Value Creation Ch14

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Hawawini & Viallet Chapter 14 2007 Thomson South-Western

Chapter 14

MANAGING FORVALUE CREATION


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Hawawini & Viallet Chapter 142

Background

After reading this chapter, students should understand: The meaning of managing for value creation

How to measure value creation at the firm level using theconcept of market value added or MVA

Why maximizing market value added is consistent with

maximizing shareholder value When and why growth may notlead to value creation

How to implement a management system based on a value-creation objective

How to measure a firms capacity to create value using theconcept of economic value added or EVA

How to design management compensation schemes thatinduce managers to make value-creating decisions


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Measuring Value Creation To find out whether management hascreated or destroyed value as of a

particular point in time, the firms marketvalue added (MVA)is employed Market value added (MVA) = Market value of

capitalCapital employed

To measure the value created or destroyedduring a period of time, the change in MVAduring the period should be computed


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Estimating Market Value Added

To estimate a firms MVA, we need to know: The market value of the firms equity and debt capital

The amount of capital that shareholders and debt holders haveinvested in the firm

Estimating the market value of capital

The market value of capital can be obtained from the financial markets

If the firm is not publicly traded, its market value is unobservable and itsMVA cannot be calculated

Estimating the amount of capital employed The amount of capital employed by the firm can be extracted from the

firms balance sheet The upper part of Exhibit 14.1presents InfoSofts standard (unadjusted)

balance sheets The lower part of Exhibit 14.1shows InfoSofts managerial (adjusted)

balance sheets

EXHIBIT 14 1


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EXHIBIT 14.1a:InfoSofts Managerial Balance Sheets on December 31,

2004 and 2005.Figures in millions of dollars

1 WCR = (Accounts receivable + Inventories + Prepaid expenses)(Accounts payable + Accruedexpenses).2 Gross value was $100 million at year-end 2004 and year-end 2005.

EXHIBIT 14 1b


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EXHIBIT 14.1b:InfoSofts Managerial Balance Sheets on December 31,

2004 and 2005.Figures in millions of dollars

1 WCR = (Accounts receivable + Inventories + Prepaid expenses)(Accounts payable + Accruedexpenses).


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Interpreting Market ValueAdded Maximizing MVA is consistent withmaximizing shareholder value

Shareholder value creation should be measured bythe difference between the market value of the firmsequity and the amount of equity capital shareholdershave invested in the firm

MVA is the difference between the market value of totalcapital and total capital employed

MVA = Equity MVA + Debt MVA

If we assume that debt MVA is different from zero only

because of changes in the level of interest rates, then, for agiven level of interest rates, maximizing MVA is equivalent tomaximizing shareholder value (equity MVA)


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Interpreting Market ValueAdded Maximizing the market value of the

firms capital does not necessarily

imply value creation

Managers should maximize MVA rather thanmarket value

MVA increases when the firm

undertakes positive net present value

projects

Id if i h D i f V l


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Identifying the Drivers of ValueCreation A firms capacity to create value is driven by a

combination of three key factors

The firms operating profitability, measured by its

ROIC

ROIC = NOPAT Invested Capital The firms cost of capital, measured by its WACC

WACC = [After-tax cost of debt Percentage of debt capital]+ [Cost of equity Percentage of equity capital]

The firms ability to grow


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Linking Value Creation to Operating Profitability,

the Cost of Capital, and Growth Opportunities

The MVA of a firm that is expected to grow foreverat aconstantrate is given by the following valuation formula

Thus, the objective of managers should not be themaximization of their firms operating profitability (ROIC)but the maximization of the firms return spread(ROICWACC)

Rewarding a managers performance on the basis of ROIC maylead to a behavior that is inconsistent with value creation

To create value,expected ROICmust exceed the

firms WACC.


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Linking Value Creation to Operating Profitability,the Cost of Capital, and Growth Opportunities

Only value-creating growth matters Only growth that is accompanied by a positive return

spread can generate value

Another general implication of the valuation formulashown above is that growth alone does notnecessarily create value

There are high-growth firms that are value destroyers andlow-growth firms that are value creators.

Exhibit 14.4provides an illustration by comparing firms Aand B

EXHIBIT 14 4


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EXHIBIT 14.4:Comparison of Value Creation for Two Firms with

Different Growth Rates.Figures in millions of dollars

Li ki V l C ti T It


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Linking Value Creation To ItsFundamental Determinants

We can identify more basic drivers of value creation ifthe firms expected ROIC is separated into itsfundamental components

It becomes clear that management can increase the firms

ROIC through a combination of the following actions:

An improvement of operating profit margin

An increase in capital turnover

A reduction of the effective tax rate

The various drivers of value creation are summarized inExhibit 14.5


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EXHIBIT 14.5:

The Drivers of Value Creation.


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Linking Operating Performance andRemuneration to Value Creation

A short case study is used in this sectionto explain how a managers operating

performance, his remuneration package,

and his ability to create value can belinked


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Mr. Thomas Hires a GeneralManager

Mr. Thomas, the sole owner of a toydistribution company called Kiddy WonderWorld (KWW), is concerned about hisfirms recent lackluster performance In January 2005, he hires Mr. Bobson to run

the company

Exhibit 14.6shows the firms financial

statements for 2004 and its anticipatedfinancial statements for 2005 submitted byMr. Bobson


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EXHIBIT 14.6a:

Financial Statements for Kiddy Wonder World.Figures in millions of dollars


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EXHIBIT 14.6b:

Financial Statements for Kiddy Wonder World.Figures in millions of dollars


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Has the General Manager AchievedHis Objectives?

A close look at Exhibit 14.7reveals thatMr. Bobson was successful in increasingsales and profits

But grew the companys WCR much fasterthan sales and profits

The result was an operating profitability that fellshort of the firms WACC and an inability to create

value

EXHIBIT 14 7:


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EXHIBIT 14.7:

Comparative Performance of Kiddy Wonder

World.

1 Previous years figures are not provided.2 Percentage changes are calculated with data from the financial statements in Exhibit 14.6.


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Economic Profits Versus AccountingProfits Because the growth of working capital does not affect

Mr. Bobsons bonus, he may have been pushing salesand boosting profits while neglecting the managementof working capital

Although KWW is profitable when profits aremeasured according to accounting conventions

(NOPAT and net profit are positive), it is not profitablewhen performance is measured with economic profits(EVA is negative) EVA can be expressed as follows:

EVA = [(NOPAT Invested Capital)WACC] Invested Capital =(ROICWACC) Invested Capital

This shows that a positive return spread implies a positive EVA, whichin turn, implies value creation

Linking Mr. Bobsons performance and bonus to EVArather than to accounting profits would have inducedhim to pay more attention to the growth of WCR


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Designing Compensation Plans ThatInduce Managers to Behave Like Owners

The KWW case study shows thatmanagers do not always behaveaccording to the value creation principle

Possible solutions to the problem include: Turning managers into owners

Remunerating them partly with a bonus linked totheir ability to increase EVA


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Designing Compensation Plans ThatInduce Managers to Behave Like Owners For an EVA-related compensation system to be

effective, a number of conditions must be met: The bonus should be related to the managers ability to

generate higher EVA for a period of several years After the compensation plan has been established and

accepted, it should not be modified and reward should not be

capped The reward related to superior EVA performance must

represent a relatively large portion of the mangers totalremuneration

As many managers as possible should be on the EVA-relatedbonus plan

If an EVA bonus plan is adopted, the book value of capital andthe operating profit used to estimate EVA should be restated tocorrect for the distortions due to accounting conventions

An EVA bonus plan must be consistent with the companyscapital budgeting process

Li ki th C it l B d ti


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Linking the Capital BudgetingProcess to Value Creation

By connecting the measures of performancethat are the concerns of the corporate financefunction, we can provide a comprehensivefinancial management system that integrates

the value-creation objective with the firms Value

Operating performance

Remuneration and incentive plans

Capital budgeting process


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The Present Value of an Investments

Future EVAs Is Equal to Its MVA The correct measure of a managers ability to create value is EVA,

and most managerial decisions generate benefits over a number ofyears

Need to measure the present value of the entire stream of futureexpected EVAs

The potential value of a business decision is the MVA of thedecision

Then, using the definition of EVA, MVA can be expressed asfollows:

EVAMVA =

WACC - Constant growth rate

This valuation formula shows that thepresent value of the future stream of

EVAs from a proposal is the MVA of thatproposal.

Management should maximize the entire stream of future EVAstheir firms invested capital is expected to generate in order to

maximize their firms MVA and create shareholder value

Maximizing MVA Is the Same


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Maximizing MVA Is the Sameas Maximizing NPV

Major advantage of the NPV approach Takes into account any nonfinancial

transactions related to the project that eitherreduce or add to the firms cash holding

Major advantage of the MVA approach

Direct relation to EVA


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EXHIBIT 14.9:

The Financial Strategy Matrix.

Exhibit 14.9 summarizesthe key elements of a

firms financial

management system andshows their managerial

implications within asingle framework that is

called the firms financial

strategy matrix.

Putting It All Together:


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Putting It All Together:The Financial Strategy Matrix

The matrix indicates that there are fourpossible situations a business can face

The business is a value creator but is

short of cash

Management has two options in this case Reduce or eliminate any dividend payments

Inject fresh equity capital from the parent company intothe business

Putting It All Together:


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Putting It All Together:The Financial Strategy Matrix

The business is a value creator with a cashsurplus

This is a preferred situationmanagement has two options Use the cash surplus to accelerate the growth of the business Return the cash surplus to the shareholders

The business is a value destroyer with a cash

surplus This type of a situation should be fixed quickly; part of the

excess cash should be returned to shareholders and therest used to restructure the business as rapidly as possible

The business is a value destroyer that is short of

cash If the business cannot be quickly restructured, it should besold as soon as possible

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