Manag., January-2017-Q20
- Option : A
- Explanation : Shareholder Wealth Maximization (SWM): SWM means maximizing the net present value of a course of action to shareholders.
Net present value (NPV) or wealth of a course of action is the difference between the present value of its benefits and the present value of
its costs. A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. A financial action
resulting in negative NPV should be rejected since it would destroy shareholders’ wealth. Between mutually exclusive projects the one with the highest NPV should be adopted. NPVs of a firm’s projects are addititive innature. That is:
NPV (A) + NPV (B) = NPV (A + B)
This is referred to as the principle of valueadditivity. Therefore, the wealth will be maximized if NPV criterion is followed in making financial decisions.
The objective of SWM takes care of thequestions of the timing and risk of the expected benefits. These problems are handled by selecting an appropriate rate (the shareholders’ opportunity cost of capital) for discounting the expected flow of future benefits. It is important to emphasise that benefits are measured in terms of cash flows. In investment and financing decisions, it is the flow of cash that is important, not the accounting profits. The objective of SWM is an appropriate andoperationally feasible criterion to choose among the alternative financial actions. It provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions on behalf of shareholders. Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. With their wealth maximized, shareholders can adjust their cash flows in such a way as to optimize their consumption. From the shareholders’ point of view, the wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, the wealth maximization principle implies that the fundamental objective of a firm to maximize the market value of its shares. The value of the company’s shares is represented by their market price which in turn, is a reflection of shareholders’ perception about quality of the firm’s financial decisions. The market price serves as the firm’s performance indicator.
