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Managing for Value Creation

by: Kathleen Sharaf

Managing for Value Creation 11199

Marketplace > La Salle University > Business Administration > 11199 > Managing for Value Creation
Kathleen Sharaf
La Salle
Financial Performance: Control and Measurement
Dr. Barenbaum

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About this Document

This is an outline on the managing for value creation chapter.
Financial Performance: Control and Measurement
Dr. Barenbaum
Class Notes
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This 4 page Class Notes was uploaded by Kathleen Sharaf on Thursday September 10, 2015. The Class Notes belongs to 11199 at La Salle University taught by Dr. Barenbaum in Fall 2015. Since its upload, it has received 52 views. For similar materials see Financial Performance: Control and Measurement in Business Administration at La Salle University.

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Date Created: 09/10/15
Chapter 17 Managing for Value Creation Measuring Value Creation 0 Capital Employed the amount of capital that equity holders and debt holders have invested in the firm Market Value Added MVA Market Value of Capital Capital Employed o If the MVA is positive value has been created because the market value of the rm s capital the market value of its equity and debt is worth more than the amount of capital that has been invested in the firm If MVA is negative then value has been destroyed o MVA measures value creation or destruction at a particular point in time To measure the value created or destroyed during a period of time look at the change in MVA during that period 0 Market Value of Capital can be obtained from the financial markets at least for firms whose equity and debt capital are publicly traded in the form of securities If the firm is not publicly traded its market value is unobservable and its MVA cannot be calculated 0 Maximizing MVA is consistent with maximizing shareholder value MVA Equity MVA Debt MVA a If we assume that debt MVA is different from zero only because of changes in the level of interest rates then for a given level of interest rates maximizing MVA is equivalent to maximizing shareholder value equity MVA o MVA increases when the firm undertakes positive net present value projects In other words saying that a firm has raised or reduced its MVA is the same as saying that it has invested in positive or negative NPV projects Identifying the Drivers of Value Creation A rm s capacity to create value is essentially driven by a combination of three key factors 1 The firm s operating pro tiabiltiy measured by its aftertax return on invested capital ROIC 2 The rm s cost of capital measured by its weighted average cost of capital WACC 3 The firm s ability to grow 0 The aftertax ROIC is de ned here as the firm s net operating pro t after tax NOPAT divided by its invested capital measured at the beginning of the accounting period ROIC EBIT X 1 Tax Rate Invested Capital NOPAT Invested Capital WACC Aftertax cost of debt X of debt capitalCost of equity X of equity capital Market Value Added ROIC WACC X Invested Capital WACC Growth Rate 0 To create value expected ROIC must exceed the rm s WACC o The valuation formula indicated that a firm creates value only if the return it expects to earn on its invested capital ROIC is higher than the cost of financing its investments WACC As long as the firm s expected ROIC exceeds its estimated WACC the numerator of the valuation formula is positive and so is its MVA indicating that the firm creates value 0 BUT if the firm s expected ROIC is lower that its estimated WACC MVA is negative and the firm destroys value 0 Return Spread ROIC WACC o The difference between ROIC and WACC the firm s return spread 0 Positive expected return spreads are the source of value creation and negative expected return spreads are the source of value destruction 0 To create value the firm must deliver to its equity holders more than what they expect to receive which is true only when ROIC exceeds the WACC It is important to keep in mind that it is the entire future stream of expected return spreads and not past or historical return spreads that drives the process of value creation or destruction 0 Only valuecreating growth matters Growth is a sign of the return spread that drives value creation irrespective of the rm s growth rate Some highgrowth firms are value destroyers and some low growth firms are value creators Only growth that is accompanied by a positive return spread can generate value Linking Operating Performance and Remuneration to Value Creation o Linking value creation to its fundamental determinants We can identify more basic drivers of value creation by breaking down the rm s expected ROIC into its fundamental components Recall that pretax ROIC can be broken down into operating pro t margin the ratio of EBIT to sales and capital turnover the ratio of sales to invested capital ROIC EBIT Sales X Sales Invested Capital x 1 Tax Rate Operating profit margin x Capital turnover X 1 Tax Rate 0 The rm s ROIC through a combination of the following actions 1 An improvement of operating pro t margin achieved by generating higher operating profit per dollar of sales 2 An increase in capital turnover achieved by generating the same or higher sales with less capital this can be done through faster collection of receivables speedier inventory turns and fewer assets while keeping sales the same or while sales are increasing 3 A reduction of the e ective tax rate achieved by taking advantage of various tax breaks and subsidies Economic Profits vs Accounting Profits 0 Economic profits or economic value added EVA as NOPAT less the capital charge Economic Value Added EVA NOPAT WACC x Invested Capital EVA NOPATInvested Capital WACC x Invested Capital EVA ROIC WACC x Invested Capital 0 The present value of an investment s future EVA is equal to its MVA Management should maximize the entire stream of future EVA that their rm s invested capital is expected to generate to maximize their firm s MVA and create shareholder value MVA EVA WACC Growth Rate KEY POINTS 1 The greatest benefit of a management system that emphasizes value creation as opposed to earnings growth is that it induces managers throughout the organization to pay closer attention to expense control to make a more effective use of the rm s assets and to become more aware of the need to earn higher returns on the rm s assets and to become more aware of the need to earn higher returns on the rm s invested capital Good management can be many things that is superior marketing skill great leadership and a mastery of manufacturing But essentially good financial management is the only one thing that is good capital management or the art of deployed scarce capital skillfully 2 How can managers make capital allocation decisions that enhance value A firm should allocate its existing capital and if required raise new capital only if the return it expects to earn on the capital exceeds its estimated cost Otherwise capital should be returned to shareholders through dividend payments or a share buyback program And of course there is no point in growing a business that does not earn its cost of capital If a business cannot be restructured to generate a return in excess of its appropriate riskadjusted cost of capital it should be sold A company creates value only if its market value added MVA defined as the difference between the market value of its capital and the amount of capital invested in it by shareholders and debt holders is positive In other words a company creates value only when the rm s capital is worth more than its reported adjusted book value 3 One way to implement a management system that is consistent with and conducive to a valuecreation objective is to link the rm s operating performance investment decisions and remuneration system to economic profit to economic value added EVA defined as the difference between net operating profit after tax and the dollar cost of the capital used to generate that profit Managers who make decisions that maximize expected future EVA will increase MVA and create value Also this objective is consistent with the net present value and the internal rate of return rules used in capital budgeting 4 The key drivers of a financial management system can be summarized into a financially strategy matrix that can help managers make valuecreating strategic decisions This matrix considers businesses that show positive EVA or negative EVA and that have cash surpluses or cash shortages


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