Maximization Of Wealth Of The Shareholders

Maximization of the wealth of the shareholders is the main function of a corporation. To maximize the shareholder’s wealth, management must take up new projects, and there is the need to evaluate such projects and investments to see whether they provide more income inflows compared to outflows. The corporation will set the minimum return they expect will increase the current position of the shareholder 's wealth, and this minimum expected return is the cost of capital (Bethlehem 16). Modigliani and Miller (261) point out that corporations can raise capital for investing by either issuing debt or equity and then using these funds to take on new projects that have uncertain yields. Cornelius (22) emphasizes that the concept of cost of capital plays a critical role in every corporation because it is the link between the investing decision and the financing decision and therefore, this brief explains how the cost of capital is determined, the factors that affect it, and how it affects firm valuation.

Determining the Cost of Capital

Firms can either use debt financing and/or equity financing sourced from capital markets as the sources of capital and their proportions of use may be different. The equity providers require a return on their investment while the creditors also require a minimum return from their borrowings. Pratt (5) points out that the cost of capital is dependent upon the use of the funds and not from their source. Pratt (6) also emphasizes that cost of capital is a representation of the expectations of investors. Therefore, the basis for calculation is market expectations, and use of the market value rather than book value. When determining the cost of capital, a firm will decide the minimum return required by the equ...

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...o of debt to equity (the optimal capital structure) that minimizes the cost of capital, and maximizes the value of the firm and shareholder’s wealth.

In conclusion, the minimum rate required by a firm to maximize the value for its shareholders is the cost of capital. Determination of the cost of capital has been the discussion of many scholars, and they acknowledge that firm’s raise capital by either debt or equity. Therefore, the average cost of capital represents the cost of these respective components. Firms have to pay attention to the cost of capital because it determines whether a firm meets its objectives of maximizing its shareholder’s wealth.

I believe that the policy manual I have presented will become part of the strategic planning material, assist in the on-going management development process, and improve communication and understanding on this topic.