Managerial Actions Affecting Firm Value

Qn. Discuss managerial actions that affect the value of the firm.

Managerial actions range from strategy decisions, to capital structure decisions to decisions on the composition of the managerial team.

• Dividend Policy

The dividends issued by a firm to its shareholders have a signalling effect to the market as they reflect the management's view on the future prospects of their firm. An increase in ordinary dividends by management is a sign of managerial optimism about the future.This has a two fold effect; firstly, by the dividend discounting model of valuing shares, the share values rise and in concert, the firm's value. Secondly, there will be a surge in the market to take up these shares with positive prospects. Market economics indicates their value will increase as demand outstrips supply.

The reverse applies when management decides to cut dividends due to pessimistic views on future performance; an initial drop in share value (and hence company value) via the discounting method, then, would lead to a further market downfall due to supply outstripping demand.

• Closing down of major operations

When a division of the firm that has proven to be a major income contributor is closed down by management, the firm's cashflows are viewed as unsteady and unpredictable. The firm may incur problems in servicing their long term debts and its credit valuation will be downgraded. A fall to 'junk bond' status will be the ultimate blow as share value will fall in tandem with the downgrade as the firm's prospects appear to be bleak.

However, if a firm expands and improves an income generating division, it may indicate a strategy to increase market share and increase cashflows. Credit upgrades will serve to create a 'good feel' and increase share value. This will automatically result in an increased value of the firm.

• Change of capital structure

Management, by deciding to change the capital structure of the firm, say by eliminating debt to become fully equity financed, would erode some of the firm’s value.

The MM proposition’s relationship with corporate taxes shows that in the real world, capital structure affects the value of the firm.

It follows that:

Firm Value = Market Value of Equity + Interest Tax Shield

A levered firm will have a higher value than an unlevered one.

Hence each firm has to find its optimal capital structure (the optimal debt/equity