MGNT 4903

Spring 2011
Dr. Amine Khayati

Chapter 1 Notes

I- Central Role of Wealth Maximization:

- Shareholder wealth maximization is the most commonly cited business goal. The justification
for shareholder wealth maximization is that managers are hired by the owners (shareholders) to
represent them and serve as their agents. From another point of view, the wealth of the managers
is closely tied to the wealth of the shareholders through employment and compensation scheme
such as: stock option, restricted stock, bonuses.
- Wealth maximization for a single-period decision is measured by economic profit which is the
excess earnings or cash flows that could have been earned on another investment with the same
risk.
- The present value of an expected future cash flow is either a single future amount discounted
back to present or the sum of a number of future amounts discounted back to the present. The
Net present value of an investment is the present value of all cash inflows, minus the present
value of all cash outflows. Therefore, the net present value is the economic profit or wealth
created by a multi-period investment.

II- Who Benefits from wealth creation?

- Owners (shareholders): shareholders’ wealth maximization is the most common answer when
we ask whose wealth is to be maximized.
- Managers: Some argue that managers are interested in their own welfare and may have several
interests that may conflict with those of shareholders, which create Agency problems.
In perfect competition, managers must maximize shareholders’ wealth since the later will have
complete knowledge of the managers’ actions and can replace them fairly easily in case of
deviation. In practice, however, any attempt to closely monitor managers involves costs in terms
of both time and money. Luckily, compensation plans can be specifically structured to reduce
this agency problem. By including stock options, restricted stocks and bonuses to the managers’
compensation plan, shareholders can tie managers’ compensation to the value of the common
stock.
There is another layer of incentive which is through the market for corporate control. In
fact, managers of poorly performing firms are under higher treat of hostile takeover and proxy
fight. In such eventuality, managers will be fired.
Managers are frequently tempted by empire building, through mergers and acquisitions
and therefore prefer size over profitability since compensation is highly related to size. The level
of risk that managers accept when making investment decisions is another issue. Managers may
take investment with higher or lower risks than what the shareholders would like to have and
managers may base this decision on their personal wealth and holdings in the company.

- Creditors: the creditors’ protection increases when wealth increases.

- Customers, Employees, and Suppliers.
- Society: conflicts between society and corporations may arise from nonpriced costs such as
pollution and nonpriced benefits such as community stability. Shareholder wealth maximization
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may benefit society through taxes, employment and increased productivity that would free up
resources to be used in other areas of the economy.

III- Competitive advantage and wealth creation:

A company must have a competitive strategy in order to create wealth. The choice of a
competitive strategy is based on two central concepts:
1- Industry attractiveness: whether the industry has potential for long-term profitability.
2- Competitive advantage: how a firm can create value for its customers in excess of the the
cost and better than the competition.

The attractiveness and the profitability of any industry are determined by the interaction of
Porter’s Five competitive forces:
 Entry barriers (treat of new entrants)
 Treat of substitutes
 Bargaining power of buyers
 Bargaining power of suppliers
 Rivalry among existing competitors.

A company can create wealth by creating a competitive advantage, which is the

elimination of some of the conditions for perfect competition. When a company achieves a
competitive advantage, it also achieves an economic profit, and positive net present values on
investments. Competitive advantage is typically achieved by first choosing between: product
advantage (differentiation) or cost advantage (leadership). Second, the company must choose
either a broad or a narrow scope. Then combining these two generic approaches to competitive
advantage with the scope yields four generic competitive strategies:
Competitive advantage
Scope Cost Product differentiation
Broad Cost leadership Differentiation
Narrow Cost focus Differentiation focus

- Cost leadership: the goal of a cost leader is to be the industry low-cost producer. This can be
achieved by maintaining low operation costs in all market segments. The low costs advantage
can stem from economies of scale, technological innovation or special access to raw materials.
- Differentiation: can be achieved when the firm selects one or more product attributes that
buyers perceive to be important and then strives to meet the buyers’ needs. These firms typically
charge higher prices and the differentiation can be based on the product itself, the method of
delivery.
- Cost focus: a firm with a cost focus strategy strives to achieve a cost leadership in a narrow
subsector of the industry overall market.
- Differentiation focus: a differentiation focus strategy is similar to cost focus, except the firm
tries to achieve differentiation in a narrow segment of the industry.

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IV- Overview of the capital investment process:
- A capital investment is an outlay that is expected to results in benefits or cash inflows
extending more than one year into the future. Capital budgeting is the process of selecting capital
investments.

Steps in capital budgeting process:

- Establish goals
- Develop strategy
- Search for investment opportunities
- Evaluate investment opportunities
- Select investments
- Implement and monitor
- Post-audit

1- Establish Goals: wealth creation is generally the overall goal, however it is difficult to know
whether shareholder value was maximized or not. Therefore, goals are traditionally translated
into some performance measures.
2- Develop Strategy: the goal and the strategy of a corporation are typically combined in the
vision. The main purpose of the strategy is the generation of wealth through the creation and use
of competitive advantage. Strategic planning involves analysis of opportunities and threats in the
environment, followed by an analysis of the company’s strength and weaknesses.
3- Search for investment opportunities: the search for investment opportunities is primarily
supported by a corporate culture that encourages creative thinking and it is carried out at all
levels of the organization. In addition, the availability of resources for research, product
development, and consumer attitude surveys are all ways to identify investment opportunities.
An investment opportunity may involve sometimes the acquisition of other companies.
4- Evaluate investment opportunities: ideally you would like to have numerous capital
investment proposals to evaluate. The fundamental decision choice is whether the present value
of the cash inflows or the savings to be generated by an investment exceed the present value of
the initial investment (remember the NPV).
- In practice, there is evidence that estimates are systematically biased because the cash flow
estimations require sales forecasts, cost forecasts, productivity estimates, and so on. Essentially,
there is a great deal of uncertainty surrounding cash flows.
Risk analysis is another standard part of the evaluation of most capital investments. Any new
investment opportunity has some form of risk that is often analyzed by looking at the sources of
uncertainty and then estimating the wealth effect of these sources on the firm value. Remember
that there are two forms of risk: risk that can be diversified away and risk that cannot be
diversified.
- An investment may not generate positive cash flows immediately meaning the project has
significant cash inflows occurring two or three years after the initial investment. This may reduce
reported accounting income for some years and send the wrong message to shareholders and
investors. This constraint can only be avoided in a world of perfect information.
5- Select investments: the selection and approval is carried out by mid-management or top-
management depending on the importance of the capital investment. It common to form a
committee that includes managers from various areas to bring their own insights into the decision
process.

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6- Implement and monitor: the major concern at this level is deviation from the plan and cost
overruns.
7- Post-audit: this step is often overlooked. It must be carried out when the investment has
matured to a stable level of activity and productivity. The main benefit of post-audit is to be used
as a learning tool to help managers to be accurate in their estimates of investments proposals.

V- Overview of long-term financing decisions:

The separation principle: states that investment and financing decisions of the firm are dealt with
separately. This principal holds only under perfect market condition.
- The rate of return that must be paid to creditors depends on the sources of money (issue bonds,
issue new common stock or preferred stock), the risk level perceived for the new capital
investment, and the amount of money raised. The lower the rate of return that must be paid to
investors, the greater the number of attractive investment opportunities the company will have.
In practice, since investment and financing decisions are interrelated, whoever making the
investment decision must be familiar with the financing considerations.

1- Financing choices:
- Debt-equity mix.
- Maturity of debt.
- Amount of debt that the firm can raise is determined by the minimum payment that it can
afford. The company must also be concerned about the possibility of the early repayment of its
debt.
- Priority of each claim.
- Source of financing: public markets, private placements.

2- Considerations in Financing:
- Debt is generally regarded as a cheaper source of funds, due primarily of the deductibility of
interest expenses.
- Agency costs: managers might take more risks than the creditors anticipated.
- Availability and flexibility.
- Strategy designed to create a competitive advantage.

VI- The capital investment crisis:

Michael E. Porter thinks that the capital investment allocation in the United States is failing. He
argues that there is an emphasis on actions that produce short-term results which in turn reduce
investments in long-term promising projects. He suggests that much current practice does not
result in capital investment decisions that result in long-run wealth maximization.
Who’s to blame?
1- Accounting standards: because R&D is treated as an expense in the financial reporting.
2- Stockholders since they focus more on short-term returns
3- Corporate governance: CEOs and managers compensation is tied to short-term annual
financial performance

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