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Give examples to illustrate the high interdependence existing between the

different decision areas of corporate finance.


Corporate finance decision is concerned with financial decisions such as

1. Investment Decision

Sometimes it is referred as the Capital Budgeting decision involves the decision of

allocation of funds to long-term assets that would yield benefits (cash flows) in the
future with the objective of maximizing the value of the firm. Most of these assets are
real assets and may be tangible such as land and buildings, plant and machinery
and stock or intangible such as patents and trademarks. In addition to that, a firm
may choose to invest in financial assets outside the business in the form of short
term securities and deposits.

2. Financing Decision

Involves decisions on when, where from and how to acquire funds to finance the
firm’s existing and proposed operations. Besides the ability of the firm to hold
financial assets such as shares and loan deposits, it can also sell claims on its own
real assets. This can take different forms such as loans and lease obligations. The
central issue is to strive to obtain the best financing mix or the optimum capital
structure for the firm.

3. Dividend Decision

Involves the decision on whether the firm should distribute all profits, or retain them,
or distribute a portion and retain the balance. The proportion of profits distributed as
dividends is called the dividend-payout ratio and the retained portion of profits is
known as the retention ratio. The optimum dividend policy is the one that maximizes
the market value of the firm’s shares.

4. Liquidity Decision

This is concerned with Working Capital Management efficiently for safeguarding the
firm against the risk of illiquidity which may lead to insolvency in extreme situations.

These decisions interact and cannot be considered separately. For instance different
investment with different risk properties may require different financing. Practically these
decisions have to be solved simultaneously. For example, a decision to acquire an
asset is an investment decision. Once a decision to acquire an asset is reached, a firm
must decide how it is to be financed. In this regard, it can be said that the firm can
purchase the asset using equity which may affect the dividend pay out ratio, borrow the
money and finance the acquisition which may affect the capital structure of the firm, or
lease the asset. Often a firm makes an evaluation to all the opportunities available to it
and considers the cheapest one.


Explain the rationale of selecting shareholders wealth maximization as the

objective of the firm. Include a consideration of profit maximization as an
alternative goal.


Shareholders wealth maximization means maximizing the net present value (or wealth)
of a course of action to shareholders. A financial action that has a positive net present
value creates wealth for shareholders, and therefore is desirable.

The shareholders wealth maximization objective takes care of the question of timing
and risk of the expected future benefits. In investment and financing decisions, it is the
flow of cash that is important, not accounting profit.

The objective of shareholders wealth maximization is an appropriate and operationally

feasible criterion to choose among the alternative of financial actions as it provides
unambiguous measure of what financial management should seek to maximize in
making investment and financing decisions on behalf of shareholders.

On the other hand profit maximization does not make sense as a corporate objective
since it fails to serve as an operational criterion for maximizing owners economic
welfare due to the following reasons:

• It is vague

The precise meaning of the profit Maximization objective is unclear. The definition of
the term profit is ambiguous. Does is it mean short-term or long-term profit? Does it
refer to profit after tax or before tax? Total profit or profit per share? Or does it mean
total operating profit or profit accruing to shareholders? Also shareholders might not
want a manager to increase next year’s profits at the expense of profits in later

• Ignores time value of money

It does not make an explicit distinct between returns received in different time
periods. It gives no consideration to the time value of money, and it values benefit
received in different periods as the same.

• It ignores risk

The stream of benefits may possess different degree of certainty. Two firms may
have the same total expected earnings, but if the earnings of one firm fluctuate
considerably as compared to the other, it will be more risky. Possibly, shareholders
would prefer smaller but surer profits to a potential larger but less certain stream of


Firm A has a stock market value of Tshs 2 billion while Firm B is valued at Tshs
1.5 billion. The firms have similar profit histories (Tshs million).

Firm A Firm B

1996 150 180

1997 160 100

1998 170 230

1999 180 150

2000 200 200

Provide reasons why, despite the same total profit over the last five years,
shareholders regard firm A as being worth Tshs 500 million more (extend your
thoughts beyond the numbers in the table)


Shareholders regard firm A as being worth more than firm B despite the same total
profit over the last five years due to the following:

• Though firm A and firm B reported the same total profit over the last five years,
firm B’s profits are uncertain i.e. they fluctuate considerably compared to firm A
This indicates that firm B is riskier than firm A. On the other hand the increase in
firm A’s profit is stable and consistent which gives a great future growth outlook.

Possibly shareholders would prefer smaller but surer profits to a potentially
larger but less certain stream of profits. Thus shareholders regard firm A as
being worth Tshs 500 million more than firm B.


Assume that the chief executive of Twende Pamoja Inc. receives a salary of
Ths 800,000 million plus a 4% of sales. Will this encourage the adoption of
decisions which are shareholders wealth enhancing? How might you change
the matters to persuade the chief executive to focus on shareholders wealth
in all decision making?


Offering the chief executive a salary plus a bonus of 4%of sales will not encourage
the adoption of decisions which are shareholders wealth enhancing instead it will
encourage the adoption of decisions which will maximize his or her own wealth. In
order to maximize the bonus the chief executive will make decisions to maximize
sales sometimes at the expense of the shareholders wealth maximization objective.
For example he/she may increase sales by spending a lot in advertisement and
promotion which may lead to a decrease in profits.

However, owners of the business may change the matter to persuade the chief
executive to focus on shareholders wealth in all decision making by using the
following alternatives:

• Linking rewards to shareholder wealth improvement

Granting directors and other senior managers share options. These permit them
to purchase shares at some date in the future at a price which is fixed in the
present. The managers under such a scheme have a clear interest in achieving
a rise in share price and thus goal congruence comes about to some extent.
Alternatively managers can be allotted shares if they achieve a certain
performance targets.

• Sackings

The threat of being sacked with the accompanying humiliation and financial loss
may encourage managers not to diverge too far from the shareholders’ wealth
path. However this method is seldom used because it is often expensive to
implement and rarely successful.

• Selling shares and other takeover threat

If shareholders observe that management is not acting in what they regard as

their best interest they will sell their shares rather than intervene. This will result
in a lower share price making the raising of funds more difficult. This should
motivate managers to increase earnings and the share price.

• Corporate governance regulations

Considerable range of legislation and other regulatory pressures (e.g.

Companies Act) designed to encourage directors to act in shareholders’ interest.


Discuss the ways in which the concepts of agency theory can be used to explain
the relationship that exist between the managers of a listed company and the
provider of its equity finance. Your answer should include an explanation of the
following terms:

a) Asymmetry of information
b) Agency cost
c) The free-rider problem


Agency theory tries to explain the existence of conflicts shareholders’ and managers’
objectives which create principal-agent problem. The shareholders are the principals
and the managers are their agents. Shareholders want management to increase the
value of the firm but managers may have their own axes to grind or nests to feather.

a) Principal agent problems would be easier to resolve if everyone had the same
information which is rarely the case in finance. Managers, shareholders and
lenders may all have different information about the value of a real or financial
asset, and it may be many years before all the information is revealed.
Financial managers need to recognize these information asymmetries and
find ways to reassure investors that there are no nasty surprises on the way.

b) Agency costs are incurred when managers do not attempt to maximize firm
value and shareholders incur costs to monitor the managers and influence
their actions. For example create incentive schemes and control for managers
to persue shareholders’ wealth maximization.

c) The free rider problem

Free riding is usually considered to be an economic problem only when it

leads to the non-production of a public good or when it leads ot excessive use
of a common property resource.

The problem will arise between owners and management when managers
benefit much from the resources of the company. This will reduce the wealth
of shareholders.









ESTHER L. METILI 2009 – 06 – 00147