Wealth Maximization and the NPV Method

Wealth Maximization and the NPV ruleIt has long been an received perception that the objective of management is the maximisation of sh argonholder richesiness. As we populate the corporate objective of a firm is to maximisation partake holders wealthinessiness in order to achieve this corporate goal in that location is a problem arising called agency problem. The corporate firms be managed by professional managers these managers do not receive a 100% share so managers whitethorn not work to wards the best of firms goal of maximising shareowners wealth beca determination of the hostile interests, in this assignment we testament examine the firms corporate goal.The this study contends that it is to pronounce the usefulness of Net Present Value but overly victorious to the account the effect of agency problem inside the smart set.2. IntroductionOwners are primarily interested in the wealth creation ability of an entity, and they typically monitor their investments b y the valuating of the investments financial return. Shareholders tend to prefer that all long-term corporate purposes to be evaluated based on the investments contribution to the maximization of shareowner wealth. Dean (1994) suggests that the primary objective of the modern corporation should be to maximise the toast worth at the companys toll of superior of the emerging current of benefits to the stockholder. All otherwise objectives should be either intermediate or auxiliary to this overriding companys financial objectiveQuestion13.0. Shareholders Wealth Maximization ConceptThe maximization of shareowners wealth is a signifi crumbt objective of management. correspond to Dr.R.Srinivasan,(2010)Any exercise which results wealth or which has a net fall in value is a favored unrivalled and should be undertaken. The wealth of the company is based on the maximization of the present value of the entity. i.e., the present worth of the entity, This wealth whitethorn be measured if the organization has shares that are traded by the public, this because the market price of the share is indicative of the value of the organization. And to a shareholder, the word wealth is based upon the get of shareholders current dividends and the market price of share.Ezra Solomon has described a wealth maximization goal in these terms The gross present worth of a course of work is equal to the capitalized value of the flow of future judge benefits, discounted (or capitalized) at a rate which reflects the uncertainty or certainty. Wealth or net present worth is the difference between gross present worth and the gist of capital investment required to achieve the benefits.On the other hand a public sector company which its loveliness stock is fully owned by the government, and also not traded in stock market? In much(prenominal) companies, the objective of management should be to maximize the present value of the stream of equity returns. Of course in determini ng the present value of stream of equity returns, and must use the most appropriate discount rate. A same observation whitethorn be made with regarding to other entities which their equity shares are either not traded or in truth rarely traded.In the above definition, one occasion is for sure that the wealth maximization is a long-term strategy that emphasizes genteelness the net present value of the owners investment in a company and the implementation of this objective that forget appraise the market value of the companys securities. This concept, if applied, meets the briars raise against the old concept of profit maximization. The manager also faces with the uncertainty problems by considering the trade-off between the different returns and their associated levels of risks. It also considers the dividends payment to shareholders. All these components of the wealth maximization goal are the outcome of the investment, financing and dividend closings of the company.Question24 .0. The Agency riddle TheoryAgency problems exist in large companies because of the combating of interests which some clock times arise between shareholders and managements. In most large organizations, managers only own a small percentage of the stock. They may consider by placing their own interests above those of the shareholders. For example, the managers may multiple their personal wealth by multiply their salaries, bonuses, or option grants as high as possible and by increasing their perquisites including luxurious offices, corporate jets, generous retirement plans, and the like at the expense of outside shareholders. Shareholders may take actions through their companys managers that affect the danger of the company like investing in more than risky assets. change magnitude a companys riskiness can banishly affect the safety of its debt.A potential agency conflict comes whenever the manager of a company owns less(prenominal) than 100 percent of the companys common stock . If a company is a restore proprietorship company and managed by its owner, the owner-manager pull up stakes al ways consider maximizing his or her own wealth. The owner-manager will carefully control cost by individual wealth, but may trade off other considerations, such as perquisites and leisure, against individual wealth. If the owner-manager forgoes a portion of his or her ownership by selling some of the entitys stock to external investors, a potential conflict of interest may arise, called an agency problem. E.g. the owner-manager may prefer a more leisurely lifestyle and not work as to maximize shareholder wealth, because less of the wealth will now accrue to the owner-manager. In addition, the owner-manager may decide to consume more perquisites, because some of the cost of the consumption of benefits will now be borne by the external shareholders.As delimit by Robert T. Kleiman. Agency theory raises a fundamental problem in company, self-interested behavior. A corporat ions managers may deal their own personal objectives that challenges with the owners objective of maximization of shareholder wealth. Although the shareholders recognize managers to manage the companys assets, a potential conflict of interest may exist between these two groups.According to Jensen/Meckling (1976) an agency relationship exists when one or more persons (the shareholders or the principles) negotiate another person (the ingredient) to do some service on their behalf which involves delegation of some authority to betray decision. If both parties maximize their own utility there is good confirmation to consider that the management (agent) will not always act in the best interest of the shareholders ( foreland). As a result the principal will try to limit the diversity from his interests by monitoring the agent. The dilemma is, that the cost of monitoring the agents actions (monitoring expenditures) can be significant and can in detail exceed the loss due to the agenc y relationship. The principal will so try to establish incentives for the agent in a contract so that the agents actions are in the interest of the principal without costly monitoring. Additionally there will be situations where it will pay for the agent to expend resources on actions to guarantee that he will act in the sense of the principal ( adhere expenditures) or to ensure that the principal will be compensated in such cases. As a result it is impossible for the principal and the agent to ensure at zero cost that the agent will exploit optimal decisions from the viewpoint of the principal. Given the complex structure of agency relationships these cost will be pecuniary and no pecuniary as well. In general, the principal and the agent will have positive monitoring and bonding costs and there will still be some divergence between the agents decisions, subject to the optimal monitoring and bonding activities, and those decisions that would maximize the welfare of the principal . The value (in money terms) of this divergence is often referred to as the residual loss. According to Jensen/Meckling (1976) agency costs could therefore be defined as the amount of The evaluating expenditures by the principal, The bonding expenditures by the management and The residual loss5.0. NPV Method of Investment AppraisalThe net present value (NPV) is described very fully both in principle and application and in how the decision rules are derived. Different sets of circumstances are introduced to show how the NPV approach can cope with the situations met in an imperfect world, (e.g. taxation, inflation, different interest rates, repeat investments, inversely exclusive investments, capital rationing).As clarified by Averkampt H. (d.t) who defined NPV as the acronym for net present value. Net present value is a calculation that differentiates the amount invested today to the present value of the future silver pass along from the investment. In other words, the amount inv ested is compared to the future exchange amounts after they are discounted by a specified rate of return.5.1. Advantages and disadvantages of NPV orderThe NPV method has pros and cons I mean negative and positive sides. First, the NPV method makes more appropriate adjustments for the time value of money. Second, the NPV rule focuses on capital flow, not accounting earnings. Third, the decision rule to invest when NPVs are positive and to refrain when from investing when NPVs are negative reflects the firms need to compete for funds in the market status quite a than an arbitrary judgment. Fourth, the NPV approach offers a relatively straight forward way to control for differences in risk among alternative investments. Cash flows on riskier investments should be discounted at higher at higher rates. Fifth, the NPV method incorporates all the funds flows that a take care generates over its life, not just those that occur in the projects early years. Sixth, the NPV gives a direct estimate of the change in shareholder wealth resulting from a given investment.Although we are enthusiastic supporters of the NPV approach, especially when compared with the other decision methods, we must acknowledge that the NPV suffers from a few weaknesses. Relative to alternative capital budgeting tools, the NPV rule seems less intuitive to many users.5.2. RecommendationsFinally, at the starting signal of an NPV synopsis it is very significant to identify the objective of the project. If the goal is to dress the costs of operations and also prices. As to enhance the organizations revenues, the forecasted make up in revenues needs to be evaluated and included as a positive cash flow in the computation. But if the objective in mind is to natural selection then a negative NPV might be reasonable if the negative financial impact of the investment is influenced by the potential financial losses that may be related with the ignored project. In some cases, the analysis led to t he conclusion that mobilizing the capital required implementing the core lab project is in keeping with a strategy to maximize potential returns.The NPV method evaluates the present value of the future cash flows that a project will have. A positive NPV is that the investment should appreciate the value of the company and also promote to maximizing shareholder wealth. A positive NPV project gives a return that is more than enough to compensate for the required return on the investment. Thus, using NPV as a guideline for capital investment decisions is reproducible with the goal of creating wealth.Moreover the NPV of the future benefits is the difference between net present value of the benefits and the investment required to achieve those benefits. A financial action resulting negative NPV should be rejected, because this will not generate a wealth to the shareholders. Therefore the organization should take a course of financial action e.g. invest in a project where there is a incr ease in the wealth of the firm or a project which have a positive NPV.6.0. ConclusionThe efficiency of management is assessed by the conquest in achieving the companys objective. The shareholder wealth maximization objective as defined that management should work towards maximizing the net present value of the expect future cash flows to the shareholders of the company. Net present value is the discounted sum of the evaluate net cash flows. Some of the cash flows, such as capital outlays, are cash outflows, while some, such as cash generated from sales, are cash inflows. Net cash flows are obtained the different between cash outflows and cash inflows. The discount rate considers the time framework and risk of the future cash flows that are available from an investment. The longer it takes to receive a cash flow, the lower the value investors wants to put on that cash flow now. The great the risk associated with receiving a future cash flow, the lower the value investors place on that cash flow.