Question

Outline and provide examples of how a firm could pursue shareholder wealth maximization in relation to the following 5 points each.

1. Capital Structure. 2. Cost of capital. 3. NPV 4. IRR 5. Risk & Return

Answer 1

1. Capital structure

In capital structure decision one has to decide if he wants to go for debt or equity financing. This has direct impact on wealth maximization. More debt is high risk for the company, also means high return. Let us understand this by an example.

Company has 200Mn$ equity and 0 debt. Profit earned is 50Mn $. Thus return on equity is 25%. If company had debt of say 150Mn$ (10% interest ) and equity of 50Mn$ then profit would have been 50Mn $ less interest of 15Mn $ i.e 35Mn $. Thus return of equity is 70% (35/50*100).

This is how wealth can be maximized by equity share holders. In contrast if company makes losses then having debt would mean that shareholders have much worse return on equity. So it is a double edged sword.

2. Cost of capital

The lesser it is the better. You always want to pay less. Say cost of capital of the company is 10% and another company is 20%. In that case company with 10% would have less outflow of cash. Thus increase in valuation and leads to wealth maximization

3&4. NPV & IRR

NPV is positive means cash inflows discounted is more than outflows. Thus project is pursued.

When more money comes to the business wealth of shareholder increases.

Similarly IRR of the project also determines rate at which cash inflows discounted is equal to outflow from the project. If project has better than IRR rate then project is worth pursuing. Thus more money in the company and wealth maximized.

5. Risk & return

Capital structure decision discussed in point 1 is the best example here. Debt is more risky thus more debt can also lead to better return.