Corporate Finance: Shareholder Wealth and Investment Decisions

Posted on Jan 8, 2026 in Finance and Accounting

Shareholder Wealth Maximisation (SWM)

Shareholder wealth maximisation requires managers to make investment and financing decisions that increase shareholders’ wealth.

Maximising shareholders means maximising the flow of cash dividends through time and/or capital gains for investors.

Reasons for Using SWM

• Multiple objectives create decision-making confusion.
• Shareholders risk capital with no guaranteed dividends or returns.
• They own the firm, ensuring its survival and aiding efficient resource allocation.

Limitations of Alternative Corporate Objectives

Sales Maximisation Limitations

• Managers may pursue unprofitable projects to increase sales.
• The objective does not specify the time frame for achieving such a goal; hence, it could lead to decisions that only have a short-term impact.

Profit Maximisation Limitations

• It is vague and difficult to implement in the context of an operating enterprise. It does not specify whether it is short- or long-term profit.
• It does not suggest which activities must be undertaken to maximise profits.
• It ignores risk, variability of profits over time, time value of money, and the firm’s prospects.
• It is not effective in communicating with the owners of the firm.
• Creative accounting and the choice of specific accounting policies can give a false impression of a company’s profitability.

Capital Rationing and Market Imperfections

Market Imperfections Causing Capital Rationing

A firm may face capital rationing due to the following:

• Imperfect capital markets: Investors lack full information about the firm, leading to higher financing costs.
• Debt financing constraints: Lenders impose borrowing limits due to high risk, debt covenants, or potential bankruptcy.
• Equity market limitations: Issuing new shares can dilute ownership or under-pricing, making equity financing unattractive.
• Managerial constraints: Managers may avoid risky investments to protect their jobs or focus on short-term profit targets.

Other Market Imperfections Causing Capital Rationing

• Information asymmetry: Investors may lack full information about the firm’s true profitability, making external financing costly or unavailable.
• Issue costs: Raising costs through equity or debt incurs transaction costs (legal, underwriting fees), reducing available investment capital.

Optimal Capital Investment Strategy Under Capital Rationing

Maximise NPV with constrained funds: The firm should allocate funds to projects that generate the highest total Net Present Value (NPV) within its budget.

Strategy for Different Types of Projects

• Indivisible projects: The firm should evaluate all possible project combinations within the budget constraint. The combination with the highest total NPV should be selected.
• Divisible projects: Rank projects based on NPV per unit of funds required. Allocate funds in descending order until the budget is fully used.

Dividend Policy and Agency Costs

Dividend Payout Policy Irrelevance (Under Ideal Conditions)

Assuming no taxes, transaction costs, or agency issues, and independent investment outcomes, a firm can pay dividends exceeding its net cash flow by issuing new equity or borrowing. Alternatively, it can pay a small dividend and repurchase equity with leftover cash flow. In either case, firm value remains unchanged, making dividend policy irrelevant.

Influence of Dividend Policy on Agency Costs of Equity

Dividend payments can limit managerial moral hazard by decreasing free cash flow for discretionary spending. Managers’ reluctance to cut dividends (due to their signalling effect) makes dividend policy like debt. However, managers might finance high dividends by forgoing positive NPV projects or increasing debt, benefiting equity holders at the expense of debt value, ultimately lowering firm values.

Information Asymmetry and Securities Issuance

How Information Asymmetry Determines Securities Issued

Information asymmetry can lead to mispricing of companies’ equity. Managers may exploit this to benefit shareholders. Overpriced ‘bad’ firms may issue new equity for projects, while underpriced “good’ firms hesitate, as it appears ‘cheap’ compared to the true value. A smart market recognises that ‘bad’ firms issue equity, prompting a decline in their share prices. Good firms will avoid equity issues. Risky debt can be overpriced if the market underestimates default probability, incentivising lower-quality firms to issue it, whereas riskless debt cannot be mispriced.

Strategies Debt Providers Use to Protect Their Position

• Debt covenants to limit risky actions.
• Collateral to secure payment.
• Credit analysis to assess risks.
• Loan structuring to ensure repayment priority.
• Monitoring mechanisms to track financial health.
• Convertible debt options for additional security.

These strategies help lenders to reduce default risk and ensure financial stability.

Capital Budgeting Consistency

Conditions for NPV and IRR to Always Agree

• Cost of capital = IRR hurdle rate: The required return used in NPV must match the IRR decision rule.
• Conventional Cash Flows: Projects must have one initial outflow followed by inflows.
• No capital rationing: The firm must be able to accept all positive NPV projects without budget constraints.

Lintner’s Empirical Study on Dividends

Key Findings of John Lintner’s Empirical Study

Lintner studied how firms determine their dividend policies and identified four stylised facts:

1. Managers set a target dividend payout level: firms aim for a long-term stable dividend payout ratio rather than adjusting dividends frequently.
2. Payout is based on suitable earnings per share: dividends are set as a percentage of expected long-term earnings rather than reacting to short-term earnings fluctuations.
3. Managers prioritise dividend stability over absolute levels: they are more focused on maintaining a steady growth pattern in dividends than the actual dividend amount.
4. Managers avoid dividend changes that may be reversed: firms hesitate to increase dividends unless they are confident that future earnings will support them, as cutting dividends damages investor confidence.

Implications for Information Asymmetry and Dividend Policy

Lintner’s findings suggest managers smooth dividends to signal financial stability to investors. This supports the signalling theory of dividends; managers have better information about future earnings and use dividends to convey this. Like Ross’s debt signalling theory, where firms use debt issuance to signal confidence, dividend smoothing may serve the same function.

Other Market Imperfections Affecting Payouts

• Tax clientele: Investors prefer dividends or capital gains depending on their tax situation, influencing firms’ payout decisions.
• Transaction costs: High costs of issuing new equity or repurchasing shares can lead firms to maintain stable dividends rather than frequently adjusting payouts.

Impact of Tax Differences on Investor Preferences and Firm Dividend Policies

Firms react to tax differences by attracting specific investor groups:

• High-income individuals: Prefer low dividends and high capital gains, as dividends are taxed at a higher rate.
• Tax-exempt institutions: Prefer high dividends, as they benefit from receiving dividends rather than waiting for capital gains.
• Corporations: Prefer high dividends, as tax systems may allow exclusion of a portion of dividend income from taxation.

How the firm reacts: Firms attract investor groups by setting dividend policies that match their target clientele. The firm clearly communicates its payout strategy so that investors can choose accordingly.

Market pricing adjustment: Investors may shift their investments if two otherwise identical firms have different dividend policies and stock prices. The lower-priced firm is incentivised to adjust its dividend policy to attract more investors. Over time, market supply and demand forces lead to an equilibrium where firms are equally priced based on investor preferences.