Shareholder Wealth Maximization free essay sample

The ultimate goal of any financial manager (as well as the firm) is the maximization of shareholders’ wealth. A good financial manager therefore should carefully consider and weigh the risk of undertaking a certain project against the profits associated with undertaking such a project. Capital Budgeting techniques enable the manager to make such decisions. The first question that comes to mind is, when making a capital investment decision, should we focus on cash flows or accounting profits. The book is stating â€Å"In measuring wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits that are actually received by the firm and can be reinvested. We will write a custom essay sample on Shareholder Wealth Maximization or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Accounting profits, however, appear when they are earned rather than when the money is actually in hand. † The answer to the question now seems too obvious; it is cash that buys new equipment, used to pay suppliers and employees etc; it is also cash that is to be reinvested to further increase shareholders’ wealth and hence brings the firm closer to its goal. This brings us to another question, should all cash flows associated with the project be considered? Again, the book provides an answer â€Å"In measuring cash flows, however, the trick is to think incrementally. In doing so, we will see that only incremental after-tax cash flows matter. † By incremental we mean â€Å"marginal†, or â€Å"additional†. Incremental cash flows are those cash flows that would affect the capital budgeting decision, but another condition also applies, those incremental cash flows must be considered on after-tax basis, this is because what really increases the value of the firm is the net cash flow (free cash flow) that would be available to the financial manager in considering future investments. In analyzing a project, one has to also consider depreciation, and although depreciation in itself is a noncash expense, it still affects free cash flow because it has an effect on taxes. Depreciation reduces Earnings before Tax (EBT), and therefore reduces the Tax Expense. Another important type of cost that needs to be discussed is what is known as â€Å"Sunk Costs†. As discussed above, only incremental (differential cash flows) need to be considered in making a capital budgeting decision, yet if the firm has, for example an empty lot of land that it had purchased in the past and that lot of land is suitable for the investment decision on hand, does the financial manager need to consider the cost of this piece of land when making his capital budgeting decision? The answer is a firm â€Å"No†; and the reason behind this is real logical: if the investment is not accepted, the cost of the land cannot be recovered, hence whether or not the investment is undertaken; the cost of the land (a sunk cost) is irrelevant to the decision. As I have stated earlier, in making a capital budgeting decision, the financial manager needs to consider only incremental cash flows, and the first of those are the initial outlays. This is because to take up an investment, the financial manager needs to make sure he has the funds initially required to undertake a certain investment (project). Those include, for example, cost of equipment, installation costs, cost of training as well as any increase in Working Capital. Based on the above, and based on the calculations on the attached excel sheet, the initial outlay for the new project is $8,100,000. The second set of cash flows that need to be analyzed is the â€Å"Differential Cash Flows†; again as stated above, those are the cash flows that are relevant to the project under consideration. Those include (but are not limited to), added revenues (less added selling expenses), any labor and/or material saved or incurred, any increase or decrease in overhead costs. Needless to say here that all such cash flows should be analyzed on after-tax basis. Such cash flows, however should not include any finance charges whether those are interest charges paid on a bank loan, interest charges on the firm’s issued debt securities, as well as dividends on preferred and common stock. The reason behind such exclusion is that such finance charges are implicitly accounted for when calculating the cost of capital (also known as the Weighted Average Cost of Capital). Having said that, Caledonia’s differential cash flow (as per the attached xcel sheet) are: Year 12345 $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000 The last type of cash flows to be examined is the Terminal cash flow which includes all incremental cash flows realized at the termination of the project such as the salvage value of the equipment plus (or minus) any taxable gains or losses associated with selling the equipment. Terminal cash flows also would include any non-expen se cash outlays related to the project such as the recovery of working capital needs. Caledonia’s terminal cash flow then is $5,980,000 as per the above table and the attached excel sheet. A cash flow diagram of the project would provide a full image of the cash out flows and cash inflows associated with the project as it would provide a summary of those cash flows that are to be analyzed using the various capital budgeting techniques: $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000 0 1 2 3 4 5 $8,100,000) Going back to the main goal of the firm maximization of shareholders’ wealth, an important question arise: how can the financial manager of Caledonia make sure that the new project adds to the value of the firm. Capital Budgeting techniques would help, and the first of such techniques is the Net Present Value method. Net Present Value (NPV) is a capital-budgeting decision criterion defined as the present value of the free cash flows after tax less the project’s initial outlay. The most important advantage of the NPV as per the book is as follows: â€Å"The project’s NPV gives a measurement of the net value of an investment proposal in terms of today’s dollars. Because all cash flows are discounted back to the present, comparing the difference between the present value of the annual cash flows and the investment outlay does not violate the time value of money assumption. † . This method tells us to accept any project for which the NPV is equal to or greater than zero. Applying this to Caledonia, the NPV is equal to $16,731,096. (Please see the full analysis on the attached excel sheet). Another capital-budgeting decision criterion that is widely used by financial managers is the Internal Rate of Return (IRR), which is defined as â€Å"the discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay. † The IRR method states that projects with an Internal Rate of Return that is equal to or higher than the required rate of return should be accepted. This makes sense because if the project’s rate of return (IRR) is equal to the required rate of return, then investors would be happy as they are earning the rate of return that they initially require. The Internal Rate of Return of the proposed project is 77% (Please see the attached excel sheet). Based on the above, Caledonia should accept the project since its Net Present Value is greater than zero, and the Internal rate of return is much higher than the required rate of return. Equally important as maximizing shareholders’ wealth, risk management is an important consideration when evaluating new projects. In capital budgeting, risk can be measured from three perspectives; first there is the Systematic Risk, and this type of risk is the risk of the project from the view point of a well-diversified Finally, there is systematic risk, which is the â€Å"risk of the project from the viewpoint of a well-diversified shareholder; this measure takes into account that some of a project’s risk will be diversified away as the project is combined with the firm’s other projects, and, in addition, some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolios† The second type of risk is the Project’s Contribution to Firm Risk, which is the â€Å"the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets, but ignores the effects of diversification of the firm’s shareholders† . Finally, there is the Total Risk (or stand alone risk of the project) which combines all risk associated with the project ignoring the fact that some of this risk will be eliminated through diversification. Actually, according to CAPM, the only relevant risk for capital budgeting purposes is Systematic Risk yet sometimes the firm might have undiversified shareholders, and for them the only relevant measure of risk is the project’s contribution to the firm’s risk. For these shareholders, a project’s contribution to firm risk brings the ghost of bankruptcy closer and therefore such measure of risk could be more relevant. Risk can also be incorporated into capital budgeting analysis through the use of simulations. Simulation â€Å"involves the process of imitating the performance of the project under evaluation. This is done by randomly selecting observations from each of the distributions that affect the outcome of the project, and continuing with this process until a representative record of the project’s probable outcome is assembled. † This enables the financial manager to base his decision on a range of possible outcomes. Usually Simulations are accompanied by a Sensitivity analysis (also known as the What-if Analysis). In this analysis, the financial manager changes the value of one input variable (Direct material, Direct Labor, Variable Overhead Rates, Interest Rates) while holding all other variables constant. The distribution of possible net present values and/or internal rates of return â€Å"is then compared with the distribution of possible returns generated before the change was made to determine the effect of the change. † In conclusion, a financial manger must realize that there is always a trade-off between risk and return, he should always utilize the tools available to him in considering any new projects such as capital budgeting techniques (Net Present Value, Internal Rate of Return, †¦etc) as well as simulations and sensitivity analysis to arrive at the most accurate decision. He also need to know how shareholders perceive risk and how they measure it so as to avoid agency problems and arrive at the ultimate goal of the firm- Maximizing shareholders’ wealth. In analyzing Caledonia’s proposed project, we only performed a capital budgeting analysis and based on that the project seems to be acceptable, but the financial manager should also strive to conduct other forms of analysis as stated above to ensure that he has taken all possible measures to achieve his goal. References: