As an investor, you are relying on the management of a company to increase the value of your investment.
According to agency theory, the management of a firm are employed on behalf of the shareholders as an agent, to run a company on their behalf.
The agent is empowered by shareholders with the authority to make decisions that affect the direction of the company.
One of the key issues between shareholders and the management of a firm is communication. This is because the management of a firm has insider information, while shareholders do not.
As a consequence, shareholders and the management of the firm have access to different levels of information. The management of the firm cannot share this information directly to shareholders as this could compromise the company to competitors.
As a result, in corpoate finance, a number of indicators have been established whereby corporate communication can be interpreted.
Signalling theory suggests that dividend policy can be used to infer whether a company is set for growth or not.
It claims that if a company grows its dividend, high levels of growth should be expected. It suggests that the management of a firm are trying to communicate to investors that the future prospects of the firm are very positive.
Equally, if a company decides to reduce the size of its dividend, signalling theory says that this is a signal that poor performance should be expected.
The issue with this theory is that a large number of companies, particularly in the United States, do not offer a dividend at all. As a consequence, it cannot be applied to those companies.
This doesn’t necessarily mean that companies don’t communicate well with shareholders. In fact, some companies decided to offer a dividend or not based on the shareholder preferences.
The other issue is that a stock may suffer from the neglected stock effect and so the management of the firm may decide to offer a larger dividend to compensate shareholders instead.
According to corporate finance theory, the main agenda of the management of a firm is to maximise the wealth of their shareholders.
As a result, the management should do whatever it takes to increase the company’s share price or dividend.
Consequently, the management of a firm needs to manage their finances in a particular way. When they have plenty of cash available, they essentially have two options, to pay this money out as a dividend or to use it on new projects that will grow the value of the company.
If the company decides to invest their cash into new projects, the management of the firm should identify projects with the highest net present value.
By doing so, the value of the company will grow as much as it possibly can, maximising shareholder wealth as much as possible.
One thing to be wary of as an investor is how much money a company keeps in cash. If a company keeps large amounts of money in cash and doesn’t invest it in a new project, it should be paid out to investors as a dividend.
If it is not, the company are not meeting their responsibility of maximising shareholder wealth.
Most recently, Apple were criticised for having a lot of cash within the company, more than $100 billion to be exact.
In response, Apple announced investing in several new projects, including the production of their own processing chips. In addition to that, since 2016 Apple started to offer a dividend to investors, which has almost doubled over the last 5 years.
Something to be wary of is if the management of a firm does not maximise wealth for investors but does act to increase executive compensation.
If a company is rewarding executives but not employees, their motivation may have shifted away from maximising shareholder wealth to maximising their own wealth.
At which point, it may no longer be a worthwhile investment.
Capital structure simply refers to the amount of debt that a company has in comparison to its levels of equity.
Striking the right balance between the two types of financing is crucial for the financial health of the firm.
According to trade off theory, the management of the firm should only raise capital if the benefits outweigh the drawbacks.
Therefore, if a company can achieve substantial growth by altering the capital structure, it is worthwhile. Likewise, if a company raises capital and does not achieve any growth, this will harm the value of the company.
Debt finance is considered more preferable to equity finance as it is tax deductible. Even if things go wrong, the financial health (to some extent) of the firm can be maintained through reduced tax liabilities.
Equity finance is seen as the most costly as a company loses ownership and more control over itself. This can be very harmful for shareholders as more stock is able to be traded.
If demand for a stock goes down, the stock price may take a larger hit.
Therefore, ensuring that the management of a firm is not wasteful with capital is important. Raising capital unnecessarily can have a significant impact upon the value of a firm.
The management of a firm should only take on more risk if the potential benefits are worthwhile in terms of growing the size of the firm.