Corporate Financial Policy and Shareholders Return
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Transcript of Corporate Financial Policy and Shareholders Return
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CHAPTER 1: SUMMARY
Competitor, or peer, firms play a central role in shaping a variety of
corporate policies ranging from executive compensation to product
market strategy. However, most research on corporate financial
policy assumes that firms choose their capital structures
independently of their peers. That is, researchers typically assume
that a firm's capital structure is determined by a function of its
marginal tax rate, expected deadweight loss in default, information
environment, or incentive conflicts among claimants. Thus, the role
for competitor firms' behavior in affecting corporate capital structures
is often ignored, or at most an implicit one through its unmeasured
impact on these firm specific determinants.
Corporate liquidity comes at a cost, however, since interest earned
on corporate cash reserves is often taxed at a higher rate thaninterest earned by individuals. Furthermore, cash may provide funds
for managers to invest in projects that offer non-pecuniary benefits
but destroy shareholder value.
Firms that face greater financing constraints, especially those with
valuable investment opportunities, the marginal value of cash should
be higher than for firms that can easily raise additional capital. While
financial constraints are often associated with information
asymmetries between firms and capital providers, they can be
thought of as tantamount to higher transactions costs in accessing
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external capital. In such a context, an additional dollar of internal
funds enables a constrained firm to avoid these higher costs of
raising funds, thereby, rendering additional internal funds relatively
more valuable.
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CHAPTER 2: INTRODUCTION
Financial Management is nothing but management of the limited
financial resources the organization has, to its utmost advantage.
Resources are always limited, compared to its demands or needs.
This is the case with every type of organisation. Proprietorship or
limited company, be it public or private, profit oriented or even non-
profitable organisation.
2.1 Finance function importance
In general, the term Finance is understood as provision of funds as
and when needed. Finance is the essential requirement sine qua
non of every organisation.
Required Everywhere: All activities, be it production, marketing,
human resources development, purchases and even research and
development, depend on the adequate and timely availability of
finance both for commencement and their smooth continuation to
completion. Finance is regarded as the life-blood of every business
enterprise.
Efficient utilization More Important: Finance function is the most
important function of all business activities. The efficient management
of business enterprise is closely linked with the efficient management
of its finances. The need of finance starts with the setting up of
business. Its growth and expansion require more funds. The funds
have to be raised from various sources. The sources have to be
selected keeping in relation to the implications, in particular, risk
attached. Rising of money, alone, is not important. Terms and
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conditions while raising money are more important. Cost of funds is
an important element. Its utilization is rather more important. If funds
are utilised properly, repayment would be possible and easier, too.
Care has to be exercised to match the inflow and outflow of funds.
Needless to say, profitability of any firm is dependent on its cost as
well as its efficient utilization.
2.2 Financial management
The term financial management has been defined, differently, by
various authors. Some of the authoritative definitions are given below:
Financial Management is concerned with the efficient use of an
important economic resource, namely, Capital Funds Solomon
Financial Management is concerned with the managerial decisions
that result in the acquisition and financing of short-term and long-term
credits for the firm
Phillioppatus
Business finance is that business activity which is concerned with
the conservation and acquisition of capital funds in meeting financial
needs and overall objectives of a business enterprise Wheeler
Financial Management is the process of financial-decisions. There
are three types of financial decisions:
Financing Decisions: such decisions involve estimating the
requirement of funds, deciding about leverage, evaluating various
sources of finance and finally raising the finance in such a way
that the cost of capital is minimum and the risk is at optimum level.
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Investment Decisions: such decisions involve investments in
working capital and fixed assets and evaluating the projects under
consideration. The management should be guided by getting the
maximum return by keeping the risk at optimum level.
Dividend Decisions: such decisions involve the consideration of
profit, liquidity, shareholder requirements, tax aspect and need of
the funds for reinvestment purposes. The management has to
decide about retaining the funds for further investment plans
without compromising the various income requirements of
innumerable shareholders.
The aim of a company is to create value for its shareholders.
Although the other stake holders are also important, the shareholder
is the most important stakeholder. The overall objective of the
financial Management is to apply the financial management policies
and principles for maximizing the wealth of the shareholders in the
long run. This can be achieved by maximizing the EPS and keeping
the risk at optimum levels.
The shareholders expect a rate of return based on the risk they
perceive. By maximizing their wealth we mean providing better than
the return they expect. How can a company earn more than the
return the shareholders and other stake holders expect in a hard-core
competitive arena? The answer is that this can be achieved by
creating a sustainable competitive advantage through exploiting the
market imperfections tapping the opportunities and identifying the
possible threats in advance. Also all the market players do not have
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same expectations and risk perception and it is here the financial
Management blooms i.e. they create value for shareholders through
appropriate level of trading on equity.
2.3 Nature of financial management
Financial management refers to that part of management activity,
which is concerned with the planning and controlling of firms financial
resources. Financial management is a part of overall management.
All business decisions involve finance. Where finance is needed, role
of finance manager is inevitable. Financial management deals with
raising of funds from various sources, dependant on availability and
existing capital structure of the organization. The sources must be
suitable and economical to the organization. Emphasis of financial
management is more on its efficient utilization, rather than raising of
funds, alone. The scope and complexity of financial management has
been widening, with the growth of business in different diverse
directions. As business competition has been increasing, with agreater pace, support of financial management is more needed, in a
more innovative way, to make the business grow, ahead of others.
2.4 Aims of finance function
The following are the aims of finance function:
Acquiring Sufficient and Suitable Funds: The primary aim of finance
function is to assess the needs of the enterprise, properly, and
procure funds, in time. Time is also an important element in meeting
the needs of the organization. If the funds are not available as and
when required, the firm may become sick or, at least, the profitability
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of the firm would be, definitely, affected. It is necessary that the funds
should be, reasonably, adequate to the demands of the firm. The
funds should be raised from different sources, commensurate to the
nature of business and risk profile of the organization. When the
nature of business is such that the production does not commence,
immediately, and requires long gestation period, it is necessary to
have the long-term sources like share capital, debentures and long
term loan etc. A concern with longer gestation period does not have
profits for some years. So, the firm should rely more on the
permanent capital like share capital to avoid interest burden on the
borrowing component.
Proper utilization of Funds:Raising funds is important, more than that
is its proper utilization. If proper utilization of funds were not made,
there would be no revenue generation. Benefits should always
exceed cost of funds so that the organization can be profitable.
Beneficial projects only are to be undertaken. So, it is all the more
necessary that careful planning and cost-benefit analysis should be
made before the actual commencement of projects.
Increasing Profitability: Profitability is necessary for every
organization. The planning and control functions of finance aim at
increasing profitability of the firm. To achieve profitability, the cost of
funds should be low. Idle funds do not yield any return, but incur cost.
So, the organization should avoid idle funds. Finance function also
requires matching of cost and returns of funds. If funds are used
efficiently, profitability gets a boost.
Maximising Firms Value: The ultimate aim of finance function is
maximizing the value of the firm, which is reflected in wealth
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maximization of shareholders. The market value of the equity shares
is an indicator of the wealth maximization.
2.5 Functions of finance
Finance function is the most important function of a business.
Finance is, closely, connected with production, marketing and other
activities. In the absence of finance, all these activities come to a halt.
In fact, only with finance, a business activity can be commenced,
continued and expanded. Finance exists everywhere, be it
production, marketing, human resource development or undertaking
research activity. Understanding the universality and importance of
finance, finance manager is associated, in modern business, in all
activities as no activity can exist without funds. Financial Decisions or
Finance Functions are closely inter-connected. All decisions mostly
involve finance. When a decision involves finance, it is a financial
decision in a business firm. In all the following financial areas of
decision-making, the role of finance manager is vital. We can classify
the finance functions or financial decisions into four major groups:
1. Investment Decision or Long-term Asset mix decision
2. Finance Decision or Capital mix decision
3. Liquidity Decision or Short-term asset mix decision
4. Dividend Decision or Profit allocation decision
Investment Decision
Investment decisions relate to selection of assets in which funds are
to be invested by the firm. Investment alternatives are numerous.
Resources are scarce and limited. They have to be rationed and
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discretely used. Investment decisions allocate and ration the
resources among the competing investment alternatives or
opportunities. The effort is to find out the projects, which are
acceptable. Investment decisions relate to the total amount of assets
to be held and their composition in the form of fixed and current
assets.Both the factors influence the risk the organisation is
exposed to. The more important aspect is how the investors perceive
the risk. The investment decisions result in purchase of assets.
Assets can be classified, under two broad categories:
Long-term investment decisions: The long-term capital decisions are
referred to as capital budgeting decisions, which relate to fixed
assets. The fixed assets are long term, in nature. Basically, fixed
assets create earnings to the firm. They give benefit in future. It is
difficult to measure the benefits as future is uncertain. The investment
decision is important not only for setting up new units but also for
expansion of existing units. Decisions related to them are, generally,
irreversible. Often, reversal of decisions results in substantial loss.
When a brand new car is sold, even after a day of its purchase, still,
buyer treats the vehicle as a second-hand car. The transaction,
invariably, results in heavy loss for a short period of owning. So, the
finance manager has to evaluate profitability of every investment
proposal, carefully, before funds are committed to them.
Short-term investment decisions: The short-term investment
decisions are, generally, referred as working capital management.
The finance manger has to allocate among cash and cash
equivalents, receivables and inventories. Though these current
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assets do not, directly, contribute to the earnings, their existence is
necessary for proper, efficient and optimum utilization of fixed assets.
Finance Decision
Once investment decision is made, the next step is how to raise
finance for the concerned investment. Finance decision is concerned
with the mix or composition of the sources of raising the funds
required by the firm. In other words, it is related to the pattern of
financing. In finance decision, the finance manager is required to
determine the proportion of equity and debt, which is known as
capital structure. There are two main sources of funds, shareholders
funds (variable in the form of dividend) and borrowed funds (fixed
interest bearing). These sources have their own peculiar
characteristics. The key distinction lies in the fixed commitment.
Borrowed funds are to be paid interest, irrespective of the profitability
of the firm. Interest has to be paid, even if the firm incurs loss and this
permanent obligation is not there with the funds raised from the
shareholders. The borrowed funds are relatively cheaper compared
to shareholders funds, however they carry risk. This risk is known as
financial risk i.e. Risk of insolvency due to non-payment of interest or
non-repayment of borrowed capital. On the other hand, the
shareholders funds are permanent source to the firm. The
shareholders funds could be from equity shareholders or preference
shareholders. Equity share capital is not repayable and does not
have fixed commitment in the form of dividend. However, preference
share capital has a fixed commitment, in the form of dividend and is
redeemable, if they are redeemable preference shares. Barring a few
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exceptions, every firm tries to employ both borrowed funds and
shareholders funds to finance its activities. The employment of these
funds, in combination, is known as financial leverage. Financial
leverage provides profitability, but carries risk. Without risk, there is
no return. This is the case in every walk of life! When the return on
capital employed (equity and borrowed funds) is greater than the rate
of interest paid on the debt, shareholders return get magnified or
increased. In period of inflation, this would be advantageous while it
is a disadvantage or curse in times of recession.
Return on equity (ignoring tax) is 20%, which is at the expense of
debt as they get 7% interest only. In the normal course, equity would
get a return of 15%. But they are enjoying 20% due to financing by a
combination of debt and equity. The finance manager follows thatcombination of raising funds which is optimal mix of debt and equity.
The optimal mix minimizes the risk and maximizes the wealth of
shareholders.
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Liquidity Decision
Liquidity decision is concerned with the management of current
assets. Basically, this is Working Capital Management. Working
Capital Management is concerned with the management of current
assets. It is concerned with short-term survival. Short term-survival is
a prerequisite for long-term survival. When more funds are tied up in
current assets, the firm would enjoy greater liquidity. In consequence,
the firm would not experience any difficulty in making payment of
debts, as and when they fall due. With excess liquidity, there would
be no default in payments. So, there would be no threat of insolvency
for failure of payments. However, funds have economic cost. Idle
current assets do not earn anything. Higher liquidity is at the cost of
profitability. Profitability would suffer with more idle funds. Investment
in current assets affects the profitability, liquidity and risk. A proper
balance must be maintained between liquidity and profitability of the
firm. This is the key area where finance manager has to play
significant role. The strategy is in ensuring a trade-off between
liquidity and profitability. This is, indeed, a balancing act and
continuous process. It is a continuous process as the conditions and
requirements of business change, time to time. In accordance with
the requirements of the firm, the liquidity has to vary and in
consequence, the profitability changes. This is the major dimension of
liquidity decision working capital management. Working capital
management is day to day problem to the finance manager. His skills
of financial management are put to test, daily.
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Dividend Decision
Dividend decision is concerned with the amount of profits to be
distributed and retained in the firm.
Dividend: The term dividend relates to the portion of profit, which is
distributed to shareholders of the company. It is a reward or
compensation to them for their investment made in the firm. The
dividend can be declared from the current profits or accumulated
profits. Which course should be followed dividend or retention?
Normally, companies distribute certain amount in the form of
dividend, in a stable manner, to meet the expectations of
shareholders and balance is retained within the organisation for
expansion. If dividend is not distributed, there would be great
dissatisfaction to the shareholders. Non-declaration of dividend
affects the market price of equity shares, severely. One significant
element in the dividend decision is, therefore, the dividend payout
ratio i.e. what proportion of dividend is to be paid to the shareholders.
The dividend decision depends on the preference of the equity
shareholders and investment opportunities, available within the firm.
A higher rate of dividend, beyond the market expectations, increases
the market price of shares. However, it leaves a small amount in the
form of retained earnings for expansion. The business that reinvests
less will tend to grow slower. The other alternative is to raise funds in
the market for expansion. It is not a desirable decision to retain all the
profits for expansion, without distributing any amount in the form of
dividend. There is no ready-made answer, how much is to be
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distributed and what portion is to be retained. Retention of profit is
related to
Reinvestment opportunities available to the firm.
Alternative rate of return available to equity shareholders, if they
invest themselves.
2.6 Corporate finance
Corporate finance is the field of finance dealing with financial
decisions that business enterprises make and the tools and analysis
used to make these decisions. The primary goal of corporate financeis to maximize corporate value while managing the firm's financial
risks. Although it is in principle different from managerial finance
which studies the financial decisions of all firms, rather than
corporations alone, the main concepts in the study of corporate
finance are applicable to the financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions
and techniques. Capital investment decisions are long-term choices
about which projects receive investment, whether to finance that
investment with equity or debt, and when or whether to pay dividends
to shareholders. On the other hand, short term decisions deal with
the short-term balance of current assets and current liabilities; the
focus here is on managing cash, inventories, and short-termborrowing and lending (such as the terms on credit extended to
customers).
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The terms corporate finance and corporate financier are also
associated with investment banking. The typical role of an investment
bank is to evaluate the company's financial needs and raise the
appropriate type of capital that best fits those needs. Thus, the terms
corporate finance and corporate financier may be associated with
transactions in which capital is raised in order to create, develop,
grow or acquire businesses.
The field of corporate finance has undergone a tremendous mutation
in the past twenty years. A substantial and important body of
empirical work has provided a clearer picture of patterns of corporate
financing and governance, and of their impact for firm behavior and
macroeconomic activity. To the extent that financial claims returns
depend on some choices such as investments, these choices, in the
complete market paradigm are assumed to be contractible and
therefore are not affected by moral hazard. Furthermore, investors
agree on the distribution of a claims returns; that is, financial markets
are not plagued by problems of asymmetric information. The key
issue for financial economists is the allocation of risk among investors
and the pricing of redundant claims by arbitrage.
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2.7 Role of finance in corporate strategy
The role of finance is obviously greater in financing decisions.
Finance plays a major role in formulating the financing strategy,
evaluating the alternatives, and monitoring the outcomes. The
objective of the financing strategy is to raise capital at the lowest cost,
which in turn increases shareholder value. At first glance, it might
appear that these decisions are the purview of the CFO and others
need not get involved in them. However, just as operating decisions
have an impact on financing policies, so financing decisions can
affect operating strategies. For example, a company whose financing
decisions have led it into too much debt might not have the financial
flexibility to raise capital quickly enough for needed growth. Or, on a
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positive note, a company whose financial policies include good risk
management might be able to create a competitive advantage for
itself by offering products that limit customer risk as well. Therefore, a
general manager with a clear understanding of financial policies can
leverage them to create value for shareholders. The role of finance in
performance evaluation is identical to its role in operating decisions:
valuation and monitoring.
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CHAPTER 3: FINANCIAL POLICY
In the simplest terms, financial policy relates to two key choices that
firms make:
How much of their capital structure to support by debt, rather than
equity
How much of their earnings to retain for use as internal equity
finance, rather than distributing dividends and raising new equity in
the market.
A portfolio consisting of a little risky equity and a lot of safe debt
should have the same value as a second portfolio with a lot of less
risky equity and a little safe debt if the underlying risk of the two
portfolios is comparable. We should go beyond terms like debt and
equity to consider the characteristics of the claims themselves. Over
the years, this lesson has been emphasized by the evolution of
financial instruments such as leases, which may act as substitutes fordebt, and options, the valuation of which can, once again, be
understood by constructing comparable portfolios with and without
options and requiring that they have the same value.
A challenge to analyzing the impact of taxation on firm decisions,
though, is that the tax system is based in large part on formal labels,
and only indirectly on underlying asset characteristics. Thus, equity
faces one set of tax rules and debt another, often more favorable, so
special rules are needed regarding the treatment of the risky debt that
more closely resembles equity. Equity repurchases are treated more
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favorably than are dividends but, again; restrictions exclude from this
favorable treatment share redemptions that too closely resemble
dividends. Evaluating the impact of taxes on firm behavior requires
that we understand the rules that apply in distinguishing among
different types of assets. Financial policy decisions often amount to
choosing the optimal trade-off between distortions to financial policy
and the tax benefits such distortions generate. Indeed, a major tax
avoidance activity consists of trying to improve this trade-off,
constructing assets and transactions to permit corporations to
characterize their financial decisions in a manner most favorable from
the tax standpoint. The impact of taxation, then, depends not only on
the tax system itself, but also on where the tax systems definitional
lines are drawn and how well they can be moved through tax
avoidance activity.
3.1 Corporate Strategy
Value creation is at the heart of corporate strategy.
Strategies are means to ends. Corporate Strategy is supposed to be
the means by which an organization achieves and sustains success.
It is about enabling an organization to achieve and sustain superior
overall performance and returns. It involves the activities of:
Defining and refining the corporate vision, mission and objectives
Problem identification
Alternatives generation
Evaluation/selection
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It is a core responsibility of the top management including CEO, CFO
and the Directors.
There are three levels of corporate strategy:
(i) Corporate level,
(ii) Business level, and
(iii) Functional level.
Corporate (Top) level managers decide what businesses to invest.
Decisions regarding the sources of funds and their allocation are also
taken at this level. This level strategy focuses on two dimensions:
Growth
Liquidity
Growth dimension refers to growth in sales, growth in assets and
growth of growth opportunities. The top level managers would need
to plan what types of growth strategies suit their market orientation.
They will need to effectively choose the optimal growth strategy from
the various alternatives like expansion into existing businesses,
diversification into new businesses, modes of growth, internal
development, acquiring firms, and collaborative ventures. Liquidity
refers to level of cash flows required to the business efficiently.
Business level strategy lays down the ways in which a company
would seek to attain competitive advantage through effective
positioning. Forming a successful business strategy involves creating
a first-rate competitive strategy. It concerns strategic decisions about
choice of products, quality of products, meeting needs of customers,
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gaining advantage over competitors, exploiting or creating new
opportunities etc. The strategy needs to be frequently reviewed
against prevailing external and internal environment Functional level
strategies are those strategies that are initiated by support centers of
an organization like human Relations department, IT department. To
be competitively superior to other firms, functional level managers
strategize to attain superior efficiency, superior quality, superior
customer responsiveness, and superior innovation.
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CHAPTER 4: CORPORATE FINANCIAL POLICIES
Corporate financial policy determines how the corporation will invest
its funds (the investment decision), how the corporation will obtain
money to purchase assets (the financing decision), and what it will do
with its net income (the dividend decision). These three types of
decisions are made in concert to maximize the value of the firm.
4.1 Investment Decision
Financial policy begins with the investment decision---if the companycannot identify profitable investments, it will not need to raise funds.
In deciding whether to invest in an asset, a company will value the
cash flows it projects the asset will earn, net of the cost of the asset.
Because the cash flows will be received over time, the company has
to account for the time value of money and the riskiness of the cash
flows. It does so by "discounting" the cash flows at a "discount" or
"hurdle" rate.
4.2 Discount Rates
Discount rates have two components: one reflects the current riskless
interest rates (normally taken to be the rate of return on Treasury
bonds, termed Rf) and the other reflects the riskiness of the business.
The "risk premium," or the difference between the discount rate and
the riskless rate, also has two components: the required risk premium
on the market as a whole (termed Rm) and the co-movement of the
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company's returns with the returns on the market as a whole (termed
beta).
4.3 Financing Decision
There are two types of financing decisions made by corporations:
how to fund asset purchases and how to fund the daily operations. In
terms of funding daily operations, firms often operate on lines of
credit from banks or other financial institutions and may issue short-
term commercial paper. In terms of funding asset purchases, firms
generally go to 'the market,' and issue either corporate bonds orequity securities.
4.4 Long-Term Debt and Equity
Corporations do not directly issue corporate bonds and equity
securities; rather, these issues are "underwritten" by investment
banks. The banks are responsible for setting interest rates for bonds
and prices for stocks and are responsible for the actual selling of the
securities. The investment banks are generally responsible for
purchasing any of the issue that cannot be sold at the announced
price.
4.5 Long-Term Debt
Corporate bonds tend to be long-term instruments (30 years is not
uncommon) and pay interest rates that are above those paid by the
U.S. Treasury. Corporate bonds are "rated" by agencies such as
Moody's in terms of their riskiness: a bond rated Aaa is safer than a
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bond rated Baa, which is safer than one rated Bbb. The better the
rating on the bond, the lower will be the required interest rate, all
other things equal.
4.6 Equity
There are two types of equity securities: common stock and preferred
stock. Common stock represents an ownership share in the
corporation. Common shareholders have a right to vote at
shareholder meetings and may or may not receive dividends from the
company. The value of their shares will fluctuate depending on thefortunes of the company and the economy a whole. Preferred stock is
non-voting stock on which dividends are paid at a contractual rate
and may be convertible into common stock.
4.7 Dividend Decision
Companies can do two things with their net income: invest it in the
business or pay it to shareholders. Monies that are reinvested in the
business are termed "retained earnings." Companies can pay money
to shareholders in two ways: they can pay dividends, or they can
repurchase stock from shareholders. Some companies are known for
paying consistent dividends, whereas other companies pay no
dividends.
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CHAPTER 5: THEORIES
5.1 Efficient Market Theory
The efficient market hypothesis holds that a market is efficient if it is
impossible to make economic profits by trading on available
information. Cowles (1933) documents the inability of forty-five
professional agencies to forecast stock price changes. Other early
work in the field by statisticians such as Working (1934), Kendall
(1953), and Osborne (1959; 1962) document that stock and
commodity prices behave like a random walk, that is, stock price
changes behave as if they were independent random drawings. This
means that technical trading rules based on information in the past
price series cannot be expected to make above-normal returns.
Samuelson (1965) and Mandelbrot (1966) provide the modern
theoretical rationale behind the efficient markets hypothesis thatunexpected price changes in a speculative market must behave as
independent random drawings if the market is competitive and
economic trading profits are zero. They argue that unexpected price
changes reflect new information. Since new information by definition
is information that cannot be deduced from previous information, new
information must be independent over time. Therefore, unexpected
security price changes must be independent through time if expected
economic profits are to be zero. In the economics literature, this
hypothesis has been independently developed by Muth (1961).
Termed the rational expectations hypothesis, it has had a dramatic
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impact on macroeconomic analysis. The efficient markets hypothesis
is perhaps the most extensively tested hypothesis in all the social
sciences. An important factor leading to the substantial body of
empirical evidence on this hypothesis is the data made available by
the establishment of the Center for Research in Security Prices
(CRSP) sponsored by Merrill Lynch at the University of Chicago. The
center created accurate computer files of monthly closing prices,
dividends, and capital changes for all stocks on the New York Stock
Exchange since 1926 and daily closing prices of all stocks on the
New York and American stock exchanges since 1962 [Lorie and
Fisher (1964) describe the basic data and its structure.] Consistent
with the efficient markets hypothesis, detailed empirical studies of
stock prices indicate that it is difficult to earn above-normal profits by
trading on publicly available data because it is already incorporated
insecurity prices. Fama (1970; 1976) provides reviews of the
evidence. However the evidence is not completely one-sided; see, for
example, Jensen (1978), who provides a review of some anomalies.
If capital markets are efficient, then the market value of the firm
reflects the present value of the firms expected future net cash flows,
including cash flows from future investment opportunities. Thus the
efficient markets hypothesis has several important implications for
corporate finance. First, there is no ambiguity about the firms
objective function: managers should maximize the current market
value of the firm. Hence management does not have to choose
between maximizing the firms current value or its future value, and
there is no reason for management to have a time horizon that is too
short. Second, there is no benefit to manipulating earnings per share.
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Management decisions that increase earnings but do not affect cash
flows represent wasted effort. Third, if new securities are issued at
market prices which reflect an unbiased assessment of future
payoffs, then concern about dilution or the sharing of positive net
present value projects with new security holders is eliminated. Fourth,
security returns are meaningful measures of firm performance. This
allows scholars to use security returns to estimate the effects of
various corporate policies and events on the market value of the
corporation. Beginning with the Fama, Fisher, Jensen and Roll (1969)
analysis of the effect of stock splits on the value of the firms shares,
this empirical research has produced a rich array of evidence to
augment positive theories in corporate finance.
5.2 Portfolio Theory
Prior to Markowitz (1952; 1959), little attention was given to portfolio
selection. Security analysis focused on picking undervalued
securities; a portfolio was generally taken to be just an accumulation
of these securities. Markowitz points out that if risk is an undesirable
attribute for investors, merely accumulating predicted winners is a
poor portfolio selection procedure because it ignores the effect of
portfolio diversification on risk. He analyzes the normative portfolio
question: how to pick portfolios that maximize the expected utility of
investors under conditions where investors choose among portfolios
on the basis of expected portfolio return and portfolio risk measured
by the variance of portfolio return. He defines the efficient set of
portfolios as those which provide both maximum expected return for a
given variance and minimum variance for a given expected return.
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His mean-variance analysis provides formal content to the meaning
of diversification, a measure of the contribution of the covariance
among security returns to the riskiness of a portfolio, and rules for the
construction of an efficient portfolio. Portfolio theory implies that the
firm should evaluate projects in the same way that investors evaluate
securities. For example, there are no rewards or penalties per se
associated with corporate diversification. (Of course, diversification
could affect value by affecting expected bankruptcy costs and thus
net cash flows.)
5.3 Capital Asset Pricing Theory
Treynor (1961), Sharpe (1964), and Lintner (1965) apply the
normative analysis of Markowitz to create a positive theory of the
determination of asset prices. Given investor demands for securities
implied by the Markowitz mean-variance portfolio selection model and
assuming fixed supplies of assets, they solve for equilibrium security
prices in a single-period world with no taxes. Although total risk is
measured by the variance of portfolio returns, Treynor, Sharpe, and
Lintner demonstrate that in equilibrium an individual security is priced
to reflect its contribution to total risk, which is measured by the
covariance of its return with the return on the market portfolio of all
assets. This risk measure is commonly called an assets systematic
risk.
5.4 Option Pricing Theory
The capital asset pricing model provides a positive theory for the
determination ofexpected returns and thus links todays asset price
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with expected future payoffs. In addition, many important corporate
policy problems require knowledge of the valuation of assets which,
like call options, have payoffs that are contingent on the value of
another asset. Black and Scholes (1973) provide a key to this
problem in their solution to the call option valuation problem. An
American call option gives the holder the right to buy a stock at a
specific exercise price at any time prior to a specified exercise date.
They note that a risk-free position can be maintained by a hedge
between an option and its stock when the hedge can be adjusted
continuously through time. To avoid opportunities for riskless
arbitrage profits, the return to the hedge must equal the market risk-
free rate; this condition yields an expression for the equilibrium call
price. Black/Scholes note that if the firms cash flow distribution is
fixed, the option pricing analysis can be used to value other
contingent claims such as the equity and debt of a levered firm. In
this view the equity of a levered firm is a call option on the total value
of the firms assets with an exercise price equal to the face value of
the debt and an expiration date equal to the maturity date of the debt.
The Black/Scholes analysis yields a valuation model for the firms
equity and debt. An increase in the value of the firms assets
increases the expected payoffs to the equity and increases the
coverage on the debt, increasing the current value of both. An
increase in the face value of the debt increases the debtholders
claim on the firms assets, thus increasing the value of the debt, and
since the stockholders are residual claimants, reduces the current
value of the equity; An increase in the time to repayment of the debt
or in the risk less rate lowers the present value of the debt and
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increases the market value of the equity. An increase in the variance
rate or in the time to maturity increases the dispersion of possible
values of the firm at the maturity date of the debt. Since the debt
holders have a maximum payment which they can receive, an
increase in dispersion increases the probability of default, lowering
the value of the debt and increasing the value of the equity.
5.5 Agency Theory
Narrowly defined, an agency relationship is a contract in which one or
more persons engage another person to perform some service on
their behalf which involves delegating some decision-making
authority. Spence and Zeckhauser (1971) and Ross (1973) provide
early formal analyses of the problems associated with structuring the
compensation of the agent to align his or her incentives with the
interests of the principal. Jensen and Meckling (1976) argue that
agency problems emanating from conflicts of interest are general to
virtually all cooperative activity among self-interested individuals
whether or not it occurs in the hierarchical fashion suggested by the
principal-agency analogy. Jensen and Meckling define agency costs
as the sum of the costs of structuring contracts (formal and informal):
monitoring expenditures by the principal, bonding expenditures by the
agent, and the residual loss. The residual loss is the opportunity cost
associated with the change in real activities that occurs because it
does not pay to enforce all contracts perfectly. They argue that the
parties to the contracts make rational forecasts of the activities to be
accomplished and structure contracts to facilitate those activities. At
the time the contracts are negotiated, the actions motivated by the
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incentives established through the contracts are anticipated and
reflected in the contracts prices and terms. Hence, the agency costs
of any relationship are born by the parties to the contracting
relationship. This means that some individuals) can always benefit by
devising more effective ways of reducing them. Jensen and Meckling
use the agency framework to analyze the resolution of conflicts of
interest between stockholders, managers, and bondholders of the
firm.
The development of a theory of the optimal contract structure in a firm
involves construction of a general theory of organizations. Jensen
(1983) outlines the role of agency theory in such an effort. Fama
(1980) and Fama and Jensen (1983a; 1983b) analyze the nature of
residual claims and the separation of management and risk bearing in
the corporation and in other organization forms. They provide a
theory based on tradeoffs of the risk sharing and other advantages of
the corporate form with its agency costs to explain the survival of the
corporate form in large-scale, complex non-financial activities. They
also explain the survival of proprietorships, partnerships, mutuals,
and nonprofits in other activities. Since the primary distinguishing
characteristic among these organizational forms is the nature of their
residual or equity claims, this work addresses the question: What
type of equity claim should an organization issue? This question is a
natural predecessor to the question of the optimal quantity of debt
relative to equitythe capital structure issuethat has long been
discussed in finance. One factor contributing to the survival of the
corporation is the constraints imposed on the investment, financing,
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and dividend decisions of managers by what Manne (1965) calls the
market for corporate control. Jensen and Ruback (1983) argue that
this market is the arena in which alternative management teams
compete for the rights to manage corporate resources, with
stockholders playing a relatively passive role accepting or rejecting
competing takeover offers. In the last ten years, there has been
extensive examination of the stock price effects associated with
corporate takeovers through mergers, tender offers, and proxy fights.
The evidence indicates that successful tender offers produce
approximately 30 percent abnormal stock price performance in target
firms shares and 4 percent abnormal stock price performance in
bidding firms shares, while for mergers the numbers are 20 percent
and 4 percent.
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CHAPTER 6: FINANCIAL THEORY AND
CORPORATE POLICY
The central purpose of a corporation is to provide value for the
shareholders. Simply put, it is to make money. The discipline that
studies money, markets and their operation with an eye to practical
application is called finance. Thus, financial theory has a significant
impact on the decisions made by the leaders of corporations.
6.1 Finance
Accountants have been described as historians. They record how
much is spent, earned and invested. They sort, classify and organize.
However, what these actions mean, in a greater sense is not their
primary concern. Economists, on the other hand, are concerned with
the more general questions of how markets operate, why they
operate thus and what this means for individuals, businesses andnations. Financial professionals stand in the middle ground. While
they must stay in touch with the accounting and have a keen
understanding of the real-world operations of the firm, they also
attempt to understand the esoteric aspects of economic theory.
6.2 Theory
Because finance requires that decisions be made, as opposed to the
decisions' impact being recorded, predictions and estimations must
be made. However, unlike economics, which addresses such general
questions, finance professionals use theories, models and statistical
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tools to answer specific questions. An economist may ask the
question, "Is this industry expanding its operations, and if so, at what
rate?" The financial professional may use some of the same tools,
but is more likely to ask, "Should our company expand operations,
and if so, when?"
6.3 Overlap
If the distinction between finance and economics is a matter of scale,
then it is only natural that there exists some overlap between the
disciplines and indeed, some of the most esteemed names infinancial theory are great economists. John Maynard Keynes, William
Sharpe and Oskar Morgenstern were responsible for innovations like
the capital asset pricing model and modern portfolio theory. However,
these scholars are almost universally referred to as economists, not
financial theorists.
6.4 Impact on Policy
While financial theory, like all theory, is imperfect, it does provide
rational guidance for dealing with uncertainty. For example, analysts
may regard the company's stock price as too low. This may lead the
directors of the corporation to purchase shares of the stock from
shareholders, allowing the firm to retain more of its profits as it would
not have to pay dividends on shares that it repurchased. Another
possibility would be theorists predicting significant changes in the
interest rates demanded by credit markets. The corporation may then
hasten, or delay, obtaining needed credit lines.
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6.5 Problems
The greatest challenge to financial theory is the reliance on reason.
While objective assessment of measurable facts and application of
proven formulas may seem unassailable, as Publius Syrus said
"Everything is worth what its purchaser will pay for it." Pricing models,
market statistics and economic data may be invaluable for providing
predictions, but sometimes a particular product, company or brand
name may fall into fashion or out of favor for reasons that may be
apparent only in retrospect or forever remain inscrutable.
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CHAPTER 7: FINANCIAL OBJECTIVES OF
CORPORATE FINANCE THEORY
Corporate finance theory takes specific models and applies them to
specific corporate finance decisions. By and large, these decisions
have financial goals, but occasionally, there are other types of goals
as well, such as good community relations. Nevertheless, corporate
finance theory has several specific goals in mind relative to both the
structure of the firm as well as the returns on assets.
7.1 Rational Choice
Rational Choice is the main model of finance theory. It is the basic,
"classical model" that holds a firm seeks to maximize its return on
capital. In this case, the financial goal is very clear: profit
maximization through direct methods and indirect methods, such as
increasing market share. This model sees the firm as a unified entityand the financial goals are calculated with this in mind.
7.2 Control
Firms have different centers of control. Stockholders, managers,
labor unions, creditors and investors all have interests and different
levers of power to use and manipulate. In this model, the final idea is
to satisfy these different interests and hence, the financial goal is
really about spreading earnings to as many different centers of power
as possible. While this remains a part of rational choice, it is a highly
decentralized version of the approach that spreads out who is doing
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the choosing over many factors. In this model, the firm is not a unified
entity.
7.3 Debt
More specific is the creation of an optimal debt/equity ratio. The
financial goal here is to maximize the tax benefits of debt financing,
while maintaining strong growth in equity. Investors do not like to see
huge debt, but the real goal here is to see how capital is performing.
If capital is performing well and cash flow is growing, then the debt
can be carried and hence, it is not an issue for investors. The basicbalance is the final goal: to use enough debt to finance projects
cheaply while maintaining solid cash flows.
7.4 Expansion
In any set of investment decisions, one additional goal is the option to
expand. A decision might come down to issuing dividends on stock
versus reinvesting that cash in expansion projects to increase cash
flow and the ability to carry debt. This might be termed an indirect
model of rational choice, since it sees cash flow as the result of good
decisions over time, not an immediate need to satisfy stockholders
and investors.
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CHAPTER 8: SHAREHOLDER VALUE CREATION
Creating shareholder value is the key to success in today's
marketplace. There is increasing pressure on corporate executives to
measure, manage and report the creation of shareholder value on a
regular basis. In the emerging field of shareholder value analysis,
various measures have been developed that claim to quantify the
creation of shareholder value and wealth.
More than ever, corporate executives are under increasing pressure
to demonstrate on a regular basis that they are creating shareholder
value. This pressure has led to an emergence of a variety of
measures that claim to quantify value-creating performance.
Creating value for shareholders is now a widely accepted corporate
objective. The interest in value creation has been stimulated by
several developments.
Capital markets are becoming increasingly global. Investors can
readily shift investments to higher yielding, often foreign,
opportunities.
Institutional investors, which traditionally were passive investors,
have begun exerting influence on corporate managements to
create value for shareholders. Corporate governance is shifting, with owners now demanding
accountability from corporate executives. Manifestations of the
increased assertiveness of shareholders include the necessity for
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executives to justify their compensation levels, and well-publicized
lists of under performing companies and overpaid executives.
Business press is emphasizing shareholder value creation in
performance rating exercises.
Greater attention is being paid to link top management
compensation to shareholder returns.
Defining Shareholder Value and Wealth Creation
From the economist's viewpoint, value is created when management
generates revenues over and above the economic costs to generatethese revenues. Costs come from four sources: employee wages and
benefits; material, supplies, and economic depreciation of physical
assets; taxes; and the opportunity cost of using the capital.
Under this value-based view, value is only created when revenues
exceed all costs including a capital charge. This value accrues mostly
to shareholders because they are the residual owners of the firm.
Shareholders expect management to generate value over and above
the costs of resources consumed, including the cost of using capital.
If suppliers of capital do not receive a fair return to compensate them
for the risk they are taking, they will withdraw their capital in search of
better returns, since value will be lost. A company that is destroying
value will always struggle to attract further capital to finance
expansion since it will be hamstrung by a share price that stands at a
discount to the underlying value of its assets and by higher interest
rates on debt or bank loans demanded by creditors.
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Wealth creation refers to changes in the wealth of shareholders on a
periodic (annual) basis. Applicable to exchange-listed firms, changes
in shareholder wealth are inferred mostly from changes in stock
prices, dividends paid, and equity raised during the period. Since
stock prices reflect investor expectations about future cash flows,
creating wealth for shareholders requires that the firm undertake
investment decisions that have a positive net present value (NPV).
Although used interchangeably, there is a subtle difference between
value creation and wealth creation. The value perspective is based
on measuring value directly from accounting-based information with
some adjustments, while the wealth perspective relies mainly on
stock market information. For a publicly traded firm these two
concepts are identical when (i) management provides all pertinent
information to capital markets, and (ii) the markets believe and have
confidence in management.
8.1 Approaches for measuring shareholder value:
8.1.1 Marakon Approach:
Marakan Associates, an international management-consulting firm
founded in1978, has done pioneering work in the area of value-based
management. This measure considers the difference between the
ROE and required return on equity (cost of equity) as the source of
value creation. This measure is a variation of the EV measures.
Instead of using capital as the entire base and the cost of capital for
calculating the capital charge, this measure uses equity capital and
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the cost of equity to calculate the capital (equity) charge.
Correspondingly, it uses economic value to equity holders (net of
interest charges) rather than total firm value.
According to Marakan model shareholder wealth creation is
measured as the difference between the market value3 and the book
value of a firm's equity. Thee book value of a firm's equity, B,
measures approximately the capital contributed by the shareholders,
whereas the market value of equity, M, reflects how productively the
firm has employed the capital contributed by the shareholders, as
assessed by the stock market. Hence, the management creates
value for shareholders if M exceeds B, decimates value if m is less
than B, and maintains value is M is equal to B.
According to the Marakon model, the market-to-book values ratio is
function of thee return on equity, the growth rate of dividends, and
cost of equity.
For an all-equity firm, both EV and the equity-spread method will
provide identical values because there are no interest charges and
debt capital to consider. Even for a firm that relies on some debt, the
two measures will lead to identical insights provided there are no
extraordinary gains and losses, the capital structure is stable, and a
proper re-estimation of the cost of equity and debt is conducted.
A market is attractive only if the equity spread and economic profit
earned by the average competitor is positive. If the average
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competitor's equity spread and economic profit are negative, the
market is unattractive.
For an all-equity firm, both EV and the equity spread method will
provide identical values because there are no interest charges and
debt capital to consider. Even for a firm that relies on some debt, the
two measures will lead to identical insights provided there are no
extraordinary gains and losses, the capital structure is stable, and a
proper re-estimation of the cost of equity and debt is conducted.
A market is attractive only if the equity spread and economic profitearned by the average competitor is positive. If the average
competitor's equity spread and economic profit are negative, the
market is unattractive.
8.1.2 ALCAR approach
The Alcar group Inc. a management and Software Company has
developed an approach to value-based management which is based
on discounted cash flow analysis. In this framework, the emphasis is
not on annual performance but on valuing expected performance.
The implied value measure is akin to valuing the firm based on its
future cash flows and is the method most closely related to the
DCF/NPV framework.
With this approach, one estimates future cash flows of the firm over a
reasonable horizon, assigns a continuing (terminal) value at the end
of the horizon, estimates the cost of capital, and then estimates the
value of the firm by calculating the present value of these estimated
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cash flows. This method of valuing the firm is identical to that followed
in calculating NPV in a capital-budgeting context. Since the
computation arrives at the value of the firm, the implied value of the
firm's equity can be determined by subtracting the value of the
current debt from the estimated value of the firm. This value is the
implied value of the equity of the firm.
To estimate whether the firm's management has created shareholder
value, one subtracts the implied value at the beginning of the year
from the value estimated at the end of the year, adjusting for any
dividends paid during the year. If this difference is positive (i.e., the
estimated value of the equity has increased during the year)
management can be said to have created shareholder value.
The Alcar approach has been well received by financial analysts for
two main reasons:
It is conceptually sound as it employs the discounted cash flow
framework
Alcar have made available computer software to popularize their
approach
However, the Alcar approach seems to suffer from two main
shortcomings: (1) In the Alcar approach, profitability is measured in
terms of profit margin on sales. It is generally recognized that this is
not a good index for comparative purposes. (2) Essentially a verbal
model, it is needlessly cumbersome. Hence it requires a fairly
involved computer programme.
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8.1.3 McKINSEY approach:
McKinsey & Company a leading international consultancy firm has
developed an approach to value-based management which has been
very well articulated by Tom Copeland, Tim Koller, and Jack Murrian
of McKinsey & Company. According to them:
Properly executed, value based management is an approach to
management whereby the company's overall aspirations, analytical
techniques, and management processes are all aligned to help the
company maximize its value by focusing decision making on the keydrivers of value.
The key steps in the McKinsey approach to value-based
maximization are as follows:
Ensure the supremacy of value maximization
Find the value drivers Establish appropriate managerial processes
Implement value-based management philosophy
8.1.4 Economic value added
Consulting firm Stern Steward has developed the concept of
Economic Value Added. Companies across a broad spectrum of
industries and a wide range of companies have joined the EVA
badwagon. EVA is a useful tool to measure the wealth generated by
a company for its equity shareholders. In other words, it is a measure
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of residual income after meeting the necessary requirements for
funds.
Computation of EVA:
EVA is essentially the surplus left after making an appropriate charge
for capital employed in the business. It may be calculated by using
following equation.
EVA= Net operating profit after tax- Cost charges for capital
employed
EVA is net earnings in excess of the cost of capital supplied by
lenders and shareholders. It represents the excess return (over and
above the minimum required return) to shareholders; it is the net
value added to shareholders.
In the above formula Net operating profit after tax [NOPAT] is
calculated as follows:
NOPAT= PBIT (1-T)=PAT+INT (1-T)
Chief features of EVA Approach:
It is a performance measure that ties directly, theoretically as well
as empirically, to shareholder wealth creation. It converts accounting information into economic reality that is
readily grasped by non-financial managers. It is a simple yet
effective way of teaching business literacy to everyone.
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It serves as a guide to every decision from strategic planning to
capital budgeting to acquisitions to operating decisions.
It is an effective tool for investor communication.
It is closest in both theory and construct to the net present valueof
a project in capital budgeting, as opposed to the IRR.
Thevalue of a firm, in DCF terms, can be written in terms of the
EVA of projects in place and the present value of the EVA of future
projects.
8.1.5 The discount cash flow approach
The true economic value of a firm or a business or a project or any
strategy depends on the cash flows and the appropriate discount rate
(commensurate with the risk of cash flow). There are several
methods for calculating the present value of a firm or a
business/division or a project. In following pages we will discuss three
main methods that are mostly used under discount cash flow
approach.
The firstmethod uses the weighted average cost of debt and equity
(WACC) to discount the net operating cash flows. When the value of
a project with an estimated economic life or of a firm or business over
a planning horizon is calculated, then an estimate of the terminal
cash flows or value will also be made. Thus, the economic value of a
project or business is:
Economic Value=Present Value of net operating cash flows+ Present
value of terminal value
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The second method of calculating the economic value explicitly
incorporates the value created by financial leverage. The steps that
are involved in this method of estimation of the firm's total value are
as follows:
1. Estimate the firm's unlevered cash flows and terminal value
2. Determine the unlevered cost of capital
3. Discount the unlevered cash flows and terminal value by the
unlevered cost of capital.
4. Calculate the present value of the interest tax shield
discounting at the cost of debt.
5. Add these two values to obtain the levered firm's total value.
6. Subtract the value of debt from the total value to obtain the
value of the firm's shares.
7. Divide the value of shares by the number of shares to obtain
the economic value per share.
The third method to determine the shareholder economic value is to
calculate the value of equity by discounting cash flows available to
shareholders by the cost of equity. The present value of equity is
given as below:
Economic value of equity= Present value of equity cash flows+
Present value of terminal investment
8.1.6 Total shareholder return
Is it sufficient to access and analyze the corporate performance only
in capital markets? Is total return to shareholders (TRS) the best way
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to measure corporate performance? Is it always a true indicator of
corporate performance? Or is there something more to corporate
performance? In order to obtain an answer to these questions let us
try and understand what TRS is and what role does it play in a
corporate performance. TRS, as the name suggests, is a measure of
total returns earned by shareholders of a company during a given
period of time i.e. the sum total of appreciation in share price plus
dividends declared during the period. Given the objective of
maximization of shareholder returns, TRS is often assumed to be the
most significant parameter governing corporate performance but that
may not be the case.
Also as share price is a major determinant of TRS (returns by way of
dividends are relatively smaller in value), it is imperative to know what
does the share price reflect. A companys share price incorporates
expectations of future growth and returns. The share price is driven
by the difference between expected and actual performance and by
changes in expectations than by the current level of performance as
such. The implication of this is that actual performance is not
important but it is the perception of performance which holds the key.
As a result the companies that consistently meet performance
expectations but do not exceed them find it hard to deliver a high
TRS. While on other hand improvements in expectations of future
performance can lead to significant increase in the TRS. Thus to
achieve total returns consistently greater than the cost of equity
requires beating the expectations consistently. The expectation of
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future financial performance is similar to a treadmill. As performance
of an enterprise improves, the expectations rise and the treadmill
begin to turn quickly. The better the management performs, the more
the market expects from them. If the company is able to beat these
expectations, it accelerates the treadmill and therefore delivers
superior returns to shareholders.
But the question here is for how long a company can continue to beat
expectations? The better the performance, the higher the
expectations become. Achieving above-average returns thus requires
consistently beating the increasing expectations. As a result, simply
performing better than the peer group is neither sufficient nor
necessary to achieve higher capital market returns. For outstanding
companies, which have performed excellently over the years, the
marker expectations are very high and thus the treadmill is moving
faster than that for any other company. Continuously beating the
expectations would eventually become impossible and hence the
company might deliver only an ordinary return to shareholders. On
the other hand, for companies that are in the process of recovery, the
market expectations are minimal and the expectation treadmill is not
moving fast and hence only a marginal improvement in performance
may lead to significant increase in share price and consequently the
TRS.
For example1, over a five-year period ending Dec 2001, Sears (US
based Retailer) achieved a higher TRS as compared to Wal-Mart
stores (the largest fortune 500 company). Does that mean that Sears
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is creating more value or is performing better than Wal-Mart? No,
because during the same period the Market Value Added (MVA)2, a
better indicator of value creation, was higher for Wal-Mart than that of
Sears. To sum up, what the expectation treadmill concept holds is
that it is the delivery of surprises (as reflected by performance
exceeding the expectations) that produces higher or lower total
shareholder returns. Hence share price appreciation or TRS, though
is a good indicator of corporate performance it cannot be applied in
isolation for all companies in all situations. The performance in capital
market is therefore one of the parameters of corporate performance.
This has to be further reinforced or backed by performance of the
enterprise along key value drivers of a company such as return on
capital and growth
Source: McKinsey Quarterly
Market Value implies the total of Equity and Debt. MVA is the
difference between Market Value at the beginning of the period and
Market Value at the end of the period.
Total Shareholder Return (TSR) is a concept used to compare the
performance of different companies stocks and shares over time. It
combines share price appreciation and dividends paid to show the
total return to the shareholder. The absolute size of the TSR will vary
with stock markets, but the relative position reflects the market
perception of overall performance relative to a reference group.
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With Pricebegin = share price at beginning of period, Priceend = share
price at end of period, Dividends = dividends paid and TSR= Total
Shareholder Return, TSR is computed as
TSR= (Priceend Pricebegin + Dividends) / Pricebegin
What DoesTotal Shareholder Return - TSR Mean?
The total return of a stock to an investor (capital gain plus
dividends).
The internal rate of return of all cash flows to an investor during
the holding period of an investment.
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CHAPTER 9: INTER-RELATIONSHIP OF
FINANCIAL POLICY & SHAREHOLDERS RETURN
All the major functions or decisions Investment function, Finance
function, Liquidity function and Dividend function, are inter-related
and inter-connected. They are inter-related because the goal of all
the functions is one and the same. Their ultimate objective is only one
achievement of maximization of shareholders wealth or maximizing
the market value of the shares. All the decisions are also inter-
connected or inter-dependent also. Let us illustrate both these
aspects with an example.
Example: If a firm wants to undertake a project requiring funds, this
investment decision can not be taken, in isolation, without considering
the availability of finances, which is a finance decision. Both the
decisions are inter-connected. If the firm allocates more funds for
fixed assets, lesser amount would be available for current assets. So,
financing decision and liquidity decision are inter-connected. The firm
has two options to finance the project, either from internal resources
or raising funds, externally, from the market. If the firm decides to
meet the total project cost only from internal resources, the profits,
otherwise available for distribution in the form of dividend, have to be
retained to meet the project cost. Here, the finance decision has
influenced the dividend decision.
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So, an efficient financial management takes the optimal decision by
considering the implications or impact of all the decisions, together,
on the market value of the companys shares. The decision has to be
taken considering all the angles, simultaneously.
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CHAPTER 10: CONCLUSIONS
The finance profession has moved from a largely ad hoc, normatively
oriented field with little scientific basis for decision making to one of
the richest and most exciting fields in the economics profession.
Financial economics has progressed through its stage of policy
irrelevance propositions of the 1960s to a stage where the theory and
evidence have much useful guidance to offer the practicing financial
manager. The theory and evidence are now sufficiently rich that
sensible analysis of many detailed problems such as the valuation of
contingent claims, optimal bond indenture covenants, and a wide
range of contracting problems are emerging. Science has not as yet,
however, provided a satisfactory framework for resolving all problems
facing the corporate financial officer. Some of the more important
unresolved questions are how to decide on:
The level of the dividend payment The maturity structure of the firms debt instruments
The marketing of the firms securities (i.e., public versus privately
placed debt, rights versus underwritten offerings)
The relative quantities of debt and equity in the firms capital
structure
We expect the frontiers of knowledge in corporate finance to continue
to expand.
The shareholder value creation approach helps to strengthen the
competitive position of the firm by focusing on wealth creation. It
provides an objective and consistent framework of evaluation and
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decision-making across all functions, departments and units of the
firm. It can be easily implemented since cash flow data can be
obtained by suitably adapting the firm's existing system of financial
projection and planning. The only additional input needed is the cost
of capital. The adoption of the shareholder value creation approach
does require a change of the mind-set and educating managers
about the shareholders value approach and its implementation.
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CHAPTER 11: REFERENCES
A perspective on corporate financial policies Acharya, Viral V
The cash flow sensitivity Journal of
Finance
Does the source of capital affect capital structure? Review of
Financial Studies 19, 4579.
Tender offers and free cash flow The Financial
Review
The determinants of corporate liquidity Journal of
Financial and Quantitative Analysis
Determinants of corporate borrowing Journal of
Financial Economics
Financial Management Pandey I. M.
Financial Management Theory and Practice Chandra
Prasanna
www.Valuebasedmanagement.com