Banks start charging high interest rates for lending that becomes restrictive and selective. This impacts money (credit) market as mortgages becomes expensive. Stock markets start fluctuating wildly. Savings get reduced affecting pensioners a great deal. Use of credit cards becomes costlier. Foreclosures of mortgages and repossession of mortgaged properties become frequent feature of credit market, and worst the rate of bankruptcy rises.
Credit crunch does not necessarily mean a period of recession. It is in fact a voluntary extension or interruption of monetary policy pursued by the federal bank. The success of any monetary policy depends upon attitude of lending institutions. 'Even if Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers, and the result is credit crunch.'(Jeff Madura, page 93)1. The government some times introduces a sort of restrictive monetary policy that accentuates credit crunch. Jeff Madura (page 93) while explaining the effects of restrictive monetary policy states that 'as the money supply is reduced, and interest rates rise, some potential borrowers may be unable to obtain loans because interest payments would be too high. Thus the effects of restrictive monetary policy are magnified because higher interest rates not only discourage some potential borrowers but also prevent others from obtaining loans. Overall the credit crunch may partially offset the desired effects of a simulative monetary policy and magnify the restrictive monetary policy.'
The prime objective of every company these days is to create and enhance the shareholders' value. Let us first understand the meaning of the term 'shareholders' value' before analyzing the effects of credit crunch on shareholders' value. Shareholder makes investment in order to earn good dividends and capital gains when shareholder happens to sell the investment. In other words a shareholder is concerned about cash flows he receive from the investment and also about the appreciation of the value of investment that will result in after tax future cash flows. Ultimately the value of an investment is related to cash flows from such investment.
Cash flows are connected directly to profitability of the firm and thus cash payout can be increased by increasing profitability. 'Since investors value cash payouts, managers increase shareholders value when they increase the present value of the firm's net cash flows, primarily by finding new ways to either increase revenues or reduce costs. Generating more cash or receiving it earlier increases shareholders value. Manipulating the timings of sales or expenses to increase reported earnings, however, will actually decrease shareholders value if it reduces the cash that can ultimately be paid out to shareholders.'(James A. Brickley, Clifford W. Smith, and Jerold L., page 23)2 It can be said that profitability that generates more cash flows in fact add to shareholders value, and vice versa. The focus is on cash payouts or cash flows on investments of shareholders. Also it is clear that profitability or growth of the company, that is ultimately important to generate cash flows, is the vital factor that affects the shareholders' value.
Growth of a company is directly related to general upward economic