Question

 

1. In the context of financial management, how does the rise in shareholder wealth from 2019 benefit society?

2. What is the appropriate goal for management decisions?

3. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

Answer 1

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(1) The economic sustainability and growth of modern societies are dependent on the market-based capitalist systems which are constantly required to be fueled by investments, risk-taking and innovation. The rise in shareholder wealth as a result of rise in markets act as a motivator and confirmation for investors to continue to invest and reinvest money into the system.

When the markets fall and shareholder wealth goes down, it creates fear and uncertainty among investors, which dries up the investment cycle, reduces capital expenditures, resulting in fall in growth, reduction in the growth of jobs, consumption and therefore the entire economic cycle.

Therefore, if the shareholder wealth rises from 2019 levels, it will bring a sense of optimism in the current year, fueling investment cycles, higher growth rates, increase in the number of jobs, increase in consumption and thus resulting in a more prosperous and stable economy going forward.

(2) The management of a company are appointed by shareholders in order to run the business operations on their behalf. Hence, the goal of management decisions has always been to achieve the goals of shareholders, i.e. increase shareholder wealth. When shareholders invest money in a business, it involves risk and thus becomes very important that shareholders generate enough returns that justify the level of risk involved.

While a company can invest its funds into various projects/businesses, the goal of the management is to invest shareholder's money in only those opportunities that earn enough returns to cover the cost of capital of the firm. This ensures that shareholders get enough returns to cover the risk and this is the goal for management decisions.

In addition to above, we must also consider that in the 21st century, the management goals also cover ensuring that the business activities are environmentally sustainable and that the company understands and discharges its corporate social responsibilities.

(3) In the simplest of words, the value of any asset is the cummulative present value of future cash flows it can generate. The rate at which future cash flows are discounted to arrive at the present value depends on how risky the future cash flows are. Higher the risk, higher would be the discount rate and vice-versa.

Just like any asset, the value of a firm is also determined in the same way. The cash flows that are expected to be generated by the firm are discounted to arrive at their cumulative present value which is the intrinsic value of the firm. With regards to the discount rate to be used to discount the future cash flows, we require the weighted average cost of capital (WACC). WACC takes into consideration the cost of funds from all sources including equities, debt, preferred stock and blends them together in the right proportion to arrive at the overall cost of capital of the firm.

Therefore, we discount the expected free cash flows of firm using its WACC and add them up to arrive at the value of the firm.