Review questions - session 4 Flashcards
R1. Explain why the overall goal of a company is to maximize shareholder value. How can shareholder value be determined?
Shareholders are the owners of the company and want to earn a return from their investment. Moreover, they hire managers to make decisions which maximize their wealth. Thus, the goal of a corporation is to create value for the shareholders – shareholder value.
Shareholder value is the value of a company from the perspective of its owners, and as such it is defined as the market value of a firm’s equity. Shareholder value can be determined in different ways, for instance, by the firm’s market capitalization or a DCF calculation.
R2. Explain why the idea of creating shareholder value inherently integrates long-term thinking and sustainable management instead of short-term profit maximization.
Shareholder value must not be confused with short-term stock-price performance. With aimless layoffs, squeezing out business partners or any other short-term motivated cost cutting, a company may realize some quick wins, but they are not a good indicator of value creation. In the long-run, the company would have undermined its future basis of business.
Companies have to remain competitive in order to succeed in the future. This may require restructurings or other decisions that adversely affect the claims of other stakeholders. But in the long-run these decisions are inevitable for the business to prosper. Ultimately, if the company is successful, all other stakeholders will benefit as well.
R3. Comment on the pitfalls of traditional accounting-based performance measures that make them unsuitable for indicating shareholder value creation.
- Traditional ratios like profit margins and other accounting profit numbers relate to one period only and are often based on historical book values.
- Accounting rules often include some leeway for earnings management.
- Accounting numbers do not provide explicit information on the risk of the business.
- Accounting profit does not consider the entire cost of the employed capital.
R4. Explain why a positive net income does not necessarily imply value creation.
It is residual income, not net income, that can indicate value creation. Net income might be positive in a period, but the concept lacks the deduction of all aspects of capital cost. In particular, the cost of equity is not considered.
Residual income is not an accounting profit – it’s an economic profit. A negative residual income indicates a destruction of shareholder value in the particular period. It means that the operating profit does not cover the financing cost of capital. While a positive net income suggests a positive performance, if residual income is negative, in fact, the company has destroyed value.
Residual income=income - capital charge = income - (required rate of return (%) × investment)
R5. Explain the concept of Economic Value Added.
EVA is a measure of residual income. In addition, as the concept soon became more and more popular, EVA was further developed from a pure financial metric into a strategic management control system with shareholder value in its center. EVA today is seen as a financial instrument which can be applied in all elements of management control systems, such as budgeting, resource allocation, evaluation of people, and management compensation.
It is calculated as the difference between a profit number and the opportunity cost of the invested capital.
Economic value added = NOPAT - (CE × WACC)
R6. Derive the value-spread formula of EVA and comment on the relationship between ROCE and WACC.
Economic value added = CE× (ROCE - WACC)
If the return on capital employed exceeds the required return, the company will create value. If the expression in parentheses is positive, EVA will be positive – no matter the amount of capital employed.
1. ROCE > WACC: EVA is positive → Value creation
2. ROCE = WACC: EVA is zero → Indifferent
3. ROCE < WACC: EVA is negative → Value destruction
R7. Explain why in the calculation of EVA, capital employed may be taken from the beginning of the
period.
This approach is based on the reasoning that capital must be invested (employed) before it can be put to productive use. Thus, in order to generate a surplus (measured as NOPAT in our case), the capital must have been invested beforehand. Since NOPAT refers to a specific accounting period, necessary capital has been employed at the beginning of this period already.
R8. How can a firm’s cost of equity be calculated?
With the security market line, a concept of the capital asset pricing model (CAPM).
R9. What is beta? Interpret the following beta coefficients:
- β_i =1
- β_i≥1
- β_i≤1
Beta measures the co-movement of a stock with the market. Beta is determined in a regression analysis. The more sensitive a stock’s return is to the return of the market, the higher is beta. A beta of 1 represents a perfect co-movement with the market. Risky companies have betas higher than 1, and less risky companies have betas lower than 1.
R10. Describe possible adjustments that can be applied to the input figures of the basic EVA calculation.
- Operating conversions
- Funding conversions
- Shareholder conversions
- Tax conversions
R11. Explain why EVA is a superior performance measure to NOPAT and ROCE for measuring the creation of shareholder value.
- EVA to NOPAT: NOPAT influenced by size
- EVA to ROCE: ROCE ignores WACC
- EVA not influenced by size and includes cost of capital
R12. Explain why it may not be advisable to use ROCE as a firm’s main performance measure. Give an example for shortcomings of ROCE as a performance measure.
Despite its popularity in practice, ROCE is not really a value-based management ratio. It merely puts profit (NOPAT) into relation to the capital employed. However, just like other ROI measures, it neglects the cost of capital, which we measure by the WACC. Therefore, ROCE has a mere focus on profitability.
A consequence of this is that companies focusing on ROCE alone often fall into an underinvestment trap. Managers might decline value creating investment opportunities simply because their ROCE is below the ROCE of the prevailing business. However, as long as the ROCE of the investment is higher than the cost of capital (WACC), the investment would create value and declining it would be a mistake.
R13. What can managers do to increase the EVA of their organization?
- Increase profitability: Generate more after-tax operating profit with the same capital base.
- Efficient use of capital: Useless capital employed to earn the same after-tax operating profit.
- Reduce cost of capital: The lower the cost of capital, the higher is EVA.
- Invest in profitable growth: Invest capital in projects as long as the incremental ROCE exceeds WACC.
R14. State the weaknesses of EVA as a performance measure.
- May be complex to calculate and cannot be compared across companies.
- Difficult to understand and to communicate.
- Based on financial accounting numbers and not on cashflow.
- Automatically increases when capital employed is depreciated over a project’s lifetime.
- Leads to an under investment problem.
- Poor accounting systems and transfer pricing can lead to wrong EVA figures for individual divisions.
- Numerous problems in calculating the cost of capital, especially the cost of equity with the CAPM.
R15. What is value-based management?
Value-based management is a management standard which focuses on company value. Management’s attention will be focused on all factors that have an influence on the value of the firm.
We have introduced the concepts of management and management control. In value-based management and value-based management control all individual functions, tasks, and activities are centered on the creation of shareholder value. The next Figure provides the big picture of value based management, including value based management control.
