Conceptual Basics—Maximization of Equity Value or Firm Value?

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Individuals in the field of finance should be familiar with the various concepts and ideas of a capital structure that is optimal. These ideas must be considered from the point of view of a businessman. By now you must have definitely got a firm idea as far as the claims to be issued by a firm are concerned. This section of the chapter will be focusing on some of the major claims that a particular firm must issue. There are various ways of visualizing the optimal structure. However, this section will be revolving around the best possible means to do so. Let us take an example into account. Suppose you are a businessman who has the complete ownership of his or her firm. It is for certain that any individual would have the desire of making the most out of it at the time of selling it. The design of the firm must be the first and foremost goal of such an individual. This design must be carried out in such a manner that the current value in the market is maximized. In the event that the capital structure or the charter of a particular firm allows the doing of anything bad in the near future, it is for certain that no one is going to buy it. Hence, it is strongly advised for you to design your firm in a proper manner so that it can yield the maximum profit in the near future. If you are considering the idea of learning the designing part in details, make sure you visit chapter 24. It contains all the information that one may possibly need as far as firm designing is concerned.

If you have a business, then it is for certain that you are going to have a management sector. Let us first consider the future plans of this sector. When doing so, several questions such as what it represents, what or whom it should represent come up. According to various ideas given by the press, maximization of the wealth of the shareholder must be the primary objective of the managers. Although it may appear to be quite simple, but in reality, that isn’t the case as several other claims may exist such as obligations for pension, accounts payable, debt, etc. Hence, the task become all the more complex.

As far as the basic structure goes, the directors of the corporate board are elected by the various shareholders. If you consider the legal authority monitoring the firm, it would be this board. The shareholders in turn ought to receive fiduciary services from the management members who are appointed by the board. This is the primary goal of the members. If you take the USA into account, you ought to figure out that the shareholders are nothing but the managers themselves. Who preserves the right of the equity owners who are residual? Well, it is the management that carries out the various sorts of negotiations. These negotiations must be carried out keeping in mind the relationship with the creditors, suppliers, etc. This however may change in the event that the management makes a decision that questions the insolvency of the constituents. If such a scenario occurs, the various duties are extended to the various claimants as well. One may wonder what the logic behind this is. Well, it does as the creditors are without a doubt the owners if the company perishes. However, these responsibilities are limited to the USA only. It varies by a considerable margin as far as the various other companies are concerned. If you consider a German company such as one that deals with joint stock, the employees themselves take up about 33.33 % seats as far as the board is concerned. Of the other hand, if you consider the steel, iron and coal industry, all the employees ought to be evenly distributed as far as the board of directors are concerned. The must also hire a directors who must be in charge of monitoring the various activities. If you consider the managers of US based companies, you ought to realize that these managers don’t represent the creditors, instead they represent the shareholders. In the event that they are asked to increase the wealth of the shareholder, the manner in which they must go about with their work is a bit too uncertain. Consider a situation when both the shareholder and bondholder stand to gain on account of a particular action of the manager, the manager mustn’t face any sort of dilemma. However, if a particular actions impact on them are related inversely, then the manager definitely has something to think about. Suppose the manager is looking forward to increasing the value of a particular firm or equity by a dollar and the cost incurred in the process is about three dollars. Well, such an action will without a doubt have a negative impact on the firm’s net value, say about two dollars. Such a scenario may even occur in the perfect world. The dilemma for the manager here is shall he or she maximize the value of the shareholder or the firm.

Here, the manager would often tend to go for the first option as it is the shareholders who have given them their seats. By opting for such options, the managers are often entitled to large sums of bonus. The chance of the worth of the firm falling may not be their concern any longer. This is perhaps one of the major reasons as to why individuals in the field would often ask you to take a more rational approach.

Leaving all that aside, if you look at this idea at a micro level, you ought to figure out that this logic has a significant flaw in it. To figure out this flaw, an individual must place himself or herself in the position of the businessman. Consider that you are looking forward to establishing a capital structure as well as a corporate charter which in turn has the sole objective of maximizing the value of the company. This in turn maximizes the current selling price. To do so, it is imperative for you figure out an appropriate structure for you capital today. Your primary objective at this point should be to find new ways and means that ought to help you in ensuring that your company is able to attractive investors. This is something every businessman looks forward to. In the event that a potential investor is looking forward to buying the shares of your company he or she will without a doubt consider what your manager might do to him or her in the future. The more the potential risk involved the greater will be the rates placed by your creditor. Considering a situation where the investors figure out that you will be selling your firm in the near future, then it is for certain that their interest rates will vary accordingly.

Ex – ante and ex – post are two terms that individuals must be well acquainted with. The first means before an event while the later means after an event. Irrespective of what the manager tells the investors, they will analyses all the future prospects of your company before actually investing. Under such circumstances, it is imperative for the owner to make a call and stick to it irrespective of the outcome.

  • The first option that the manager or the owner has it to commit himself or herself. By doing so today, he or she ought to ensure that the holders of the bond won’t be exploited in the near future.
  • The second option that you must consider is the idea of selling the company at a net value which is considerably lower than its future worth. The reason behind the current low worth is that the buyers ought to consider the forms of destruction that the firm may be subjected to in the future. In turn the firm value ought to come down by about a dollar or two.
  • Lastly, the manager or the owner can even consider the option of not going into any sort of debts.

The manager or the owner must get one thing clear and i.e. he or she must do everything possible in order to ensure that the investors don’t come across any sort of doubts in their mind as far as his or her commitment is concerned. This commitment should be based on the fact that the manager or the owner isn’t going to encourage the exploitation of the bond holders in the future. Doing say will without a doubt have a positive impact on the worth of the firm in the near future. This procedure may be carried out time and again as it would definitely have a positive impact on the worth. If you look at the capital structure of a particular company, it is without a doubt one of the major insights. The owners currently focus on internalizing the ex – post expenses while it is carried by the claimants in the near future. Thus if you look at it from the owners perspective, the best option for the claimant at present would be not considering the idea of exploitation of the claimants. This should be followed all the more because everyone has a firm idea about the fact that the individuals owning the firm often tend to change their mind when the time is right.

When it comes to the claimants, they mostly look for a company that commits itself to increase its own worth in the future. As a result, at the time of making claims in the future, the claimants can indeed receive a better worth. When it comes to ex – ante, the firm or company itself has various reasons for ex – post. Ex – ante and ex – post have already been discussed in details in the beginning of the chapter.

Consider a scenario where in the team of manager of your company isn’t able to annihilate an estimated poor future. For example an exchange of three dollars with a dollar. What can you expect in the event that you reside in a capital market that is perfect? Under such circumstances, you might as well consider the idea of getting a separate management team that has the capability of restraining itself. This definitely ought to pay off as far as the future of your company is concerned. Such a team would be able to make instant profit once it is given complete control. If you are a business man, it is for certain that you must be aware of the fact that your sole objective must not be maximizing the value of shareholders, instead, you must also focus on maximizing the value of the firm which definitely ought to come in handy. The main highlight of this chapter would be the fact that the firms that can promise ex – post will without a doubt be able to promise ex – ante. Though this may appear to be repetitive, such a fact cannot be ignored. In addition to this, there exists a lot of competition among the various management teams which in turn tends to ensure that the capital value is optimized.

Every businessman would tend to look forward to the idea of designing a proper structure for his or her capital which will in turn play a huge role as far as maximizing the worth of the firm is concerned. The ex – ante structure is often considered to be the optimum structure as it is known to provide the greatest current worth. Another thing that needs to be kept in mind as far as individuals in the field of finance are concerned is the fact that both the purchasers of the bond and the stock have a forward nature. The only may that these buyers can have an issue is in the event that the owners surprise them with new regulations every now and then.


  • If you are purchasing a firm, you will without a doubt take into account the future aspects of the firm so as to decide at what amount you should buy the firm.
  • If you reading this section, then it is for certain that you have come across the idea of capital structure and its optimization. This refers to the fact that the owners will without a doubt want to increase their firms value. While trying to do so, the owners often tend to ignore the equity.

When studying in this field, you must be well aware of the fact that as far as theoretical problems are concerned, the world is considered to be perfect. This is one of the major assumptions as far as this chapter goes. In this world, the prime objective of the managers should be to increase the value of the frim and not that of the shareholder. However, if you move back to the real world scenario, there is only a thing line of separation between these objectives and the objectives of companies in the real world. In addition to this, this difference tends to prevail only under circumstances where in the company comes across some sort of distress. However, it becomes all the more important for the owners to be able to distinguish between the firm value and the value of the shareholder as it can play a huge role in the future. The both of them must be balanced in such a manner that both the shareholders and the owners stand to benefit. A capital structure can be considered to be optimal only under the circumstance that it has the capability of increasing the overall value of the firm. In the real world however, the managers and their team are a lot more concerned about themselves which in turn results in conflicts. This portion has been discussed in details under the scope of the chapter 12.8. This will further be elaborated in chapter 24. This in turn results in managers screwing things up.


Conceptual Basics—Maximization of Equity Value or Firm Value? 1

Conceptual Basics—Maximization of Equity Value or Firm Value? 2


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