ANSWER The investment decision relates to the manner in which funds raised in capital markets are employed in productive activities. The objective of such investments is to generate future cash flows, thus providing a ‘return’ to investors. The capital budgeting or project evaluation function is the process by which the investment decision is undertaken. Maximising the future cash flows generated will maximise the value of the firm and the wealth of owners. The financing decision relates to the mix of funding obtained from capital markets; that is, the mix of debt and equity issued by the firm to fund its operations. Obtaining the most appropriate sources of finance, taking into account the cost of finance and the risk, will maximise the value of the firm and therefore the wealth of owners. The dividend decision relates to the form in which the returns generated by the firm are passed on to equity holders. There is a substantial body of theory that indicates that an appropriate dividend policy can also maximise firm value and owner wealth. (a) (b) Investment decision – the firm has invested in shares with the intention of using them to generate return for their own shareholders. Investment decision – this is a project that will generate cash flows.
(c) (d) (e) (f)
Financing decision – the decision to issue shares as a source of finance. Investment decision – a project designed to generate cash flows. Dividend decision – deciding how to distribute returns to shareholders. Financing decision – just as issuing shares to raise finance is a financing decision, buying back shares to reduce the amount of equity finance is also part of the financing decision. Financing decision – the decision to use debt as a source of finance. Financing decision – the decision to issue shares as a source of finance.
Discussion Question 4 ‘Maximising the value of the firm to its shareholders is consistent with the firm exercising considerable social responsibility.’ Discuss. ANSWER As explained above, maximising the value of the firm means using scarce resources as efficiently as possible, which is in the interests of the economy as a whole. If all companies operate in this way, the wealth created within the economy will be maximised. In addition, socially responsible companies are likely to benefit from considerable goodwill and custom, which in turn translates into the maximisation of firm value and owner wealth in the long run. Discussion Question 14 Managers of companies face an impossible task because they cannot really increase the wealth of each and every shareholder. Because there are thousands of shareholders, it is impossible to find projects that allow the manager to meet the investment and consumption needs of every shareholder. As a consequence, managers should...