Shareholder Wealth Maximization
The ultimate goal of any financial manager (as well as the firm) is the maximization of shareholders’ wealth. A good financial manager therefore should carefully consider and weigh the risk of undertaking a certain project against the profits associated with undertaking such a project. Capital Budgeting techniques enable the manager to make such decisions.
The first question that comes to mind is, when making a capital investment decision, should we focus on cash flows or accounting profits. The book is stating “In measuring wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits that are actually received by the firm and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand.”
The answer to the question now seems too obvious; it is cash that buys new equipment, used to pay suppliers and employees...etc; it is also cash that is to be reinvested to further increase shareholders’ wealth and hence brings the firm closer to its goal.
This brings us to another question, should all cash flows associated with the project be considered? Again, the book provides an answer “In measuring cash flows, however, the trick is to think incrementally. In doing so, we will see that only incremental after-tax cash flows matter.”
By incremental we mean “marginal”, or “additional”. Incremental cash flows are those cash flows that would affect the capital budgeting decision, but another condition also applies, those incremental cash flows must be considered on after-tax basis, this is because what really increases the value of the firm is the net cash flow (free cash flow) that would be available to the financial manager in
The first question that comes to mind is, when making a capital investment decision, should we focus on cash flows or accounting profits. The book is stating “In measuring wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits that are actually received by the firm and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand.”
The answer to the question now seems too obvious; it is cash that buys new equipment, used to pay suppliers and employees...etc; it is also cash that is to be reinvested to further increase shareholders’ wealth and hence brings the firm closer to its goal.
This brings us to another question, should all cash flows associated with the project be considered? Again, the book provides an answer “In measuring cash flows, however, the trick is to think incrementally. In doing so, we will see that only incremental after-tax cash flows matter.”
By incremental we mean “marginal”, or “additional”. Incremental cash flows are those cash flows that would affect the capital budgeting decision, but another condition also applies, those incremental cash flows must be considered on after-tax basis, this is because what really increases the value of the firm is the net cash flow (free cash flow) that would be available to the financial manager in
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