Question

In your own words, outline and provide examples of how a company could pursue shareholder wealth maximization in relation to the following concepts (5 points each): 1) Capital structure 2) Risk & return 3) Cost of capital 4) Net present value 5) Internal rate of return 6) Payback period

Answer 1

1) Capital Structure

Company will choose adding debt in capital structure which will provide lever to returns to the shareholder. By using lenders money,company will invest in any profitable project which will increase shareholder returns. Also company will choose capital structure which will have lowest weighted average cost of capital.

E.g. If ABC limited has only $100 million equity in capital structure. They will give 150 million debt in the balance at lower cost than equity and investment the money in project which suppose give $50 million returns and if company pay $15 million to lenders and then $35 million will be available to equity holders

2) Risk & Return

If company takes calculated risk and it receives good returns. Very high risk sometimes to leads to losing all the money invested.

E.g. If XYZ invest in risky project which also 20% return. If company thinks although project is risky but it has 70% probability of success and hence invest in the project. As project succeeds, it leads to shareholder wealth maximization

3) Cost of Capital

Lower the cost of obtaining fund or lower the opportunity cost of fund results higher present value from any project. Hence leads to shareholder wealth maximization

E.g. Project A has cost of capital 8% and B has cost of capital of 10%. In this case, project A with 8% cost of capital will results in shareholder wealth maximization

4) Net present value

Higher the net present value of any investment, higher the shareholder wealth maximization. Any project with NPV greater than zero will give shareholder wealth maximization

E.g. 2 projects - A has NPV of $100 million and B has NPV of $150 million. In this project B with higher NPV will give shareholder wealth maximization

5) Internal rate of return

If IRR of any investment greater than cost of capital then it will lead shareholder wealth maximization

E.g. 2 projects - A has IRR of 10% and B has IRR of 12%. If cost of capital is 11% then project B with IRR of 12% will lead to shareholder wealth maximization

6) Payback period

Project with smaller payback is better. But it is not necessary will lead to shareholder wealth maximization as it depends on NPV or IRR of projects.