SHAREHOLDER WEALTH MAXIMISATION: SUMMARY ‘Business Finance’ assumes that the objective of a company is to maximise shareholder wealth. This means that companies should attempt to maximise the value of the shareholders’ investment in the company. This is achieved by maximising ‘Total Shareholder Returns’: dividends and share price appreciation.
The most powerful basis for understanding and measuring shareholder wealth is the ‘economic valuation model’, under which the value of the shareholders’ investment is measured as the present value of future cash flows that are attributable to the shareholders. This approach involves converting future cash flows into their equivalent value in today’s terms, by adjusting for the effect of the ‘time value of money’. The ‘time value of money’ concept refers to the reality that ? 100 today is worth more than ? 100 in a year’s time.
This is for three reasons: • Inflation: which reduces the purchasing power of money over time • Consumption preference: we prefer to spend money now rather than wait to spend in the future • Risk: this refers to the variability of future returns from an investment. This time value of money effect means that shareholders require a rate of return from their investment in a company which is sufficient compensation for the time value of money effect that they suffer. This rate of return is known as the ‘cost of capital’.
For a company to create wealth for shareholders, it must generate a rate of return which exceeds the ‘cost of capital’. Arguments in favour of ‘shareholder wealth maximisation’ being the assumed objective of the company: • Shareholders are the legal owners of the company • Shareholders bear the risk • Assuming competitive markets, maximising wealth of shareholders should ensure the interests of customers and employees are also met • Decision-making is simplified Arguments against shareholder wealth maximisation: Some argue it will lead to the interests of other stakeholders such as customers and employees being neglected (eg through selling poor quality, over-priced products and providing poor conditions and rates of pay to employees). However, in competitive markets, arguably the only way that companies will create wealth for shareholders is by selling products/services customers want to buy, and therefore customers’ interests cannot be ignored. Also, the way to ensure customers’ interests are met is arguably by ensuring staff are well motivated and properly trained.
Furthermore, employees prospects of having a secure and well paid job are improved by working for a company that is financially successful. • Some argue that it will lead to ‘short-termism’ (decisions that improve short-term profits at the expense of long-term value, such as reducing research and development and marketing investments). However, the concept of economic value means maximising shareholder wealth should mean that long-term and short-term performance is captured.