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What are the Major Implications of the Finance Theory?
61 Lectures 1 hours
43 Lectures 33.5 hours
The ultimate aim of a company is to earn profits and the financial managers play a big role in this by utilizing their skills and knowledge.
Some of the major implications of the finance theory which can be summarized as follows −
Wealth maximization as the Primary Objective
Shareholders’ wealth maximization is the primary objective of the management. Shareholders are the owners of a company and they have the primary interest in the prosperity and growth of the company. A company cannot deny the role of shareholders in forming the organization by investing money in the company through shares.
Therefore, when a company earns profit, it should be distributed to the shareholders in the form of dividends. The board of directors is responsible for deciding to distribute dividends but even if dividends are not distributed, the retained earnings should be meant to grow the company and pay dividends in the future when the profit is large enough.
For example, the market inefficiency theory gives rise to the shareholders’ wealth maximization principle. In fact, increasing the shareholders’ wealth is a policy looked after by financial managers because of the imperfections of capital markets.
Current value of shares is a market-determined value
The current value of a share is not only important in terms of the value of the company but it also shows the measure of shareholders’ wealth. The current value of shares is a market-determined value that goes up and down according to the demand and supply. Therefore, the current values of shares show the value of shareholders’ wealth at any given point in time.
Investments that generate Positive Net Present Value
Since positive net present value (NPV) allows a company to enjoy flexibility in terms of liquidity, companies should accept only those investments that generate a positive net present value. By accepting investments with positive net present values, the companies can increase the value of their shares.
As shareholder wealth maximization is the primary objective of the companies, this ideology of accepting investments with positive net present value augurs well for the companies.
No additional investment for expansion
Companies should not invest in additional projects just to expand the business portfolio. In fact, the additional projects’ NPVs only add up. It does not create any extra value for the shareholders. Therefore, investing in extra projects is just an increase in additional management and operational expenses.
Therefore, companies should avoid individual projects that do not add any positive net present value. It is especially not desirable to invest in new projects from the point of view of the company’s investors.
Imperfect capital markets
The capital structure and dividend policies of a company are applicable only because the capital markets are imperfect. This goes against most of the financial theories that consider capital markets to be perfect and completely efficient.
A perfect capital market is one where information about the market is exclusively available to all participants. Moreover, in an efficient capital market, there is no cost of a transaction, there are no taxes and no individual subscriber can influence the market as a whole.
However, in most cases, these assumptions are found to be inapplicable to real capital markets. This gives the finance managers an opportunity to create capital structure and financial policies to gain profit from the market. If the markets were perfect, there would have been no need for financial policies for the capital markets.
The implications of finance theory are related to one another. The supply and demand of shares in the market determine the share price. However, in an inefficient market, finance managers can improve their bottom line to increase the prices of the shares. This would not be possible in the case of a perfect share market.
Information about companies is not evenly shared in real capital markets too. Although most investors know the real demands and why it is occurring, many investors do not have the insider-information about the companies. This helps shareholders earn more money in comparison to their peers. This also helps the capital markets become lucrative destinations for investors.
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