Business first, Shareholder wealth second!

Dividends! This is the only word that comes into the mind of investors especially shareholders. All they think about is returns, returns, returns. They leave the decision making into the hands of the managers who's obligations are to make sure the shareholder's investment reach as far as possible to create shareholder wealth maximisation whilst at the same time encourage profit maximisation. Shareholder wealth is achieved when the sum of share price and dividends for the year is greater than the previous year's share price as described by Porterfield (1965). However M&M (1961) challenged  that idea by suggesting share prices were determined by future earning potential and not by dividends paid now.

This idea goes further to suggest that a rational investor is indifferent to capital gains and dividends. This i believe means shareholders dont necessarily care about the method of returns but rather the idea of just knowing they are going to be paid. But again M&M argue that it is better for a firm to prioritize the idea of increasing their market value, which in turn will increase share price and in turn increase shareholder wealth. To do so means any little overflow of cash a firm makes should rather be injected into an investment project that generates a positive NPV as this will give a firm the end result it desires, and in the case of surplus after the investment, it should be paid as dividends. Should there be no surplus after the investments, no dividends will be paid.

Based on the M&M idea, i do not think it to be something the shareholders will be finding favourable, especially in the case of those wanting quick dividends returns rather than reinvesting it back into  the business for future potential investments. Most firms in their annual reports make it a duty to highlight the share price trends as well as the dividend rate their company offers as they know  these are the details investors will be looking forward to see. But as it happens there are also some firms who  have alternative thinking shareholders that are after greater market value first and shareholder wealth second. These are the M&M followers i guess. But another approach as to why some firms decision to not pay dividends but rather use surpluses to pay down debt is because it wants to lower their gearing level hence reduce capital  risks. A good example of surpluses used in paying down debt is that of Vodaphone's minority stakes 'Verizon Wireless' who's parent company is Verizon Communications. Apparently the parent company has ordered the Verizon Wireless not to pay dividends (since 2005) and the cash generated by the company should be used to pay down debts (as reported on 4th April on FT.com by Simon Mundy).

The example above simply suggests that most managers are  in the habit of putting the organisation's interest first and then the shareholders second. In a way it makes me think it is quite a logical method, considering it is better knowing the financial position and value of an organisation is going strong than just focusing on the needs of the shareholders. In the real world, shareholders would not exist without a business and without a business there will be no shareholders, so its vice-versa. Therefore if a business stands firm so should shareholder wealth maximisation respectively.

 

Capital Structure- Good returns, Happy shareholders

In a world where everything revolves around finance, there is no doubt in saying business decisions are always financially based whether it is  a profit or non-profit organisation. Finance in the form of capital is what determines the beginning of a business whether it is a large or small corporation. However the bottom line is, capital is what runs and keeps the business going, but what is the consequential side of obtaining that source of finance? There are at least two sources of capital, Equity and Debt, and both are affected by the level of risk, meaning the implication of gearing within a capital structure.

Equity financing is a means of obtaining capital from shareholders, whilst Debt financing is a means of obtaining capital via borrowing and is viewed as a cheaper method of obtaining finance than Equity. The risks involved in these methods of finance is determined by an indicator known as gearing. Dependant on the level of gearing as well as the level of debt, this affects the overall WACC and this determines the level of  rate of return a firm receives based on the investment it finances.

Without one knowing the real methods used in obtaining capital to finance prospective investments, one might think it is quite simple to choose which investment is  more appropriate based on how lucrative the future of the investment might be and ignoring other factors such as the cost of capital. Businesses with strategic visions of growth really do play around with their capital structure to ensure the best method is always favourable to their organisation by providing them not only with good returns but also maximum shareholder wealth. It is now understandable  as to why high importance is given to capital structure as any mistakes done will have a  dramatic  effect on the organisation as a whole and the hope of the shareholders will be shaken. With this  in mind, careful financing of debt with the right level of gearing ensures financial security.