Thursday, February 25, 2010


Shareholders’ Opportunities and Values

In the case of companies, there is a divorce between management and ownership. In an all-equity financed company, management makes investment decisions, but shareholders supply the capital. Therefore, a question may be raised: whose opportunity cost or the required rate of return should be considered in evaluating the investment projects?

Since the firm’s objective is to maximize the shareholder’s wealth, the investment projects should be analyzed in terms of their values to shareholders. To appreciate this point, suppose you are the owner-manager of a firm. You make the investment decisions and you supply funds to finance the investment projects. You will use your required rate of return to evaluate the investment projects. Your required rate of return will depend on investment opportunities of equivalent risk available to you in the financial markets. Thus, the required rate of return or the opportunity cost of capital is market-determined rate.

Suppose you appoint a manager to manage your business. She has the responsibility for the investment decisions. Whose opportunity cost should the manager use? Since you are the supplier of funds and you own the firm and the manager is acting on your behalf, you will required her to use your required rate of return in making investment decisions. If she is unable to earn return equal to your required rate of return, you can ask her to return the money to you, which you can invest in securities in the financial markets and earn the required rate of return.

Assume that you convert your firm into a joint stock company where you invite other shareholders to contribute the capital and share ownership with them. Now many shareholders own the firm. The manager should consider all owners’ required rate of return in evaluating the investment decisions. Hence, in an all-equity financed firm, the equity capital of ordinary shareholders is the only source to finance investment projects, the firm’s cost of capital equal to opportunity cost of equity capital, which will depend only an the business risk of the firm.

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