Corporate Value

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Introduction
• Objective of the existence of firm is shareholder wealth maximization
and acceptance or otherwise of proposed projects
• If managers unable to achieve returns at least as high as those
available elsewhere for the same level of risk, they are fail
• This required knowledge of the concepts of the time value of money
and the opportunity cost
• Applying opportunity cost of capital and focusing on the cash flow of
new projects rather than profit figures is merely skimming the surface
Introduction
• The complete one are following questions:
• How much money has been (or will be) placed in this business by investors?
• What rate of return is being (or will be) generated for those investors?
• Is this sufficient given the opportunity cost of capital?
• They about the entire organization or about a particular division,
strategic business unit or product line
• Ultimately every unit s hould be contributing to the well-being of
shareholders
Introduction
• Create true shareholder value-orientated company that can revolutionize almost
everything managers do
1. Instead of plans drawn up in terms of accounting budgets, with their vulnerability to
distortion and manipulation of ‘profit’ and ‘capital investment’, managers are encouraged
to think through their new strategies: what shareholders are interested in: cash inflow >
cash injected
2. Instead of being rewarded for accounting rates of return (and other ‘non-value’
performance measures, such as earnings per share and turnover), they are rewarded by
their contribute to shareholder value
3. Instead of directors accepting low cash-flow return—poorly performing subsidiary
because the accounting profits look satisfactory—they are forced to generated by either
closure and selling off the subsidiary’s assets or selling the operation to more satisfactory
return
4. There then follows a second decision: should the cash released be invested in other
activities or be given back to shareholders to invest elsewhere in the stock market? The
answers, uncomfortable for executives who prefer to expand rather than contract the
organisation.
Definition
• Value-based management is a managerial approach in which
the primary purpose is long-run shareholder wealth
maximisation.
• The objective of the firm, its systems, strategy, processes,
analytical techniques, performance measurements and
culture have as their guiding objective shareholder wealth
maximisation.
Why wealth-maximizing goal?
1. Many commercial companies put shareholder value in second or
third place behind other objectives
2. Growth in sales or market share, the return to the labour force, and
to society generally, no more worthy
3. Increasing threat of takeover by teams of managers searching for
poorly managed businesses. Perhaps at present running a
competitor firm or are wide-ranging ‘corporate raiders’ ready to
swoop on under-managed firms through radical strategic change,
divestiture and shifting of executive incentives, can create more
value for shareholders.
Confusing objectives

• Some managers claim shareholder wealth same as firm perfomence

such as customer satisfaction, market share leadership or lowest cost
producer
• These proxies are then set as ‘strategic objectives’.
• In many cases achieving these goals does go hand in hand with
shareholder returns but, there is frequently a trade-off between
shareholder value and these proxy goals.
Share holder value VS Market share
 Three steps of value
• There are three steps to creating shareholder value
1. Create awareness of shareholder wealth through mission throughout the
organisation.
2. Put in place techniques for measuring value at various organisational levels,
and make sure everyone understands and respects.
3. Ensure that every aspect of management is suffused with the shareholder
value objective, from human resource management to research and
development; from target setting to the allocation of resources
• Clearly important to have a management team that both understand and fully committed
o shareholder value
• To implement it manager need to know how to measure the wealth-creating potential of
their actions.
The three steps of value-
based management
Earnings-based management
• Traditional accounting-based performance measure of earnings per share (EPS)
• EPS is not a holy grail in determining how well a company is performing.
• This is not merely because management still have latitude in deciding what
earnings to report; it is because EPS growth says little about whether a
company is investing shrewdly and managing its assets effectively.
• There are many reasons why earnings can mislead in the measurement of
value creation:
1. Accounting is subject to distortions and manipulations;
2. The investment made is often inadequately represented;
3. The time value of money is excluded from the calculation;
4. Risk is not considered.
Accounting numbers
• Accountants have to make judgements and choose a basis for their
calculations.
• They try to match costs and revenues.
• Unfortunately, there can be many alternative approaches, which give
completely different results, and yet all follow accounting body
guidelines.
• Accountant at X views the machinery has life of ten years and 25%
declining depreciation.
• Accountant at Y judges that a seven-year life with straight-line
depreciation more true
Ignoring the investment money
sacrificed
• Examining earnings per share growth as an indicator of success fails to
take account of the investment needed to generate that growth
• Case of companies A and B, both of which have 10% growth in EPS
• B has to offer much more generous terms than A to gain sales;
therefore it has to invest cash
• B is also less efficient in its production process and has to invest larger
amounts in inventory for every unit increase in sales
Time value of money
• It is possible growth in earnings destroy value if the rate of return
earned on the additional investment is less than the required rate
• Case:
• A team of managers trying to decide to make a dividend payment of £10 m.
• If they retained within the business, both earnings and cash flow would rise by
£1,113,288 for each of the next ten years
• By earnings growth, manager tempted to omit the dividend payment
• Future earnings would rise and therefore the share price also rise on the
announcement that the dividend would not be paid
• Wrong! Investors likely to have a higher annual required rate of returnon their
£10 m than the 2% offered by this plan (A ten-year annuity of £1,113,288 per
year for a £10m investment at time 0 has an effective annual rate of return of
about 2%).
• The share price (in a rational market) will fall and shareholder value will be
destroyed
Time value of money
• What the managers forgot was that money has a time value and
investors value shares on the basis of discounted future cash flows.
• It seems so obvious 2% rate of return on invested money is serving
shareholders badly
• Many companies holding cash rather than giving it back to
shareholders to invest elsewhere. Why?
• Gives managers security in case company be liquidated and they lose their
jobs
• It is easy to increase EPS just by holding larger money
• Variation on growing EPS by acquire other companies in low PER
Ignoring risk
• Focusing purely on the growth in earnings fails to take account of another
aspect of the quality of earnings: risk.
• Increased profits also subject to higher levels of risk require a higher
discount rate.
• Case:
• Firm is contemplating two alternative growth options with the same expected
earnings, of £100,000 per year to infinity.
• Each strategy is subject to risk, but S has wider dispersion outcomes than T
• Investors are likely to value strategy T more highly than strategy S.
• Examining crude profit figures, either historic or projected, often means a
failure to allow adequately for risk.
• In a value based approach it is possible to raise the discount rate in
circumstances of greater uncertaint
Other measurements
• It is clear that simply examining profit figures is not enough for good
decision making and performance evaluation.
• The amount of capital invested has to be considered
• This was recognised long before the development of value-based
management
• A signified by the widespread use of a ratio of profits to assets
employed
• Return on capital employed (ROCE)
• Return on investment (ROI)
• Rreturn on equity (ROE)
• Accounting rate of return (ARR)
Other Measurements
• They still the same root
• They provide a measure of return as a percentage of resources
devoted.
• The major problem with using these metrics of performance is that
they are still based on accounting data.
• The profit figure calculations are difficult enough, but when they are
combined with balance sheet asset figures we have a recipe for
unacceptable distortion
Business Value Creation
• Value is created when investment produces a rate of return greater
than that required or return for the risk class of the investment
• Value is driven by the four factors
• The difference between the second and third elements creates the
performance spread
• The spread is measured as a percentage spread above or below the
required rate of return, given the finance provider’s opportunity cost
of capital
• The amount of value is determined by the quantity of capital invested
multiplied by the performance spread
The Four Factors Ditermine Value
• Black plc has:
• Required rate of return of 14% per annum
• Actually produces 17% on an investment
• Investmeny £1,000,000
• Value creation is £30,000 of value per year:

• Annual value creation = Investment × (Actual return – Required

return)
= I (r – k)
= £1,000,000 × (0.17 – 0.14) = £30,000
Attentions
• The fourth element needs more explanation. It unreasonable to
assume that positive or negative return spreads will be maintained for
ever
• If return spreads negative, managers will take the necessary action to
prevent continued losses. If they fail to respond shareholders will take
the steps: sackings or acceptance of a merger
• Positive spreads arise as a result of a combination of the
attractiveness of the industry and the competitive strength of a firm
within that industry
• High returns can be earned because of market imperfections (firm
may be able to prevent competitors entering its market)
Attentions
• In shareholder value analysis it is usually assumed returns will be
driven towards the required rate of return.
• Beyond some point in the future (the planning horizon) any new
investment will, on average, earn only the minimum acceptable rate of
return.
• There are some remarkable businesses that seem to be able to
maintain positive performance spreads for decades
• Such companies ‘Inevitables’ because there is believe they will be
dominating their industries
• For the majority of businesses their value consists of two components
• In the second period (after the planning horizon), even if investment
levels are doubled, corporate value will remain constant as the
discounted cash inflows (to time zero) associated with that
investment exactly equal the discounted cash outflows (to time zero)
• If assumed Black plc can maintain its 3 per cent return spread for ten
years and pays out all as dividends then its future cash flows will look
like this:
• Alternative approach: the firm value is equal to the initial investment
(£1,000,000) plus the present value of all the values created annually
The five actions for creating
value
• Good growth occurs when a business unit or an entire corporation
obtains a positive spread on the new investment capital.
• Bad growth, occurs when managers invest in strategies that produce
negative return spreads.
• This can so easily happen if the focus of attention is on sales and earnings
growth
• Managers encouraged to believe that their job is to expand the
business and improve the bottom line
• Acceptance bad growth in profits is a problem.
• Growing profits on a larger Investment base an incremental return
less than the incremental cost of capital
 To expand or not to expand?
• Assume the firm consists of two divisions: a clothing factory and a toy
import business.
• Each business use £500,000 of assets (at market value).
• Clothing division produce 11% return per annum next ten years
• Toy division produce 23% per annum return the same period.
• The ten-year planning horizon both divisions produce returns equal to
their risk-adjusted required return: Clothing division 13%, and for
more risky toy division 15%
To expand or not to expand?
• Despite the higher return, toy division creates value
for the next ten years a 15% return plus shareholder
bonus of £40,000. This division could fit into the top
left box
• To pass up positive return spread investments would
be to sacrifice valuable opportunities and enter the
top right box
• The clothing operation does not produce returns
sufficient to justify its present level of investment.
• Best option is scaling down or withdrawal from the
market
1. Increase the return on
existing capital
• Value of Black of £1,000,000 + £156,481 could be increased if the
management implemented a plan to improve the efficiency.
• If the rate of return on investment over the next ten years raised to
18% then the firm’s value rises to £1,208,644:
2. Raise investment in positive
spread units
• If Black could obtain £500,000 with a required rate of return of 15% to
invest in toy division to produce a 23%, the value would rise to
£1,847,242:
3. Divest assets
• If Black could close its clothing division, release £500,000 to expand
the toy division and achieve returns of 23%, the transferred
investment then increases value dramatically:
4. Extend the planning horizon
• The toy division get exclusive import licence, closing the door on the entry of
competitors
• Suppose the toy division now produce spread of 23% for a 15-year
• The value will rise to £1,179,634:
5. Lower the required rate of
return
• Lower the required rate of return by adjusting the proportion of debt to equity in
the capital structure or by reducing business risk.
• Suppose that Black can lower its required rate of return by shifting to a higher
proportion of debt, so overall rate falls to 12%.
• Then the value of the firm rises to £1,282,510.