value creation ch14
TRANSCRIPT
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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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Hawawini & Viallet Chapter 143
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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Hawawini & Viallet Chapter 144
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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Hawawini & Viallet Chapter 145
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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Hawawini & Viallet Chapter 146
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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Hawawini & Viallet Chapter 147
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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Hawawini & Viallet Chapter 148
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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Hawawini & Viallet Chapter 149
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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Hawawini & Viallet Chapter 1410
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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Hawawini & Viallet Chapter 1411
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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Hawawini & Viallet Chapter 1412
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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Hawawini & Viallet Chapter 1413
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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Hawawini & Viallet Chapter 1414
EXHIBIT 14.5:
The Drivers of Value Creation.
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Hawawini & Viallet Chapter 1415
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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Hawawini & Viallet Chapter 1416
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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Hawawini & Viallet Chapter 1417
EXHIBIT 14.6a:
Financial Statements for Kiddy Wonder World.Figures in millions of dollars
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Hawawini & Viallet Chapter 1418
EXHIBIT 14.6b:
Financial Statements for Kiddy Wonder World.Figures in millions of dollars
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Hawawini & Viallet Chapter 1419
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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Hawawini & Viallet Chapter 1420
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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Hawawini & Viallet Chapter 1421
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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Hawawini & Viallet Chapter 1422
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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Hawawini & Viallet Chapter 1423
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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Hawawini & Viallet Chapter 1424
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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Hawawini & Viallet Chapter 1425
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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Hawawini & Viallet Chapter 1426
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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Hawawini & Viallet Chapter 1427
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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Hawawini & Viallet Chapter 1428
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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Hawawini & Viallet Chapter 1429
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