Shareholder Wealth Theory

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Shareholder wealth maximization is the main and most suitable goal of a business in a capitalist society although it lacks a clear and concise definition, because it not only brings risk but also return and the time value of money into a business (Denzil Watson & Antony Head, 2010). In addition, shareholder wealth maximization is a criterion of corporate governance that encourages a firm’s board of directors to implement all major decisions that preserve long-run shareholder wealth (S.Sharfman, 2015).Wealth of a business is represented by the market price of a firm’s common stock invested by shareholders. Moreover, shareholder wealth maximization happens when the business increase their stock price, following, the stock wealth that the individual…show more content…
Risk refers to the variability of potential returns. In addition, cash flow risk can also be explained as the extent to which future cash flows may decline short of expectations as an outcome of changes in market variables (Bartlett, 2015). The perceived risk of the cash flows is expected to generate, it may influence the market value of a share of stock. The relationship between risk and required return is significant as economic theory explain that risk and return commonly shows a positive relationship. That is, the greater the perceived risk associated with an expected cash flow, investors want a higher return, because a rational investor are a risk-averser, they would rather less risk to more, and they must be compensated for additional risk. Thus, the risk of the cash flows expected to be generated by the firm must in a financial manager consideration because investors will think about this risk in their valuation of the business. The investors will think that the company is making profit and invest more if the risk of the cash flow is low and cash flow is high. Therefore, the market price of the share will increase in case investor invest more, leading maximization of the shareholder wealth increase (Laux,…show more content…
Although the goal of the business is the maximization of shareholder wealth, in reality, the agency problem may impede with the implementation of this goal. The agency problem results from the detachment of management and the ownership of the business. It is said to occur when managers make decision that are not consistent with the purpose of shareholder wealth maximization. To being with, an agent is an individual authorized by another person, referred to as the principle, to act on the latter’s behalf. The agency problem may also manifest itself in the financing decision. Equity finance is the first choice of manager rather than debt finance, even though it is costlier than debt finance, since lower interest payments mean lower bankruptcy risk and higher job security. This will be unwanted from a shareholder point of view because if increasing equity finance, the result is, the cost of the company's capital will increase (Denzil Watson & Antony Head, 2010). Thus, shareholders are wishing that the agents will act in the shareholders' greatest interests, delegate decision-making authority to them. The interests of managers, that are called agent, and shareholders may be aligned by establishing management stock options, bonuses, and perquisites that are straightly tied to how closely their decisions coincide with the interest of shareholders. The agency problem will continue unless an incentive structure is

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