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Part 1. An Introduction

1. An Overview

Introduction

Once a company issues shares (common stock) and receives the proceeds, it has no direct involvement with their subsequent transactions on the capital market, or the price at which they are traded. These are matters for negotiation between existing shareholders and prospective investors, based on their own financial agenda.

As a basis for negotiation, however, the company plays a pivotal agency role through its implementation of investment-financing strategies designed to maximize profits and shareholder wealth. What management do to satisfy these objectives and how the market reacts are ultimately determined by the law of supply and demand. If corporate returns exceed market expectations, share price should rise (and vice versa).

But in a world where ownership is divorced from control, characterized by economic and geo-political events that are also beyond management's control, this invites a question.

How do companies determine an optimum portfolio of investment strategies that satisfy a multiplicity of shareholders with different wealth aspirations, who may also hold their own diverse portfolio of investments?

1.1. The Development of Finance

As long ago as 1930, Irving Fisher's Separation Theorem provided corporate management with a lifeline based on what is now termed Agency Theory.

He acknowledged implicitly that whenever ownership is divorced from control, direct communication between management (agents) and shareholders (principals) let alone other stakeholders, concerning the likely profitability and risk of every corporate investment and financing decision is obviously impractical. If management were to implement optimum strategies that satisfy each shareholder, the company would also require prior knowledge of every investor's stock of wealth, dividend preferences and risk-return responses to their strategies.

According to Fisher, what management therefore, require is a model of aggregate shareholder behaviour. A theoretical abstraction of the real world based on simplifying assumptions, which provides them with a methodology to communicate a diversity of corporate wealth maximising decisions.

To set the scene, he therefore assumed (not unreasonably) that all investor behavior (including that of management) is rational and risk averse. They prefer high returns to low returns but less risk to more risk. However, risk aversion does not imply that rational investors will not take a chance, or prevent companies from retaining earnings to gamble on their behalf. To accept a higher risk they simply require a commensurately higher return, which Fisher then benchmarked.

Management's minimum rate of return on incremental projects financed by retained earnings should equal the return that existing shareholders, or prospective investors, can earn on investments of equivalent risk elsewhere.

He also acknowledged that a company's acceptance of projects internally financed by retentions, rather than the capital market, also denies shareholders the opportunity to benefit from current dividend payments. Without these, individuals may be forced to sell part (or all) of their shareholding, or alternatively borrow at the market rate of interest to finance their own preferences for consumption (income) or investment elsewhere.

To circumvent these problems Fisher assumed that if capital markets are perfect with no barriers to trade and a free flow of information (more of which later) a firm's investment decisions can not only be independent of its shareholders' financial decisions but can also satisfy their wealth maximization criteria.

In Fisher's perfect world:

- Wealth maximising firms should determine optimum investment decisions by financing projects based on their opportunity cost of capital.

- The opportunity cost equals the return that existing shareholders, or prospective investors, can earn on investments of equivalent risk elsewhere.

- Corporate projects that earn rates of return less than the opportunity cost of capital should be rejected by management. Those that yield equal or superior returns should be accepted.

- Corporate earnings should therefore be distributed to shareholders as dividends, or retained to fund new capital investment, depending on the relationship between project profitability and capital cost.

- In response to rational managerial dividend-retention policies, the final consumption-investment decisions of rational shareholders are then determined independently according to their personal preferences.

- In perfect markets, individual shareholders can always borrow (lend) money at the market rate of interest, or buy (sell) their holdings in order to transfer cash from one period to another, or one firm to another, to satisfy their income needs or to optimize their stock of wealth.

Activity 1

Based on Fisher's Separation Theorem, share price should rise, fall, or remain stable depending on the inter-relationship between a company's project returns and the shareholders desired rate of return. Why is this?

For detailed background to this question and the characteristics of perfect markets you might care to download "Strategic Financial Management" (both the text and exercises) from bookboon.com and look through their first chapters.

 
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