Executive salaries have been shown to be more closely correlated to the size of
ID: 2769115 • Letter: E
Question
Executive salaries have been shown to be more closely correlated to the size of the firm than to its profitability. If a firm’s board of directors is controlled by management rather than outside directors, this might result in the firm’s retaining more earnings than can be justified from the stockholders’ point of view. Discuss those statements, being sure (1) to discuss the interrelationships among cost of capital, investment opportunities, and new investment and (2) to explain the implied relationship between dividend policy and stock prices.
Explanation / Answer
Internal stakeholders of the company are the board of directors, executives and other employees who guarantee the responsibility of the company and its working in a transparent manner. Board of directors needs sufficient skills and understanding so that their decisions are not bias to the company or in favor of the company. If Board of directors is controlled by internal management, it may be possible that their decisions are bias or in favor of the company and in that case transparency is affected. On the other hand if proper controlled is imposed on Board of directors then the chances are reduced to minimum. Interrelationship amongst cost of equity, new investment, and dividend policy and stock prices.
Investments are made so that their money is invested in best profitable area. Boards of directors have to take decisions on behalf of the shareholders and other people whose interest is involved in the company directly or indirectly.
When company declares dividend, price or market value of the firm increases. Thus, dividend and stock split or capital structure provide management a way to prove firm goodwill at a very low cost. Fluctuating dividend affect the company adversely and so it will have a negative impact in the cost of its equity and stock price. Board of directors and management should have such a policy of investment so that they can give a return more than what shareholders would have earned if they would have invested somewhere else. Companies with limited investment opportunities have flexible distribution of cash policy.
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