Theories On Corporate Finance Practices

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02 Nov 2017

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2.0 Introduction

The chapter review relevant literature on corporate finance practices; capital budgeting and dividend policy. The chapter examines theories and studies on the study area. The study goes on to take a brief look at the Ghanaian banking sector, review literature on capital budgeting theories and dividend policy theories. As a result, the chapter provides information on already existing studies conducted into the study area.

2.1 Theories on Corporate Finance Practices

Numerous studies, both old and recent have been conducted into the corporate finance practices of firms all over the world.

Klammer (1972) found that the number of large industrial companies who used DCF techniques to evaluate proposed capital investments increased over the years.

According to a study of 14 medium and large companies in India, Pandey (1989) finds that with the exception of one company, all companies use payback method, about two-thirds use IRR, and about two-fifths use the NPV with payback and/or other methods. According to Pandey (1989) IRR is the second most popular method of project appraisals.

Another study by Petry and Sprow (1993) of 151 firms indicates most firms use the traditional payback period either as a primary or as a secondary method for capital budgeting decisions. The majority of responses also indicated that firms use NPV and IRR either as a primary or as a secondary capital budgeting decision making tool.

Drury et al (1993) conducts a survey of 300 manufacturing companies. Their results indicate that payback and IRR are the most widely used project appraisal methodologies. They further reported that the most widely used project risk analysis technique is sensitivity analysis.

Bierman (1993) also reported that almost all respondents in his 1992 survey of the 100 largest Fortune 500 companies used IRR or NPV as either the primary or secondary evaluation measure. He also found that although payback was used extensively it was not used as a primary measure.

Chen (1995) also studied the use of different quantitative evaluation techniques across three types of investments: equipment replacement, expansion of existing products, and expansion into new products. He found that DCF techniques are used more widely than non-DCF techniques such as payback and accounting rate of return to evaluate all three types of investments. He also found that DCF techniques are relied upon more heavily in expansion projects than equipment replacement and that non-financial considerations play a significant role in capital budgeting, especially in decisions related to new products.

According to Cherukuri (1996), in a survey conducted of 74 Indian companies; reports indicates that more than fifty per cent of companies use IRR as project appraisal criterion. The report further noted that the accounting rate of return and payback period methods are employed as supplementary decision criteria.

Chadwell-Hatfield et al. (1997) reports in their study that more than 70 per cent of firms consider a high IRR an important criterion in deciding which project to accept. The report further showed that firms use NPV as one of the methods in appraising projects. Nearly two-thirds of the firms believe that acceptable project should have shorter payback period in addition to either high IRR or NPV. According to them, the discount rate used in the project evaluation is based on the project risk.

Payne et al (1999) focused their study primarily on methods of evaluating project profitability and risk. Their results show that the sophistication of the analytical techniques used by U.S. executives has increased over time. Their results further noted that the Discounted cash flow (DCF) techniques, such as net present value (NPV), internal rate of return (IRR), and profitability index (PI), which are based on cash flows and take into account the time value of money, have become the dominant methods of evaluating and ranking proposed capital investments.

Rajatanavin and Venkatesh (2007) found that the NPV and IRR are two of the most frequently used capital budgeting techniques by Thai companies. Their results further show that seventy-five percent and sixty-eight percent of respondents use NPV and IRR respectively. They further reported that 77.5% of respondents use the payback period making it the most popular capital budgeting technique used by Thai companies. They note that, the payback method is very popular among Thai companies amidst several serious limitations which are discussed in standard finance textbooks and finance courses. They argue that popularity of the payback period could be either due to severe capital constraints on investing firms or due lack of sophistication in making capital budgeting decisions.

2.2 The Ghanaian Banking Sector

According to the 2011 banking survey which was jointly presented by Price Water House Coopers (PwC) and the Ghana Association of Bankers (GAB), analysis of the survey suggests that for sustainable growth to be experienced in the banking sector, there has to be a move of local industry players aligning their business activities with local market and global trends. This realignment will fuel their ability to make a significant impact in converting the unbanked population in Ghana and enable banks to sustain their long term growth.

The survey report highlighted that in a survey conducted by PwC on "Unlocking Opportunities–Perspectives on Strategic and Emerging Issues in Africa West Coast Banking", risk management, capital management and compliance were noted as the three top areas banks are currently experiencing the greatest shortage of skills. These three things noted were found to form the fundamental objectives of internal controls; suggesting that the control systems in banks in Ghana suffered in its application. According to the survey, successful human capital transformation should originate from banks core business operations and must fit into the bank’s strategy to be successful. This report recommendation to the control system is consistent with GAO (1999). This approach ensures that change is not only performance driven but also centered on the knowledge, skills and talent that support performance and growth (PwC, 2011).

The survey reiterated that banks in their quest to grow must develop new economic models with deeper focus on alternative revenue streams, transformation of customer segmentation, Risk management, robust Management Information Systems (MIS) and Human Capital geared towards a performance culture.

According to the survey report, the prospects for the future are rife and backed with the right transformation strategy, banks in Ghana stand to benefit from sustained profitability.

The survey noted that transformation in Risk Management and Governance framework is essential for growth in the long term and attracting investors. Synonymous to growth is exposure to risks. Banks must therefore strengthen their current Risk Management framework to include Early Warning strategies and respond to operational risk and credit risk envisaged. Addressing occurrence of a risk event takes up executive time and distracts management from its focus on profitable growth. Thus the banking sector should find the right blend of control system which does not cause the profitability of organizations to suffer.

The survey revealed that transformation in Information Systems is the backbone for sustaining product development and improving service delivery. Strengthening the IT infrastructure such as centralized processing, disaster recovery plans, and Information Security should become a priority. Attracting, developing and retaining human capital, the key for pursuing sustainable growth, is critical. The survey concluded by noting that the Ghanaian economy is growing and the banking industry will continue to experience profitable growth. To remain competitive and be sustainable in the long term requires the industry to innovate and transform its operations. It is worth noting that in transforming the operations of banks, control measures to risks should not be ignored. The survey further stated that responding successfully to emerging external threats, will require industry players to focus on developing an efficient, effective, and flexible banking infrastructure. Increased competition, growing customer demands, and new regulations will continue to add complexities to the operations of banks. These complexities can lead to an inability to capture opportunities or respond successfully to global or local challenges. Finally it is worth noting that trends observed in the banking industry revealed;

a) strengthening of risk management practice

b) increasing support for trade financing

c) rationalizing and aligning staff cost to revenue.

Given these facts about the Ghanaian banking sector, it is important to use the appropriate and needed techniques and appraisal tools to evaluate its projects and determine the right value of firms. This move is to address the risk of taking on a project. With the right and appropriate tools and techniques, banks are better-off and ready to take on more risk of doing business.

(PwC, 2011: available at www.pwc.com/gh).

2.3 Capital Budgeting

2.3.1 Capital Budgeting Practices

In capital budgeting, researchers assert that the Net Present Value (NPV) and Internal Rate of Return (IRR) are the best methods that should be used in the appraisal of capital investment projects (Rajatanavin and Venkatesh, 2007). Indeed, techniques like the accounting rate of return are inefficient as it relies on profits and not cash flows and is not consistent with the maximization of shareholders’ wealth and are used as supplementary methods (Cherukuri, 1996).

Capital budgeting addresses the issue of strategic long-term investment decisions. It is seen as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Capital budgeting has been described as the formulation and financing of long term plans for investment (Olawale et al., 2010).

Capital budgeting decisions are among the most important decisions the financial manager of a company has to deal with. Capital budgeting refers to the process of determining which investment projects result in maximization of shareholder value (Hermes et al, 2005).

Thus capital budgeting is the process of determining which real investment projects should be accepted and given an allocation of funds from the firm. To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance. Capital budgeting decisions become critical and must be evaluated very carefully. Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders.

2.3.2 Determinants of Capital Budgeting Practices

A number of factors influence the type of capital budgeting technique to use. The choice of capital budgeting technique to use in the evaluation of capital investments may therefore be determined by individual preferences of the manager and/or by the environment in which decisions have to be made (Hermes et al, 2005).

Hermes (2005) notes that financial markets have developed over time, making the use of DCF methods more applicable, convenient and necessary. They argue that due to the development of financial markets, shareholder maximization has gained importance, which influences financial managers of firms to use DCF methods over other more simple, but also less accurate alternatives.

Secondly, they note that training of finance managers has improved over time, which may have enabled them to better understand and thus use more sophisticated techniques.

Thirdly, financial tools and programmes that help the financial mangers to determine which investments are beneficial to the firm have become increasingly sophisticated, which may also have stimulated the use of more sophisticated techniques.

Finally, the increased use of computer technology and the related reduction in the cost of this technology may have stimulated the use of more sophisticated techniques (Hermes et al, 2005).

Size of Firm

Other researchers have also identified size of the firm (Danielson and Jonathan, 2006).

Firm size is seen as a determinant because some papers have found evidence for the fact that larger firms are more inclined to use more sophisticated capital budgeting techniques (Payne et al., 1999; Brounen et al., 2004). It is argued that one important reason for this may be that larger firms generally deal with larger projects, which makes the investment in the use of more sophisticated techniques less costly (Payne et al., 1999).

Educational Level of Financial Managers

Hermes et al (2005) argues that the measure of the educational level of the financial manager is also seen as a determinant of capital budgeting. Since it may be expected that financial managers with higher levels of education will have less problems in understanding and using more sophisticated capital budgeting techniques. Results from Leon et al (2008) suggests that financial managers of the responding firms having a college or university education would use the DCF techniques as opposed to those without a university education.

Size of Annual Capital Investment

Leon et al (2008) identifies the size of annual capital investments as a determinant of capital budgeting. They note that annual capital investment is measured by annual increase in net fixed assets. It is expected that firms with a large annual investment in fixed assets would be more inclined to use sophisticated capital budgeting techniques as opposed to those with smaller investments.

Type of Industry

Difference companies in different industry types; have been argued to behave differently in terms of capital budgeting practices (Leon et al, 2008). They note that this difference in capital budgeting practices may be due to differences in technology, competition, human resource skill, amount of investment in fixed assets, business risk, and many others. Therefore, it seems reasonable to assume that the extent of usage of DCF techniques would be different between industries.

Type of Ownership

It is also argued that foreign firms would be more inclined to use the more sophisticated DCF techniques than local firms because presumably international firms employ better qualified managers and are, therefore, better managed (Leon et al, 2008).

Financial Risk

In Leon et al’s (2008) study, the debt-to-asset ratio was used to represent financial risk. The study suggests that firms with high financial leverage tend to use the more sophisticated capital budgeting techniques because they need to be more cautious in making capital investments.

2.3.3 Capital Budgeting Techniques

Hermes et al (2005) identifies four main capital budgeting techniques financial managers may use when evaluating an investment projects. They note that two of the techniques; Net Present Value (NPV) and Internal Rate of Return (IRR) methods; are considered to be discounted cash flow (DCF) methods. However, the Payback Period (PB) and Average Accounting Rate of Return (ARR) methods are non-DCF methods.

Discounted Cash Flow Methods

Net Present Values

The net present value (NPV) method is based on the method that the present values of the cash inflows will be adequate or sufficient to recover the cost of the project. The net present value (NPV) method relies on discounted cash flow (DCF) techniques. It looks at the value added by a project. To find NPV; it is the sum of present values of cash inflows minus initial investment. We will accept an NPV with surplus or positive values; because it provides the best value for a project. Cash outflows (expenditures such as the cost of buying equipment or building factories) are treated as negative cash flows.

Internal Rate of Return

This is the rate at which the net present value of cash flows of a project is zero. That is, the internal rate of return is the rate at which the present value of cash inflows equals initial investment, (NPV = 0). Project’s promised rate of return given initial investment and cash flows

We may accept the internal rate of interest if project’s IRR ≥ Cost of Capital.

Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project.

Non Discounted Cash Flow Methods

Payback Period

The payback period method is the amount of time needed to recover the initial investment. The number of years it takes a firm to pay its cost of capital with the expected cash inflows of the firm, including a fraction of the year to recover initial investment is called payback period. To compute payback period, we keep adding the cash flows till the sum equals initial investment. It is a very simple method of evaluating projects but it has a limitation; it does not consider the time value of money or it does not take into recognition that money today is not the same as money tomorrow.

Thus, an improvement of the payback method is the discounted payback method. Under the discounted payback period, we keep adding the discounted cash flows till the sum equals initial investment. Thus, the value today should be recovered by the present values of the cash inflows of the project.

Profitability Index

The profitability index (PI) is the present value of future cash flows divided by the initial cost. It measures the benefit per cost of a project. We may accept a project which derives one (1) benefit per one (1) cost or more.

2.3.4 Importance of Capital Budgeting

A number of factors combine to make capital budgeting perhaps the most important task faced by financial managers. One of the most important factors is timing. Since the results of capital budgeting decisions continue for many years, the firm loses some of its flexibility. For example, the purchase of an asset with an economic life of 10 years "locks in" the firm for a 10-year period. Further, because asset expansion is based on expected future sales, a decision to buy an asset that is expected to last 10 years requires a 10-year sales forecast. Finally, a firm’s capital

budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures. Effective capital budgeting can improve both timing and the quality of asset acquisitions. If a firm forecasts its needs for capital assets in advance, it can purchase and install the assets before they are needed. Capital budgeting typically involves substantial expenditures, and before a firm can spend a large amount of money, it must have the funds lined up. Therefore, firm contemplating a major capital expenditure program should plan its financing far enough in advance to be sure funds are available.

2.4 Dividend Policy Practices

2.4.1 Literature on Dividend Policy

The dividend decision function of firms involves identifying the proportion of a company’s earnings to be paid out as dividend or to plow-back or retain within the firm for further expansion (Olowe, 1999; cited in Idolor, 2010). The financial manager is to ensure the maximum returns of a firm’s income which would ultimately translate into the value to shareholders. It is argued that "at all times, the optimum dividend policy is the one that maximizes the market value of the organizations shares" (Idolor, 2010). Archbold and Vieira (2008) notes that a well known the dividend puzzle consists of two elements. They point out that , the apparent necessity perceived by some corporate executives to pay dividends and their occasional willingness to do so, even in the face of financial fragility. The second puzzle, they note, involves the eagerness of some investors to receive dividend payments, even when such payments give rise to an additional tax liability.

Evidence from studies suggests that in some senses managers seem to pursue active dividend

Policies (Lintner, 1956; Brav et al., 2005; and Dhanani, 2005). Other studies also report that

Managers consistently have regard to the changes in dividend payouts, than dividend levels. Hence they tend to smoothen the pattern of dividend growth (Baker and Powell, 1999; Baker, et al, 2001).

Other studies also suggest that managers think that decreases in the payout will cause an adverse price reaction (Dhanani, 2005). Redding (1995) found a positive link between firm size and dividend payouts. He also argued that informational factors and ‘signaling’ represented a strong influence on dividend policy. Other researchers have also reported that ‘signaling’ does not have any relationship with dividend policy (DeAngelo et al, 1996). Benartzi et al (1997) suggests that dividend increases did not provide reliable signals of future performance. Nnadi and Akpomi (2005) attempted in their study to explain the effect of taxation on the dividend policy of Nigerian banks. They reported current profits, past dividends, target capital structure, financial leverage, shareholders’ needs for dividends, legal restrictions, desire for signaling and for conformity with the industry level of dividend payment; as some of the factors for dividend policy in Nigerian Banks.

2.4.2 Theories on Dividend Policy

Archbold and Vieira (2008) provide empirical evidence to explain the dividend puzzle. According to Archbold and Vieira (2008), three fundamental positions or theories can be found in the literature with respect to dividends. The first of these is known as ‘bird-in-the-hand’ hypothesis (Gordon and Shapiro, 1956); dividend irrelevance (Miller and Modigliani, 1961); and market imperfections such as transaction costs and taxes (Archbold and Vieira, 2008).

Literature further provides further typical developments; principal-agent theory and the signaling hypothesis. Studies have argued that increasing dividend payments increases a firm’s value (Gordon and Shapiro, 1956). Another study report claims that high dividend payouts have the opposite effect on a firm’s value; that is, it reduces firm value (cited in; Archbold and Vieira, 2008). Another theory asserts that dividends should be irrelevant and all effort spent on the dividend decision is wasted (Miller and Modigliani, 1961).

These views are embodied in three theories of dividend policy: high dividends increase share value theory (‘bird-in-the- hand’ argument), low dividends increase share value theory (the tax-preference argument), and the dividend irrelevance hypothesis.

Dividend policy theories are however limited to these three approaches. Several other theories of dividend policy have been presented, which further increases the complexity of the dividend puzzle. Some of the more popular of these arguments include the information content of dividends signaling, the clientele effects, and the agency cost hypotheses (Archbold and Vieira, 2008).

High Dividends Increase Stock Value (Bird-In-The-Hand Hypothesis)

It is seen that a popular view about the effect of dividend policy on a firm’s value is that dividends increase firm value (Archbold and Vieira, 2008). Literature notes that in a world of uncertainty and imperfect information, dividends are valued differently to retained earnings or capital gains. Investors prefer the "bird in the hand" (BIHH) of cash dividends rather today than the "two in the bush" of future capital gains and dividends tomorrow. Increasing dividend payments, all things being equal, may then be associated with increases in firm value. As a higher current dividend reduces uncertainty about future cash flows, a high payout ratio will reduce the cost of capital, and hence increase share value. That is, according to the so-called "bird-in-the hand" hypothesis, high dividend payout ratios maximize a firm’s value. Graham and Dodd (1934) for instance, argued that a dollar of dividends has, on average, four times the impact on stock prices as a dollar of retained earnings (Diamond, 1967).

Dividend Irrelevance Hypothesis

Miller and Modigliani’s (1961) refuted the argument of Graham and Dodd (1934), that "the sole purpose for the existence of the corporation is to pay dividends", and firms that pay higher dividends must sell their shares at higher prices (cited in; Frankfurter et al., 2002). When as part of a new wave of finance in the 1960’s, they demonstrated that under certain assumptions about perfect capital markets, dividend policy would be irrelevant. Given that in a perfect market dividend policy has no effect on either the price of a firm’s stock or its cost of capital, shareholders wealth is not affected by the dividend decision and therefore they would be indifferent between dividends and capital gains. The reason for their indifference is that shareholder wealth is affected by the income generated by the investment decisions a firm makes, not by how it distributes that income. Thus, it is argued that dividends are irrelevant because that regardless of how the firm distributes its income, its value is determined by its basic earning power and its investment decisions. They stated that "…given a firm’s investment policy, the dividend payout policy it chooses to follow will affect neither the current price of its shares nor the total returns to shareholders" (Frankfurter et al., 2002).

Low Dividends Increase Stock Value (Tax-Effect Hypothesis)

It has been assumed that there is no difference in tax treatment between dividends and capital gains. However, in the real world taxes exist and may have significant influence on dividend policy and the value of the firm. In general, there is often a differential in tax treatment between dividends and capital gains, and, because most investors are interested in after-tax return, the influence of taxes might affect their demand for dividends. Taxes may also affect the supply of dividends, when managers respond to this tax preference in seeking to maximize shareholder wealth (firm value) by increasing the retention ratio of earnings. Brennan (1970) developed an after-tax version of the capital asset pricing model (CAPM) to test the relationship between tax risk-adjusted returns and dividend yield. Brennan’s model maintains that a stock’s pre-tax returns should be positively and linearly related to its dividend yield and to its systematic risk. Higher pre-tax risk adjusted returns are associated with higher dividend yield stocks to compensate investors for the tax disadvantages of these returns. This suggests that, ceteris paribus, a stock with higher dividend yield will sell at lower prices because of the disadvantage of higher taxes associated with dividend income.

The tax-effect hypothesis suggests that low dividend payout ratios lower the cost of capital and increase the stock price. In other words low dividend payout ratios contribute to maximizing the firm’s value. This argument is based on the assumption that dividends are taxed at higher rates than capital gains. In addition, dividends are taxed immediately, while taxes on capital gains are deferred until the stock is actually sold. These tax advantages of capital gains over dividends tend to predispose investors, who have favourable tax treatment on capital gains, to prefer companies that retain most of their earnings rather than pay them out as dividends, and are willing to pay a premium for low-payout companies. Therefore, a low dividend payout ratio will lower the cost of equity and increases the stock price; a prediction which is almost the exact opposite of the BIHH and of course challenges the strict form of the DIH.

Clientele Effects of Dividends Hypothesis

The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Similarly, companies with low dividends will attract a clientele with little need for current income, and who often have high marginal tax rates. Allen, Bernardo and Welch (2000) suggest that clienteles such as institutional investors tend to be attracted to invest in dividend-paying stocks because they have relative tax advantages over individual investors. Allen et al. conclude with the proposition that, "…these clientele effects are the very reason for the presence of dividends…" (2000, p. 2531).

The Information Content of Dividends (Signaling) Hypothesis

The information content of dividends is a theory which holds that investors regard dividend changes as "signals" of management forecasts. Thus, when dividends are raised, this is viewed by investors as recognition by management of future earnings increases. Therefore, if a firm's stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future. Lintner (1956) argued that firms tend to increase dividends when managers believe that earnings have permanently increased. This suggests that dividend increases imply long-run sustainable earnings. This prediction is also consistent with what is known as the "dividend-smoothing hypothesis". That is, managers will endeavor to smooth dividends over time and not make substantial increases in dividends unless they can maintain the increased dividends in the foreseeable future. Lipson, Maquieira and Megginson (1998) observed that, "managers do not initiate dividends until they believe those dividends can be sustained by future earnings".

Agency Costs and Free Cash Flow Hypothesis of Dividend Policy

Manager’s interests are not necessarily the same as shareholders’ interests, and they might conduct actions that are costly to shareholders, such as consuming excessive perquisites or over-investing in managerially rewarding but unprofitable activities. Shareholders therefore incur (agency) costs associated with monitoring managers’ behavior, and these agency costs are an implicit cost resulting from the potential conflict of interest among shareholders and corporate managers. The payment of dividends might serve to align the interests and mitigate the agency problems between managers and shareholders, by reducing the discretionary funds available to managers (Rozeff, 1982, Easterbrook, 1984, Jensen, 1986, and Alli, Khan and Ramirez, 1993).

Also there could be a potential conflict between shareholders and bondholders. Shareholders are considered as the agents of bondholders’ funds. In this case, excess dividend payments to shareholders may be taken as shareholders expropriating wealth from bondholders (Jensen and Meckling, 1976). Shareholders have limited liability and they can access the company’s cash flow before bondholders; consequently, bondholders prefer to put constraints on dividend payments to secure their claims. Conversely, for the same reasons, shareholders prefer to have large dividend payments (Ang, 1987).

In an often-cited article, Easterbrook (1984) argued that dividends could be used to reduce the free cash flow in the hands of managers. In addition, Eastbrook hypothesised that dividend payments will oblige managers to approach the capital market to raise funds. In this case investment professionals such as bankers and financial analysts will also be able to monitor managers’ behavior. Therefore, shareholders are able to monitor managers at lower cost (and minimize any collective action problems). This suggests that dividend payments increase management scrutiny by outsiders and reduce the chances for managers to act in their own self-interest.

2.5 Corporate Finance Practices and Performance

Copeland (1979) argues that traditional financial theory asserts that the implementation of capital budgeting techniques will result in improved corporate performance. In finding the right measure of performance, pose a challenge to most researchers (Axelsson et al, 2002). However, they show that performance can be measured from either stock market information, accounting information or a combination of both.

Market Performance

Axelsson et al (2002) argue that the efficient market hypothesis is often used as a tool to create structure when analysing information contained in stock prices. They explain that the implication of efficient capital markets is that security prices fully reflect all available information.

Haka et al (1985) also use market information in order to determine the effect on a firm’s market performance of switching from naive to sophisticated capital budgeting selection procedures.

Haka et al (1985) justifies the use of a market performance measure based on the fact that the main reason for implementing sophisticated capital budgeting procedures is to maximize, or at least increase, shareholders’ wealth. According to them, measuring firm performance using accounting data is not necessarily consistent with the goal of shareholders’ wealth maximization. Other studies also deny the authenticity of the use of market performance as a measure of performance. For instance (Ross et al, 1999; Copeland, 1999) argue that managers’ objectives to a large extent involve growth in sales, personal prestige and power. They further argue that this problem of managers not acting in the best interest of the shareholders is referred to as the agency problem. Thus, they argue that if managers place a higher importance on return on capital and profit growth goals than on shareholders’ goals, superiority in performance might be most correctly measured using accounting information.

Accounting Performance

Other researchers also affirm the use of firm performance using accounting information.

Axelsson et al (2002) argue that accounting ratios are well-known and widely used tools for financial analysis. Thus "the computation of a ratio involves a simple arithmetical operation, its interpretation is a far more complex matter". According to Bernstein (1993), there are many criteria by which performance can be measured using accounting information. He argued that changes in sales, in profits, or in various measures of output are among the frequently used criteria. According to Bernstein (1993) the relationship between net income and the capital invested in the generation of that income (return on investment or ROI) is one of the most valid and most widely recognized measures of firm performance, in general, and in a capital budgeting context in particular. In using ROI, two common modified ROI investment measures are return on total assets (ROA) and return on stockholders’ equity (ROE). Thus, ROA is perhaps the best measure of the operating efficiency of a firm (Bernstein, 1993; Stickney & Brown, 1999).



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