Shareholder Wealth Maximisation

The theory of finance is based on the idea that the managers of a company act as agents on behalf of the company's owners: the shareholders. Consequently, the managers must strive to find investment opportunities that help to maximise their shareholders' wealth. This implies providing a better return than the return available elsewhere for equally risky projects. So the market return (and thus the cost of obtaining capital from the market) provides a benchmark which must be beaten if the shareholders' wealth is to be increased.

Note: both the market return and any return on an investment in the company are based on expectations about the amounts and timings of future cash flows - so in reality this is all somewhat subjective.

Net Present Value (NPV)

By applying this market return or cost of capital benchmark to the cash flows from a specific project, as a discount factor it is possible to estimate the Net Present Value (NPV) of the project - the amount by which (based on current expectations) the project increases shareholder wealth.

Returning to our example above, if we assume the market return expected for funds invested in a project of this type is 10% p.a. (and therefore funding would be available from banks, etc. at this interest rate or cost of capital). The cash flows can be discounted back to their present values and compared on a basis that eliminates this opportunity cost effect.