Shareholder Wealth

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`“Critically assess how finance managers can, in practice, contribute to the maximisation of shareholder wealth”.

This essay will examine how finance managers in day to day practice can participate in the aid of increasing maximum shareholder wealth. The focus point of this is based on the financial managers themselves, how they can manipulate and change things in order to increase shareholder wealth using certain tools and methods of analysis.

Shareholders are deemed as the owners of the business. Their main aim is to increase their wealth, finance managers are employed to achieve this aim. In order to maximise shareholder wealth it would mean “Maximising the flow of dividends to shareholders through time – there is a long term prospective” (Arnold, 2005) Finance managers are employed by organisations to look after and increase shareholder wealth, the role of a financial manager can be seen through looking at financial management, “Financial management is the area of business management, devoted to a judicious use of capital and a careful selection of sources of capital, in order to enable a spending unit to move in the direction of reaching its goals” (Gitman 1986) Every investment decision affects the wealth of those who own the company. This is because the value of an asset is determined by expected future income streams, and investments are undertaken now to generate income in the future. When you buy a share in a company you buy an asset, and the value of that asset depends on the market view of the expected income stream likely to be generated by the company in the future. When the company undertakes an investment it changes the expected future income stream and hence changes its own value as an asset. Consequently, the value of shares in the company will also change. Risk and return play an important role with the financial manager. Risks need to be analysed and returns need to be assessed. This is a way in which organisations use to become more profitable. The portfolio theory developed by Markowitz (1952) is a technique used today to aid financial managers in finding a low risk and a high return. The portfolio theory operates on a basis whereby the investor would spread their investments over a number of tangible and intangible assets instead of investing in one singular one. The reason being if manager was to receive bad news about one investment, they could alternatively receive good news on another, thus “the portfolio theory allows investors to estimate both the expected risks and returns, as measured statistically, for their investment portfolios, (Greekshares, 2007). A good portfolio would be “one that gives the highest return for a given level of risk”. Once finance managers are able to apply this theory and continue with it, it will demonstrate that managers are able to increase shareholder wealth and reduce the risk of loss, this will furthermore attract other keen investors into the organization.

Moving on from the portfolio theory, managers are able to use another strategic way of increasing shareholder value and this is through the Capital asset pricing model also known as CAPM. This model developed by William Sharpe and other theorists (1960) has had a great influence on finance. CAPM is “A model that describes the relationship between risk and expected return and that is used in the pricing of risky” (Investopedia, 2007). Investors are compensated by time value of money and risk. The requirements are that the expected asset or portfolio needs to meet the rate of a risk-free security plus a risk premium, if not then the investment should not be taken. The CAPM theory has been more widely used because of its accuracy. Managers are able to predict the returns on shares over a period of time and give this back to shareholders. This method of risk and return gives an insight to the investor of how much return they are approximately going to get whilst assessing risks and time, thus attracting...
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