Maximizing Firm Value versus Maximizing Stockholder Interests

The following example illustrates that the capital structure that maximizes the value of the firm is the one that financial managers should choose for the shareholders.

Example-

Suppose the market value of the J. J. Sprint Company is $1,000. The company currently has no debt, and each of J. J. Sprint's 100 shares of stock sells for $10. A company such as J.J. Sprint with no debt is called an unlevered company. Further suppose that J. J. Sprint plans to borrow $500 and pay the $500 proceeds to shareholders as an extra cash dividend of $5 per share. After the issuance of debt, the firm becomes levered. The investments of the firm will not change as a result of this transaction. What will the value of the firm be after the proposed restructuring?

Management recognizes that, by definition, only one of three outcomes can occur from restructuring. Firm value after restructuring can be either (1) greater than the original firm value of $1,000, (2) equal to $1,000, or (3) less than $1,000. After consulting with investment bankers, management believes that restructuring will not change firm value more than $250 in either direction. Thus, they view firm values of $1,250, $1,000, and $750 as the relevant range. The original capital structure and these three possibilities under the new capital structure are presented next.

Ross-Westerfield-Jaffe: I IV. Capital Structure and I 15. Capital Structure: Basic I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy Concepts Companies, 2002

Edition

392 Part IV Capital Structure and Dividend Policy

Value of Debt plus Equity No Debt after Payment of Dividend

(original (three possibilities)

capital structure) I II III

Equity 1,000 750 500 250

Note that the value of equity is below $1,000 under any of the three possibilities. This can be explained in one of two ways. First, the chart shows the value of the equity after the extra cash dividend is paid. Since cash is paid out, a dividend represents a partial liquidation of the firm. Consequently, there is less value in the firm for the equityholders after the dividend payment. Second, in the event of a future liquidation, stockholders will be paid only after bondholders have been paid in full. Thus, the debt is an encumbrance of the firm, reducing the value of the equity.

Of course, management recognizes that there are infinite possible outcomes. The above three are to be viewed as representative outcomes only. We can now determine the payoff to stockholders under the three possibilities.

Payoff to Shareholders after Restructuring

I II III

Dividends 500 500 500

Net gain or loss to stockholders $250 $ 0 -$250

No one can be sure ahead of time which of the three outcomes will occur. However, imagine that managers believe that outcome I is most likely. They should definitely restructure the firm because the stockholders would gain $250. That is, although the price of the stock declines by $250 to $750, they receive $500 in dividends. Their net gain is $250 = -$250 + $500. Also, notice that the value of the firm would rise by $250 = $1,250 - $1,000.

Alternatively, imagine that managers believe that outcome III is most likely. In this case they should not restructure the firm because the stockholders would expect a $250 loss. That is, the stock falls by $750 to $250 and they receive $500 in dividends. Their net loss is -$250 = -$750 + $500. Also, notice that the value of the firm would change by -$250 = $750 - $1,000.

Finally, imagine that the managers believe that outcome II is most likely. Restructuring would not affect the stockholders' interest because the net gain to stockholders in this case is zero. Also, notice that the value of the firm is unchanged if outcome II occurs.

This example explains why managers should attempt to maximize the value of the firm. In other words, it answers question (1) in Section 15.1. We find in this example that:

Changes in capital structure benefit the stockholders if and only if the value of the firm increases.

Ross-Westerfield-Jaffe: IV. Capital Structure and Corporate Finance, Sixth Dividend Policy Edition

15. Capital Structure: Basic Concepts

© The McGraw-Hill Companies, 2002

Chapter 15 Capital Structure: Basic Concepts

Conversely, these changes hurt the stockholders if and only if the value of the firm decreases. This result holds true for capital-structure changes of many different types.2 As a corollary, we can say:

Managers should choose the capital structure that they believe will have the highest firm value, because this capital structure will be most beneficial to the firm's stockholders.

Note however that the example does not tell us which of the three outcomes is most likely to occur. Thus, it does not tell us whether debt should be added to J. J. Sprint's capital structure. In other words, it does not answer question (2) in section 15.1. This second question is treated in the next section.

Question

Hr------• Why should financial managers choose the capital structure that maximizes the value of

The Power Of The Entrepreneurs Mind

The Power Of The Entrepreneurs Mind

The revenue is in the list. Youve likely heard that previously correct? Well, thats not precisely true. Not the complete truth anyhow. The greatest obstacle you face and have to defeat when you publish a ezine or put any free or paid info out there's the fact that individuals have gotten used to receiving junk from your rivals disguised as helpful free or paid info.

Get My Free Ebook


Responses

  • robin
    How financial managers would choose a capital structure that maximizes the value of the firm?
    7 years ago
  • Girma Asmara
    How to maximize Firm Value versus Maximizing Stockholder Interests?
    7 years ago
  • DUENNA
    Why maximize capital structure?
    6 years ago
  • Marco
    Why should financial managers choose capital structure maximizing the value of the firm?
    6 years ago

Post a comment