Custom «Shareholders' Wealth» Essay Paper

Introduction

Shareholders’ wealth may be used as a measure of an organization’s success. Shareholders invest in public or private corporations by raising the capital resource required to form and run a corporation. In return, they gain from their investments by getting dividends and increasing their investments value. Shareholders hardly get involved in the day to day running of business organizations with the exception of privately run business organizations. Instead, these corporations hire qualified and experienced people to run their businesses. The management team in any given corporations is, therefore, tasked with maximizing the returns to investors. Increased returns accrue to investors in terms of dividends and increases in shareholder value. Therefore, Shareholder value is a constituent of an organization capitalization.

An organization’s capitalization or equity may be measured in terms of its outstanding shares at current market price. Among the ways that corporations use to augment shareholders’ value is by regularly paying dividends. This means that a firm has to remain profitable in order to fulfill these expectations. Dividends are mainly determined by profits; higher profits translate into higher dividends. Listed companies that pay higher dividends are attractive to investors, and this raises their shareholders value. The cost of capital can also affect the shareholders value in that high interest borrowing reduces profitability. Therefore, management should ensure that additional capital is invested through lower interest debts.

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Business firm’s capital structure describes the way firm assets are financed. Assets can be financed through equity or debts. Capital structure can be expressed in ratios describing the composition of a firm’s equity to its liabilities. A business firm’s capital structure can be affected by a number of factors that include sales stability, asset structure, operating structure, profitability, growth rate, taxes and management attitudes as well as the attitudes of an organizations ‘lender’s attitude, market conditions, internal conditions, financial flexibility and the way the organization is controlled.

A firms’ sales stability can have serious affects on its capital structure. This is because firms with stable sales have the capability of taking on additional debts if more capital infusion is needed. Firms with unstable sale, on the other hand, imply that a firm cannot easily take on additional debts. This makes them vulnerable to bankruptcy and takeovers ensuring that firms have stable sales, therefore, ultimately add to shareholders’ value. A manager should ensure that there are stable sales to improve the firm’s resource base. Profitability is a vital factor in a firm’s capital structure since it determines the level of returns investor gets from their investments. High profitability also means that a firm finances its operational costs and can raise additional capital requirements internally (Baker and Martin).

Shareholders value can also be increased by steady and faster growth of a firm. However, for firms to grow at a faster rate additional capital is a requirement. This means that faster growing firms often finance their additional capital requirements through borrowing. Growth can, therefore, be curtailed due to increased borrowing. Although much faster growth rates are preferred, management should ensure that capital resources are not stretched to the limit. Capital structure can also be affected by a firm’s control (Graham, Smart and Megginson). If a firm is controlled by the management through higher voting rights, the management is capable of controlling the levels of debt and equity. This means that they are able to buy or sell more stocks making it easier to raise more capital if additional resources are required. However, in cases where this control can be relinquished by selling more stock, it is highly advisable to do so. In such a case, when additional capital is required, the firm has to borrow from the financial institutions at an interest. This increases their cost of operations and lowers their profitability.

Taxes also play a crucial role in a firm’s capital structure by reducing profitability and increasing expenses. One of the detectable expenses that can reduce the amount of taxes a firm pays to the government is interest. Interest on loans is a tax deductible item; therefore, a firm can prefer to finance its capital requirements in order to lower the amount of taxes charged by the government. Firms that have higher tax rates can finance their capital requirement as a strategy to lower their taxes. Financial flexibility of a firm is also a significant determinant of its capital structure. Firms that can easily raise additional capital through stocks and bonds are said to be in excellent financial conditions. This is because when additional capital needs arise, they have cheaper options of raising the additional resources. A weak financial flexibility means that when more resources are required the options are limited to borrowing from the financial institution, which is a costly alternative. Additionally suppliers are more comfortable dealing with firms in stronger financial position. Financial flexibility, therefore, increases the shareholders value and gives a business more leverage. The internal conditions of a firm can determine its access to additional capital and, therefore, affect its capital structure and profitability. Firms with stable internal conditions manage to finish their projects in a timely manner and at projected cost raising their profitability. This increases their alternatives when they require raising additional capital implying that the shareholders value can be easily maximized.

The prime motive of any business enterprise is to maximize its profits. By managing working capital, a firm can ensure that there is enough cash flow for its operating expenses and short-term debts. Decisions to manage working capital usually involve short –term cash flow measures that can be reserved. The decisions are used to ensure that enough cash resources are available from one period to the next to pay short-term debts and operating cost. The main aim of operational capital management is to make certain that an organization has at any point enough cash flow to pay all maturing short-term debts and meet the day-to-day cash requirement (Hanke). This minimizes the risks of the firm running into bankruptcy. It also ensures the survival of the firm. Management should, therefore, leverage its cash flow needs not only to ensure survival, but also to improve the shareholders value. In addition to this, the management must also ensure that there is adequate cash flow in the organization so as to reduce its exposure from takeover. These decisions can be, therefore, crucial in ensuring that the shareholders are able to maintain their investments.

The management of working capital entails decisions to manage current assets and how to finance these assets. To finance current assets management must consider the risks and returns of all options available. Assets can be financed through short-term and long-term financing. In a firms short- run financing the liabilities that continuously recur in the short-term are referred to as accruals and they can be in form of wages, taxes or interest (Wachowicz, Horne and Wachowicz). Paying wages, interest or taxes in accrual costs much less since no interest is paid, resources become raised through accrual, unlike loans. When the turnover increases  the accruals increase as well.

Financial leverage refers to a firm’s ability to utilize all the financial instruments available to increase shareholders value through high investments returns. Leverage can also refer to the capital structure of a firm. Business firms can be highly leveraged if their debt levels far outstrip the equity levels. Financial leverage increases returns by availing additional capital funds increasing shareholders value. However, more borrowing also increase the risk levels that face a firm, this is because returns cannot always be guaranteed, as market conditions can change with time (Preve and Sarria-Allende). Highly leveraged firms are, therefore, capable of increasing shareholders returns when their investments payoff. The management should ensure that they only increase their financial leverage when chances of getting investments returns are high.

Firms require capital to establish and once established the need for additional capital often arises to increase their level of activity. This is in line with any firms’ primal motive maximizing profits. Borrowing is one easier option of raising capital and can be either short-term or long-term. Short-term debts are more expensive due to higher interest rates that are charged and require short periods to pay. Long-term debts are, on the other hand, less expensive and payment periods are often stretched to longer periods. This makes long-term debts appropriate for a project that takes a long period to complete. A firm borrowing option should, therefore, depend on the project being undertaken. Long-term projects should be financed through long-term debts while short term debts used to finance short term projects.

In conclusion as earlier noted a firm’s main motive is to maximize its profit and its shareholders’ investments.