) References Balke, N., Wohar, M. (2006). What Drives Stock Prices? Identifying the Determinants of Stock Price Movements. Southern Economic Journal, 73(1): 55-67 Barclay, M., Smith, C. (1999) THE CAPITAL STRUCTURE PUZZLE: ANOTHER LOOK AT THE EVIDENCE. 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