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Chapter 2 • A framework for financial decision making

Project X – to invest or to spend

Industries Ltd is a business owned by a number of independently minded shareholders.

Three of these, Eager, Patient and Steady, own 20,000 each of the business’s total of

200,000 ordinary shares. At present, Industries Ltd has only one asset, namely £100,000 in

cash. Management is undecided whether to pay this cash to the shareholders as a dividend,

which would amount to £10,000 (one-tenth of £100,000) in the case of each of the above

trio, or to invest it in Project X. This investment project requires an initial cash investment of

the whole of the £100,000 payable now, and will produce a cash receipt of £120,000 in a

year’s time, and then come to a close. If the project is undertaken the whole of the cash pro-

ceeds will be paid as a dividend next year (£12,000 each for Eager, Patient and Steady). For

the time being, let us assume that there is no alternative investment project available to the

business, nor any shareholdings in other businesses available to investors, also that it is not

possible to borrow or lend money.

Suspecting that there might be disagreement between shareholders on Project X, the

management decided to call a shareholders’ meeting to sound out opinion. During the meet-

ing the following three comments were made:

l Eager said that she thought Industries Ltd should not make the investment but should pay

the dividend immediately because, while she does not necessarily want to spend the

money now, it would be nice to have it available should some need arise. She does not

consider that the additional £2,000 of dividend will compensate her for delaying.

l Patient said that he would prefer Project X to be undertaken because he would not, in any

case, spend his dividend before next year and would prefer to have £12,000 than £10,000

when he does come to spend it.

l Steady said that she would be in favour of Project X but that, since she needs the cash

in six months’ time to pay for a new extension to her house, she would reluctantly have

to vote for the immediate dividend.

Similarly diverse views were expressed by the business’s other shareholders.

Example 2.2

Clearly, management has a problem. If it were trying to maximise the wealth of the

shareholders then perhaps a decision to undertake Project X would be the correct one.

This would not be acceptable to at least two shareholders: Eager would rather have

her money now and Steady must have it in six months at the latest. Clearly, £12,000 is

For the remainder of this book we shall assume that shareholder wealth maximisa-

tion is the major financial goal of the business. However, we should continually bear

in mind that, in reality, decisions reached on the basis of this objective might be in

conflict with a business’s non-financial goals. If this is the case, the final decision may

need to be a compromise.

2.4 Financing, investment and separation

If we accept that businesses should seek to maximise the wealth of the shareholders in

making their financial decisions, we can now turn our attention to how, in theory at

least, managers should approach their decision making so as to promote this objective.

Let us do this by consideration of an example.

Project X