Measuring Value Created by the Whole Firm

Total Shareholder Return (TSR) is based on the rise in the price of shares plus dividends received over a set period of time.

There are some important considerations when using TSR, such as: Risk. When using TSR to compare the performance of two or more companies it is important to allow for relative risk. TSR assumes efficient share pricing at the beginning and end of the period examined. The time period of examination: A TSR over a five-year period can look very different from a TSR measured over a one-year or ten-year period when examined alongside the TSR of a peer group. Please note that, using TSRs for bonuses may not always align managerial interests with shareholders. And, TSR is useless in the case of companies not quoted on a stock market.

The wealth added index (WAI) takes as its starting point the factors in TSR, i.e. capital gain or loss on shares plus dividends over a period of time, but also takes into account the time value of money by deducting the ‘cost of equity’.

WAI is measured in terms of absolute money amounts.

To calculate WAI: First, calculate the rise in market capitalisation over the period. Second, deduct the portion of that market capitalisation rise due to the firm raising more equity capital, e.g. through a rights issue. Third, add back any cash paid out to shareholders, e.g. dividends, share buy-backs. Fourth, deduct the required return on equity committed by shareholders at the start.

Considerations when using wealth added index: Doubts about the capital asset pricing model -Assumes that the stock market prices shares correctly at the beginning and end dates; There can be long periods of poor performances; Big companies appear to do best. Market Value Added (MVA) compares the market value of the firm (debt plus equity) with the total capital contributions to date (debt plus equity).

MVA is measured in terms of absolute money amounts.

If the market value of debt is assumed to be the same as the book value, then MVA will compare the market value of the equity with the total equity contributions to date (including the economic value of retained profits).

And, the following are considerations when using market value added: Doubts about the validity of the ‘capital invested figure’; When was value created? Distorted by size; Does not state if the rate of return is high enough

Excess return (ER) tries to solve two of the problems present in MVA calculations: First, it allows for the required rate of return for the period of time that the firm has held shareholders’ money. Second, it includes the dividends received by shareholders over the years since the firm’s foundation.

Excess return expressed in present value terms equals Actual wealth expressed in present value terms minus Expected wealth expressed in present value terms

Expected wealth is the current value that one should expect shareholders to have in the business given the amount of capital they put in (and retained in the business) and given the required rate of return since they put it in.

Actual wealth is the accumulated present value of the cash flows received by shareholders over the years of their investment plus the current market value of the shares.

ER is measured in terms of absolute money amounts.

The drawbacks of excess return include: The difficulty of identifying the amount of equity capital put into a business that has traded for many decades; The assumption of market pricing efficiency in ‘correctly’ pricing the company’s shares at the present time; It is difficult to state with precision what the required rate of return should be, and; Large companies dominate a ‘league table’ of ER because it is measured in absolute money amounts.

Market to book ratio, MBR = Market value divided by capital invested.

Because MBR is so similar to MVA it has similar advantages and disadvantages.

Limitations of whole-firm value metrics: They require a market valuation and thus they are useful only for the minority of corporations with a quotation and they cannot be employed to analyse a sub-section of a company (such as a strategic business unit or product line).

Creating Value

Shareholder value is driven by the following four factors: The amount of capital invested; The actual rate of return on capital invested; The required rate of return on capital invested; The length of time over which the performance spread (see below) will persist to create value. And, essentially, the actual return must be more than the required return for value to be created. That is, there must be a positive performance spread.

The performance spread is the percentage spread of the actual return above or below the required rate of return, given the finance provider’s opportunity cost of capital. To measure annual value created (or projected value yet to be created), multiply the quantity of capital invested by the performance spread.

Annual value creation = Investment x (actual return – required return) = I (r - k)

The point in the future where the required and the actual rates of return become the same is the ‘planning horizon’.

Corporate value = Present value of cash flows within planning horizon + Present value of cash flows after planning horizon

After the planning horizon even if investment levels are increased significantly corporate value will remain constant. This is because the discounted cash inflows (to time zero) associated with that investment exactly equal the discounted cash outflows (to time zero). In other words, after the planning horizon it is not possible to make returns greater than those required by investors.

Good growth and bad growth: Good growth occurs when a business unit or an entire corporation obtains a positive performance spread on new investment capital. Bad growth occurs when investment is made in strategies that produce negative performance spreads.

There are five key actions firms can take in order to increase shareholder value: Increase the return on existing capital; Raise investment in positive spread units; Divest assets from negative spread units to release capital; Extend the planning horizon; and,  Lower the required rate of return.

Shareholder Value

Shareholder value can be defined as the value of the return that a shareholder is able to obtain from their investment in a company. This is made up of capital gains, dividend payments, proceeds from buyback programs and any other payouts that a firm might make to a shareholder.

Managers should examine a business , or parts of their business, in terms of the following questions: How much money has been (or will be) placed in this business by investors? What rate of return is being (or will be) generated for those investors? Is this sufficient given the opportunity cost of capital? These three questions can be used to examine past performance, or future plans.

Value-based management is a managerial approach in which the primary purpose is long-run shareholder wealth maximisation. The objective of the firm, its systems, strategy, processes, analytical techniques, performance measurements and culture, all have as their guiding objective shareholder wealth maximisation.

Identifying value destructive and value generating activities within a business can lead to realignment of management priorities: -Plans for the business are considered by focusing on the extent to which their current or planned business operations will create value for shareholders. That is, business operations should generate discounted cash inflows greater than the cash devoted to the investment by the finance providers. -Managers are rewarded according to the achievement of shareholder value over the long term. Large changes to incentive systems in most firms can be the result. -Often the discounted cash inflows in a part of the business amount to less than the amount that could be generated by closing down the activity or selling it. -If a subsidiary is sold, managers then need to consider whether the cash released should be invested in other activities or be given back to shareholders to invest elsewhere in the stock market?

Once an organisation becomes value based a wide range of questions becomes informed by value principles, e.g. Mergers, Strategic analysis, Capital structure and Dividend payouts

Frequently, a shift in culture, in systems and procedures as well as a major teaching and learning effort is required to create a value-based corporation.

The three steps to creating shareholder value are: Communicate the importance of shareholder value and then encourage a genuine commitment to shareholder wealth-enhancement throughout the organisation; Use good measurement techniques to evaluate whether value is being created at various organisational levels; and then manage actively to ensure that every aspect of management is suffused with the shareholder value objective.

Multinational WACC

The appraisal of projects is a complicated area, especially if investments take place in countries other than the domestic country. It is common to confront additional challenges, eg: Which perspective to take? Is it the project's cash flows in the host country or, those cash flows expected to be repatriated to the head office?. The receipt of net cash flow in the domestic currency is usually exposed to foreign exchange risk; What is the systematic risk on an international project? and Political/country risk.

There are 2 approaches in discounting overseas project cash flows: Discount the overseas cash flows at the overseas discount rate to create a overseas NPV. Then convert this NPV at the current spot exchange rate to give the NPV in home currency; Convert each of the estimated future overseas cash flows into home currency. Then discount these to generate a home currency NPV. Problem: Difficult to hedge project cash flows against currency risk.

Overall, however, overseas projects should be evaluated from the parent point of view. That is, after allowing for restrictions on cash repatriation. By diversifying internationally the variance (standard deviation) of the investor's or the firm's portfolio is generally reduced and therefore the equity risk premium can be reduced.

Shareholders with an internationally diversified portfolio will theoretically measure the systematic risk of an individual share in terms of a worldwide portfolio and global betas. Many investors are not fully diversified internationally and firms can lower risk for shareholders through international diversification

International diversification of operations can lower the fluctuations in shareholder returns back home, which is a force that lowers the cost of capital. However, many institutional investors are diversified internationally (among developed economies) and so required returns are determined by these international diversified investors.

In many parts of the world the financial markets are illiquid and function poorly, and the cost of capital is relatively high - global accessibility of finance outside of the home base has led to greater availability of finance at lower cost.

There are factors raising the cost of capital when sourced abroad. These include foreign exchange risk, asymmetric information and political/economic risk. There is thus a trade-off between the benefits and additional costs of raising funds overseas.

The cost of debt for a MNC is higher in some countries than in others due to: - The risk free rate of return being higher. - The risk premium being higher.

The cost of debt for large firms can generally be estimated using publicly available information such as the bond yields incurred by other firms in that country carrying the same risk as the proposed project.

If a firm diversifies its portfolio of projects internationally there is an argument that it will have less cash flow variability and therefore the risk, as perceived by lenders would be lower, resulting in a lower cost of debt. However, this is frequently more than offset by the agency costs of debt, political risks, foreign exchange risks and asymmetric information costs.

Cost of Equity

The cost of equity capital is the return that needs to be offered to investors to induce them to buy and hold the equity shares in a company. This return is determined by the returns available on similar securities of the same risk class.

The capital asset pricing model gives a required rate of return for any asset if it is possible to obtain its beta (measure of its systematic or non-diversifiable risk) and the equity risk premium demanded by investors above the risk free rate of return for accepting the risk associated with investing in shares, generally.

Some risks are unique to the particular share. The impact of these variables is known as diversifiable risk (also referred to as firm, unique or unsystematic risk).

Some risk variables will affect all shares, to a greater or lesser extent. The impact of these variables is known as non-diversifiable risk (also referred to as market or systematic risk).

The reduction in standard deviation of the returns on the portfolio comes about because security returns generally do not vary with perfect positive correlation.

Because most shares are held by highly diversified institutions, market returns are dominated by the actions of fully diversified investors. These investors ensure that the market does not reward investors for bearing some unsystematic risk.

A share‟s sensitivity to general market movements is its beta value. A beta of 1.0 indicates that the share tends to produce returns that move broadly in line with the market index. A beta greater than 1.0 indicates that the share displays amplified movements relative to the market.

Beta can measure the systematic risk of any asset – so shares, debt instruments, and indeed any asset can have a beta.

The required return from any risky investment is described by the Capital Asset Pricing Model – the CAPM.

For share j, under the CAPM, the required return is: rj = rf + Beta(rm – rf)

Since the required return for equity is the same as the cost to the firm kE, kE = rf + Beta(rm – rf) This is the CAPM formula.

The CAPM formula can be shown on a graph as the Security Market Line , which shows the rise in expected returns as beta increases.

Market (equity) risk premium (rm – rf) or RP, is the extra return demanded by investors in equities generally above the risk free rate. Historical data on equity and government bond returns reveal the equity risk premia above the risk free rate are generally in the range of between 3% and 6% per annum.

Any measure of the equity risk premium will be sensitive to: - the period covered by the study. - the proxy for the risk-free rate (short-dated or long-dated government securities?); - the analyst‟s view of the riskiness of the average share relative to rf. - the market and currency.

To obtain the risk-free rate we ideally need to satisfy two conditions: - There is a zero default risk. - When intermediate cash flows are earned on a multi-year investment there is no uncertainty about reinvestment rates. In practice, finance directors and analysts use a long-term government rate on all the cash flows of a project that has a long-term horizon. Also, the bond used is one with coupons.

The slope of the characteristic line is the beta for the share. This relationship between rj and rm can be expressed thus for a generic share j: - Betaj = Covariance of security with the market / Variance of the market; or- Betaj = Correlation of security with the market x (Standard Deviation of security / Standard Deviation of the market)

Criticisms of CAPM: - It relies on the identification of a market portfolio to calculate both the equity (or market) risk premium and beta. In theory, this consists of a representative sample of all possible assets on which a return can be generated by an investor - identifying such a portfolio is almost impossible. - What data should be used to measure beta? Changing the time period the periodicity or the market proxy will change the measured beta. - Can the past be used to predict the future? Betas change, sometimes considerably, over time. - CAPM is a one period model – it assumes the variables (rf, beta, rm – rf ) will be stable for the period of the cash flows to be valued.

Assumptions that were used to derive the CAPM: -investors are rational and risk averse; -all investors have identical investment horizons; -all investors have identical perceptions regarding the expected returns, volatilities and correlations of available risky investments; -information has no cost and there are no barriers to information: investors come to identical conclusions regarding expected risks and returns given identical information; -there are no transaction costs or taxes; -investors can borrow and lend at the risk-free rate; -there is no dominant player in the market; and -no one transaction will move the market price of an asset.

Early (1970s) measurements of the Securities Market Line suggest that it is flatter than is predicted by the theory - beta risk requires some compensation, but not as much as suggested by the model. Also at a zero beta, investors seem to receive more than the rf. Studies in the 1990s concluded that a rise in beta does not lead to a higher return - many academics and practitioners have drawn the conclusion that beta is „dead‟ as relevant factor in adjusting required returns.

Arbitrage pricing theory (APT) uses a number of factors (each with betas and each with risk premiums), which relate to unexpected changes in economic quantities.

Expected returns = risk free rate + Beta1(r1 – rf) + Beta2(r2 – rf) ….+βn(rn– rf)

Beta is used for: -Assessing the risk of a portfolio; -Identifying whether a fund manager‟s performance is the result of good management or excessive risk taking; -Identifying „mispriced‟ shares, and; -To evaluate investment projects as well as to value shares. The Gordon growth model method for estimating the cost of equity capital is kE = d1/P + g

Cost of Debt

Investors in a company's debt are interested in getting a rate of return that is in line with the return offered on other interest-bearing instruments, which carry the same risk. This is called the cost of debt.

It is also essential to note the following: That is, the yield to redemption, or market yield, is the average pre-tax marginal rate of interest (kd) on a firm‟s debt, reflecting its current credit rating. For irredeemable debt this is determined as: kd = I/P0. For redeemable debt, the yield to redemption will be the internal rate of return of debt using the current market value of the debt and future cash flows.

The relationship between the price of redeemable bonds, the coupon rate and the yield to redemption: P = PVcoupon flows + PVface = {C/r x [1-1/(1+r)n]} + {F/(1+r)n}

Also note that: the longer the maturity of a bond, the greater the sensitivity of the bond to changes in interest rates; and, therefore the greater the change in price corresponding to a particular change in yield.

The average cost of debt can be calculated on the basis of the cost of each of the different elements, with appropriate value weighting. Short-term debt should be included as part of the overall debt burden of the firm. However, cash and securities which can be sold easily may be deducted to derive the net short-term debt burden. And,  the capitalised value of lease commitments may be added to the overall debt.

Required Rate of Return and WACC

Required Rate of Return can also be referred to as the opportunity cost of capital. This represents the rate which should adequately compensate investors for their investments in a company.

The cost of capital is important for several reasons, because: Investors expect a return on their investment sufficient to compensate them for their risk; Value creation is evidenced by a residual positive net present value (NPV) after discounting cash flows at the cost of capital; and many management compensation packages are based on metrics using cost of capital numbers.

The cost of capital can also be described as the rate of return that a firm has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by the returns offered on alternative securities with the same risk.

Investing in government bonds is, usually, considered the safest form of investment available. Government bonds are, normally, associated with the “risk-free” rate of return, and given the symbol rf.

The cost of debt capital: kd = rf + RP

If a company is financed by both debt and equity, then the required return on projects, etc. (of the same risk as the existing set of projects in the firm) is a weighted average of the required returns on each form of finance. In the absence of corporation tax, this gives:

WACC = kd x (proportion of debt) + kE x (proportion of equity), where the proportions of equity and debt are evaluated at market value.

Modigliani and Miller presented a case that in a perfect capital market the increase in kE due to the additional financial risk as gearing rises is only just sufficient to offset the benefit from the increase in the debt proportion. Thus the WACC is constant as the debt weight alters.

By being able to lower the tax burden through financing through debt the effective cost of debt is reduced (the „tax shield effect‟). However, in practice, companies do not use excessive amounts of gearing. One of the reasons firms generally do not select very high financial gearing levels to take advantage of the tax shield benefits is that firms with high borrowing are vulnerable to financial distress.

Bringing it together, when firms are calculating their WACC they should use the target gearing ratio and not a gearing ratio they happen to have at the time of calculation. Calculating the WACC when there are three or more sources of finance: WACC = kd1 x (1-Tc) x (proportion of debt type 1) + kd2 x (1-Tc) x (proportion of debt type 2) + kE x (proportion of equity).

The proportions should: always be based on the market values of debt and equity, not their book values; and reflect the target proportions of debt and equity financing (market values), i.e. based on optimum capital structure estimates; and, finally, always add to one.

Risk and Project Appraisal

As you consider investing in a project it is necessary to think about the possibility of failure. So, therefore, this chance that you might fail needs to be captured in the appraisal model.

Raising the discount rate is one way of dealing with project risk. There are 2 difficulties with this approach: A high degree of subjectivity in categorising projects into risk categories, and the difficulty of choosing an appropriate risk premium.

Sensitivity analysis: A method of allowing for risk (and one used by over 80% of large companies) which builds up a picture of possible outcomes by recalculating the NPV when one or more of the variables at a time is changed by a certain percentage or round amount. With sensitivity analysis managers can pay special attention to the potential for deviations from estimated mostly likely value for the variables. They may also pre-plan to control cash flows in that area.

We can also use the break-even model. Break-even represents the point at which no profits or losses are made. And, this occurs when total costs equals total revenue or when total contribution equals total fixed costs. In break-even analysis we try to establish the point at which the NPV becomes zero as one variable deviates from the most likely outcome.

In both sensitivity analysis and break even analysis we can look into how changing two variables may affect the NPV, especially when those variables might be related, such as volume and sales price.

Scenario analysis: managers consider more drastic events occurring or looking at best and worse cases in a project and review the consequent NPV.

Probability analysis: calculate the expected return and the standard deviation of the project given estimated probabilities for a range of possible outturns. Probability analysis is conducted by about one-third of large companies.

Expected NPV: weight each of the outcomes by the probability of occurrence and sum the result

Standard deviation: Standard deviation is a statistical measure of the dispersion around the expected value. Standard deviation is the square root of the variance.

To rank projects we generally assume that investors (and managers) are risk averse. That is, Project X will be preferred to project Y if at least one of the following applies: The expected return (NPV) of X is at least equal to the expected return of Y, and the variance is less than that of Y: or the expected return of X exceeds that of Y and the variance is equal to or less than that of Y.

Practical Project Appraisal: profitability index, tax and inflation

Profitability index, PI is present value of all cash flows except the initial investment (GPV) divided by initial investment. Projects with a PI > 1 are acceptable; they generate shareholder value. If there is a rationing of capital, so that not all positive NPV projects can be financed, then the rule is to select those projects with the highest PI first, going down the PI ranking until the capital investment limit is reached.

In capital rationing, sometimes, we have to deal with divisible and indivisible projects. Divisible projects are those whereby a fraction can be undertaken, and a proportionate cost and NPV is produced. On the other hand, an indivisible project is where fractions of the project cannot be implemented.

Other important considerations in project appraisal are hard capital rationing, and soft capital rationing. Hard capital rationing: capital from outside the firm (e.g. from lenders or shareholders) is limited, even though managers have identified positive NPV projects. It is a form of externally imposed risk management. Soft capital rationing: internal management-imposed limits on investment cash outflows. This may be to control divisional expenditure, to prevent the firm from over-stretching itself, to avoid breaching key financial ratio levels, or because a controlling shareholder/manager may also be unwilling to provide more finance but also unwilling to allow the sale of new shares to other shareholders. It is also a form of risk management.

It is essential that tax be considered in project appraisal, since it is the after tax returns that will be available to shareholders. So, deduct tax payments to arrive at the cash flows generated for the finance providers.

There are 2 rules to follow in allowing for tax in NPV calculations: Include incremental tax effects; and Include the tax outflow at the right time

Depreciation is not allowable as a deductible expense in the calculation of taxable profits in many jurisdictions. However, a writing down allowance (WDA) is usually permitted.

Inflation should also be factored in the project appraisal model. It is important to note that there are 2 types of inflation: Specific inflation, which refers to price changes of an individual good or service, and General inflation, which is associated with the reduced purchasing power of money, measured by an overall price index.

The rate of inflation does affect the rate of the required return, hence we can start talking about the Real Rate of Return and the Money/Nominal Rate of Return. Real rate of return is the rate of return required in the absence of inflation. And, the Money (or Nominal) rate of return includes a return to compensate for inflation.

The relationship between real and money rates of return is: (1 + money rate of return) = (1 + real rate of return) x (1 + anticipated inflation).

To allow for inflation either of these approaches may be used: Forecast the future cash flows in money terms and use a money discount rate, or Forecast the future cash flows in real terms and use a real discount rate.

The following two methods are incorrect: Using a real discount rate with money cash flows, and using a money discount rate to discount real cash flows.

Practical Project Appraisal: the investment process

Aside from the quantitative aspects, project appraisal should be subjected to qualitative scrutiny. The following is a suggested process towards investment.

Idea generation: the creation of a culture and system that encourages people within the organisation to come forward with ideas for future projects or improvements to existing ones. An atmosphere that allows investment ideas to surface and to evolve can be a significant competitive advantage for a firm.

Sponsorship of a project might involve: - presenting the idea to others who have specialist expertise helping to test the idea and shed light on the project’s viability - considering how the investment fits with the strategic direction of the business - evaluating the project using the discounted cash flow techniques as well as more traditional techniques such as payback - applying for authorisation and funding - taking a leading role in the project implementation; and - helping to assess the project as it is being undertaken to see if it lives up to its promise, to learn from mistakes and to control a run-away cash outflow.

Develop proposals and classify: ideas need to be examined in more critical detail as the data collected increases and estimates of future cash flows are refined. Major capital expenditures are treated differently in the evaluation process from more routine investments as it would be very expensive to apply sophisticated analysis to all projects.

A suggested classification of projects: New products; Expansion or improvement of existing products; Equipment replacement; Cost reduction; Statutory and welfare

Screening, strategy and budget: Proposals need to be screened to filter out those that will not go forward to detailed project appraisal, so as not to over-burden managers with numerous evaluations. Many will not taken further because they do not fit the strategic direction of the firm or because of some other limitation. To some extent (especially in the long-run) the budget can expand or contract depending on the availability of positive NPV projects.

Appraisal: detailed cash flow forecasts needed for the appraisal of projects using NPV or IRR.

Report and authorisation: NPV, IRR, payback and ARR are often presented, together with a description of the project in qualitative terms and a risk analysis in ‘capital appropriation request forms’.

Capital expenditure controls: While the investment phase of a project is underway managers track it to ensure that if there are delays or costs different from the plan they can take corrective action quickly.

Post-completion audit: monitor and evaluate the progress on the project by comparing forecast cash flows with actual cash flows over many years. Reasons for post-completion audits can be summarised as: To control the progress of the particular project under consideration; The knowledge gained from regular reviews of previous projects helps future capital investment decision-making; Psychological impact on managers.

Practical Project Appraisal: what techniques do managers use?

It is always important that before undertaking an expensive capital project, a company evaluate it to determine whether it has the potential to increase shareholders' wealth; rather than destroy it. To this end, several appraisal techniques are used. These techniques include the Net Present Value (NPV); the Internal Rate of Return (IRR) and others.

Generally, NPV is viewed to be a much superior capital budgeting method than others. Despite this, IRR is still a popular choice among managers.

The Association of Corporate Treasurers (ACT) report indicated that companies have increased their use of discounted cash flow techniques over the last thirty years. Also, large firms are more likely to use net present value (NPV) than small firms and small firms use payback as much as the discounted cash flow (DCF) methods. Companies do not tend to select one of the techniques to the exclusion of all the others, many use three or four.

Explanations advanced for the continued use of methods other than net present value include the fact that: Practitioners take time to catch up with state of the art techniques; Each method has something positive to offer, e.g. allows easier communication of project viability or that the metric more closely relates to managerial incentives;‘True’ NPV is rarely known with any great certainty therefore it helps the decision-makers select projects if a portfolio of approaches is used to estimate project viability; Managers are not solely focused on returns to shareholders;Managers use more than one technique and switch between them so that they then can choose the method that shows the current project they are sponsoring and promoting to the rest of the organisation in the best light

Why is IRR still so popular? The following are possible explanations: Managers prefer to discuss project viability using a measure that is expressed as a percentage; Senior managers often like to separate the discount rate hurdle they are trying to achieve from the discounted cash flow calculation.