Shareholder Wealth Maximization

1912 Words Sep 1st, 2011 8 Pages
The ultimate goal of any financial manager (as well as the firm) is the maximization of shareholders’ wealth. A good financial manager therefore should carefully consider and weigh the risk of undertaking a certain project against the profits associated with undertaking such a project. Capital Budgeting techniques enable the manager to make such decisions.

The first question that comes to mind is, when making a capital investment decision, should we focus on cash flows or accounting profits. The book is stating “In measuring wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it,
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Such cash flows, however should not include any finance charges whether those are interest charges paid on a bank loan, interest charges on the firm’s issued debt securities, as well as dividends on preferred and common stock. The reason behind such exclusion is that such finance charges are implicitly accounted for when calculating the cost of capital (also known as the Weighted Average Cost of Capital). Having said that, Caledonia’s differential cash flow (as per the attached excel sheet) are:
Year
1 2 3 4 5
$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000

The last type of cash flows to be examined is the Terminal cash flow which includes all incremental cash flows realized at the termination of the project such as the salvage value of the equipment plus (or minus) any taxable gains or losses associated with selling the equipment. Terminal cash flows also would include any non-expense cash outlays related to the project such as the recovery of working capital needs. Caledonia’s terminal cash flow then is $5,980,000 as per the above table and the attached excel sheet.
A cash flow diagram of the project would provide a full image of the cash out flows and cash inflows associated with the project as it would provide a summary of those cash flows that are to be analyzed using the various capital budgeting techniques:

$3,956,000 $8,416,000 $10,900,000 $8,548,000
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