Shareholder Wealth Assignment Example | Topics and Well Written Essays - 1500 words

Shareholder Wealth - Assignment Example Such claims are limited by the proportion of ownership derived from the amount of the investment. Shareholders who invest have one common goal: maximise the value of invested wealth. Every investment decision is made with the expectation that its value would increase over time. Shareholders do not necessarily manage the business, so they hire managers as their agents to increase the value of their (shareholders') wealth such that there would be enough profits for everybody. A portion of these profits is given back to owners through dividends whilst the balance may be re-invested to create more wealth. The agency theory describes the dynamics of the relationship and potential conflicts of interest between shareholder-owners and manager-agents. How shareholder wealth is measured indicates how managers can maximise it. For any business with more than one shareholder, the ultimate measure of shareholder wealth is the share price, the value of one share of ownership in the business. Share valuation follows a systematic process based on the value of the corporation's assets, which equal its liabilities plus stockholders' equity, all information available from the balance sheet. At start-up, the value of a share is derived from dividing equity by the number of shares offered. Once the business generates profits, cash can be distributed as dividends to shareholders or re-invested in the business. Profits increase assets and the value of the shareholders' equity, thereby increasing each share's value. Or, assets can increase with debt, but it does not automatically follow that stockholders' equity would stay the same, decrease, or increase. The effects of debt depend on what managers do with it, and whether or not borrowing allows the corporation to generate more cash. At some future time, when a shareholder decides to sell the shares, both buyer and seller only need to analyse the balance sheet to agree on the price. However, a single share of stock is not only a claim on the assets the corporation owns today, or the value of the shareholders' equity now. It is also a claim on future profits and the future selling price of the share. Neither is the investment totally risk-free, since the share's value could drop because of mismanagement and bankruptcy. Risk is part of valuation because of the risk-return relationship. Therefore, a share's value today is calculated by getting the present value of: 1) Cash dividends until the shares are sold; 2) Proceeds from selling the shares; or if the corporation ceases operations, 3) The firm's break-up value after selling assets to pay off liabilities. Financial analysts simplify share valuation by focusing on the present value of cash dividends, making the convenient assumptions that shares would not be sold and the business would not be closed. Since cash dividends are equivalent to the free cash flow (FCF), the value of a share now is the present value of the FCF stream discounted at the rate of return investors expect to receive on comparable investments. FCF is not profits, which can be re-invested or given out as dividends. Rather, FCF is the cash not retained nor