Overview
How does a company decide whether to build a new factory? How should it pay for it (Debt vs. Equity)? Should it pay dividends or buy back stock?
Core Idea
Maximizing Shareholder Value: The primary goal of financial management is to maximize the current value per share of the existing stock.
Formal Definition (if applicable)
Modigliani-Miller Theorem: In a perfect market (no taxes, no bankruptcy costs), the value of a firm is independent of its capital structure (how much debt vs. equity it has). It’s like slicing a pizza—the size of the pizza doesn’t change depending on how you slice it.
Intuition
- Debt (Bonds): Cheaper (tax deductible), but risky (you must pay interest or go bankrupt).
- Equity (Stocks): Safer (no mandatory payments), but expensive (dilutes ownership).
Examples
- IPO (Initial Public Offering): Going from private to public to raise cash.
- M&A (Mergers and Acquisitions): Buying another company to grow.
- WACC (Weighted Average Cost of Capital): The hurdle rate a project must beat to be profitable.
Common Misconceptions
- “Profit is Cash.” (You can be profitable on paper but go bankrupt if you run out of cash. Cash is King.)
- “Dividends are free money.” (When a dividend is paid, the stock price drops by that amount.)
Related Concepts
- Agency Problem: Managers might act in their own interest (private jets) rather than shareholders’ interest.
- Leverage: Using debt to amplify returns (and risks).
- Financial Statements: Balance Sheet, Income Statement, Cash Flow Statement.
Applications
- CFO: Chief Financial Officer makes these decisions.
- Investment Banking: Helping companies raise money.
Criticism / Limitations
Focusing only on shareholder value can harm employees, customers, and the environment (Stakeholder Theory).
Further Reading
- Brealey, Myers, & Allen, Principles of Corporate Finance
- Damodaran, Corporate Finance