As Moyer, McGuigan and Rao (2007) states that the Objective of Financial Management in a company is to Maximize Shareholder Wealth (MSW), where the market value of the shareholders’ common stock holdings is used to measure the shareholder wealth, and the price at which the stock are traded in the marketplace (New York Stock Exchange) is defined as the market value of a share.
Arnold (2008) pointed out that by maximizing the flow of dividends to shareholder through a period of time can maximize shareholder wealth. In another words, a company needs to invest to bring in profits in order to MSW.
But before any projects are undertaken, they have to be analyzed to prevent the ...view middle of the document...
But with a shorter PB, less capital will be tied up and more liquidity can be used for future investments, which will MSW. The risk for the projects will be lower, due to the short PB, plus the calculation is simple, quick and easily understood.
Accounting Rate of Return (ARR)
Arnold (2008) defines ARR as the ratio of the accounting profit to the capital invested which is expressed as a percentage, which is also known as return on investment (ROI).
In Appendix 2, the company’s required ARR is 40%. Hence, Equipment X will be chosen as it has an ARR of 46% compared to Equipment Y which only has an ARR of 38%, and with the high return, the shareholders wealth will be maximized. The data required can be easily obtained and it’s easy to calculate. And it covers at the entire shelf-life of the equipment (5 years), but it doesn’t take into account the actual shelf-life of the equipment. It’s also easy to understand as the ARR is based on the concept of a percentage returned (profit). It also ignores the time value of money, which may lead to miscalculation and wrong decision made for long-run projects.
Net Present Value (NPV)
Grinblatt and Titman (2004) says that the NPV of an investment project is measured by the differences between the present value and the capital investment.
Appendix 3 shows the calculation of the NPV for Project X, which has a positive value of $14,600 at a discount factor of 10%. Since Project X has a positive NPV, it should be undertaken. A positive NPV can increase the equity of a company which leads to MSW. It has taken into account the time value of money, as the calculations is based on discounted cash flows. However, the discount factor can’t be easily obtained.
Internal Rate of Return (IRR)
Watson and Head (2007) states that the IRR of an investment project is measured by using the required rate of return to discount the cash flows for projects which produces a NPV of zero.
Based on the calculation in Appendix 4, the IRR for the investment is 10.78%, which is more than the company’s requirement, which means that the investment is worth taking. And we don’t have to find the discount factor, as we can find the actual rate of return that produces a NPV of zero, which means that if rate of return for that is more than 10.78% is worth taking.
However, there are a few General Issues that I would like to discuss about. Firstly, the 3 main decisions of Financial Management, the Dividend Decisions, Financing Decisions and Investment Decisions, are interrelated, and they affect one another by the types of decisions that financial managers make. An example is if you make a wrong Investment Decision and make a loss, the shareholders might not get their dividends (the Dividend Decisions is affected), and the financing department will have to find ways to solve the financial problems (and the Financing Decisions is also affected), which will damage the company’s goodwill. In another words, you can’t make...