Page 11 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management
Notes
6 LOVELY PROFESSIONAL UNIVERSITY
dividend, or working capital management decision that increases the company value is a good
financial-management decision. The finance manager strives to act in the best interests of the
shareholders by making decisions that increase the value of the stock. It is assumed that financial
markets are efficient and stock prices truly reflect shareholders’ wealth and that shareholders’
wealth is not increased at the expense of bondholders.
The goal of maximization of shareholders’ wealth involves maximizing the NPV or wealth of
an investment decision to the shareholders. The NPV of a project is the sum of the present value
of all the cash flows that are expected to occur during the life of the project. The NPV can be
explicitly defined as:
A1 A2 A3 An
W = + + + – IO
(1 + k) (1 + k) (1 + k) (1 + k)
Where:
W = NPV of a project
IO = Initial investment or cost of the project
A1, A2 = Cash flows expected to occur every year if the project is adopted
k = Discount rate used by the project for finding the present value of the cash flows
Shareholder-wealth maximization is considered to be a more appropriate objective than profit
maximization because it considers the net benefits after taking into account the compensation
for time and risk. The decision rule associated with NPV is that if a project has a positive NPV,
it creates wealth for its shareholders and should be accepted. If the NPV is negative, the project
should be rejected because it will reduce shareholders’ wealth. If there are several projects, the
finance manager should select the projects with the highest NPV. If this criterion is adopted, the
wealth of the shareholders will be maximized.
Stakeholders’ Consideration
Companies have broadened their focus, and, in addition to the interests of the shareholders,
they focus on the interest of the stakeholders. The term ‘stakeholder’ is a broad term and refers
to the parties who have a direct interest in the company, such as customers, owners, creditors,
suppliers, and employees. If the company follows a strategic vision and a goal such as maximizing
the market value of the share, the stakeholders will be amply rewarded.
Management’s Consideration
From the viewpoint of management, the shareholders’ wealth maximization is not always a
practical governing objective.
Example: If the market conditions are temporarily adverse, management can decide to
adopt maximization of sales as the objective.
This objective need not be in harmony with shareholders’ wealth maximization and can lead to
a conflict. Management discipline can be hard to maintain if directors and shareholders are
disinterested in running the company. The management can also manipulate information to
increase the share prices.
Societal Consideration
Stock prices respond positively to the actions of management that enhance the value of the
company and improve the ability of a company to be successful in the long run. This means that