BUS601: Financial Management

6a. Recognize the importance of increasing firm value 

• What are some of the factors that analysts and interested investors will consider when placing a value on a corporation?
• What information is available from the company's financial package to identify the firm's value?
• What are at least two ways of determining a firm's value?

A considerable amount of information has been presented in this course that discusses the importance of management's decisions that lead to increasing the value of the firm. As value increases, there are some positive outcomes for the company, including a stronger capital base, more options for developing the capital plan, additional opportunities for investment, and the added benefit of attracting new investors. Some of the factors that we can review to establish the value of the firm are the effectiveness of management, view of positive future earnings, the current market value of the firm's assets, and its capital structure.

A good place to start is to review the company's balance sheet. This is a record of the firm's current and non-current assets (what the firm owns), current and non-current liabilities (what the firm owes), and owner's equity. For shareholders, this is an important piece of information. If the business were to close today, they would liquidate the assets (convert them to cash), pay off the debts, and the owner's equity is what is left for the shareholders to divide up based on the number of shares they own. As the company makes good decisions on investments that will increase the company's operating efficiencies, cash flows, and add valuable assets, while reducing the weighted average cost of capital (the capital structure), one would expect owner's equity to increase.

In addition to the balance sheet, it is also possible to determine value through other financial models. For example, the firm can use the capital asset pricing model (CAPM) and the weighted average cost of capital (WACC). The firm can use both the CAPM and the WACC to evaluate investments to determine its expected rates of return. The asset approach considers the worth of the firm's assets, their potential for supporting operations and creating value, and the cost to replace these assets at current market prices. A potential shareholder will also take a market approach, look at the firm's position in the market, and evaluate how they perform against the industry participants as well as against specific competitors.

To review, see:

• Valuing the Corporation
• Discounted Dividend vs. Corporate Valuation
• The Balance Sheet

 

6b. Calculate various measures of corporate value 

• What does the market value added (MVA) calculation show about corporate value?
• What does the economic value added (EVA) calculation show about corporate value?

Let's accept the proposition that, as executives of a company, we are committed to our business's successful operation and growth. As we have stakeholders, including shareholders and other businesses holding our debt, we are focused on ways to demonstrate to them that our management decisions are having a positive impact on increasing value. Shareholders can expect to receive returns that meet or exceed their expected return rates. (As we have discussed many times so far in this course.) Two measures of corporate value that are widely used are the market value added (MVA), and the economic value added (EVA).

Market value added considers the firm's total market value minus the total amount of capital that the company's investors have made. When investors purchase shares of stock in a firm, they expect that the firm will use this capital to make investments that will increase its value and increase the value to each shareholder. MVA is a method for demonstrating if this is happening with this business. The calculation for MVA is:

MVA = market value of shares – book value of shareholder's equit

The market value of shares is the current price that a share of stock is trading at. The book value of shareholder's equity is found in the firm's financial reports on the balance sheet.

Economic value added analyzes the investments (projects) undertaken by the firm and looks to see if the returns from these investments were sufficient to cover the costs and generate additional wealth for shareholders. The calculation of the economic value-added measure is:

EVA = NOPAT – (WACC × capital invested)

In this formula, NOPAT is the net operating profit after taxes, WACC is the weighted average cost of capital, or what it costs the firm to acquire and use the capital needed for the investment opportunity, and the capital invested is the equity and any long-term debt at the start of the period.

To review, see:

• MVA and EVA
• The Association between Economic Value Added, Market Value Added, and Leverage

 

6c. Apply value creation methodologies to business decisions

• Define a merger and an acquisition. How are they similar?
• How can mergers and acquisitions (M&A) be used to create value?
• What are some advantages and disadvantages to forming a corporate alliance?
• When might a firm consider it appropriate to divest of parts of the business?

We have discussed some of the ways that firms look to increase the value of their business for their stakeholders. This process encompasses a wide range of activities, from implementing good management practices, creating strategic plans, developing a corporate culture that recognizes and rewards employees and fosters high levels of employee engagement, satisfying customers with quality products and services, and making investments that will support these goals. One area where firms can make investments externally is to evaluate opportunities involving mergers and acquisitions (M&A).

A merger involves reaching an agreement with another firm to combine their companies. After the merger, the companies will usually form a new company consisting of both firms. Decisions will be made on the management structure of the newly formed business, if all the assets of both firms will be kept in place, etc. In an acquisition, one company buys another company. The original firm retains its identity and incorporates the acquired firm into its organizational structure.

To be successful (that is, to increase the firm's value because of the M&A activity), this process requires substantial research and analysis. Some of the reasons for engaging in M&A activity can include:

• acquiring new technology or manufacturing processes
• increasing market share
• access to new distribution channels
• ability to have a larger global supply chain
• addition of new products and services
• opportunities to consolidate some functions and reduce costs economies of scale)
• new opportunities for offering customers a broader range of products
• addition of locations, local presence
• opportunities for diversification (air conditioning company adding a heating company)

Whatever the reasons, M&A activity should focus on the most important goal of the firm, which is to make decisions that will increase the firm's value, benefitting the firm's stakeholders.

One approach that can realize some or most of the advantages of M&As is for two or more firms to consider allying. With a corporate alliance, the parties remain independent but agree to work together on initiatives that can provide a benefit to each company that is greater than what they could achieve on their own. These activities might include sharing technology, distribution channels, shared expenses for entering a new market, or launching a new product. In an alliance, all parties share the risks that may be involved in any new venture. A benefit of this approach is that it is less complex than a merger or acquisition, less expensive, and can have a future end date.

A final activity that a business can consider for increasing its value is to decide to divest itself of, or eliminate, one or more of its existing business units. There are several reasons why it may make financial sense for a firm to divest part of its operation:

• the business unit is unprofitable or may require a large investment to continue;
• the company needs to obtain funds needed for more profitable investments;
• the company decides to focus on a core group of products and/or services; or
• regulatory actions require it, such as in the case of a monopoly.

As you can see, the executive management team for a corporation has a great deal to consider as they strive to produce financial results that the firm's stakeholders require.

To review, see Other Topics in M&A.

 

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• acquisition
• asset approach
• balance sheet
• capital asset pricing model
• corporate alliance
• divest
• economic value added
• market approach
• market value added
• merger
• value of the firm
• weighted average cost of capital