Corporate Value Creation
CORPORATE VALUE CREATION
That as, you may remember, we mentioned in passing before that this is one of those two issues that we were going to address that not, are not only important and critical for all companies, but they’re also related to that extremely critical variable that we call the cost of capital. So in sessions three and four, we discuss the intuition and estimation of the cost of capital, then we apply that cost of capital to evaluate projects. And remember that both the NPV and the IRR, they both use the cost of capital as an input in order to make a decision of whether you should go ahead with a project or not. And today the cost of capital will also be a critical variable in determining whether we’re creating value or not. Now, this is an extremely important issue because, at the end of the day when capital is provided to the company, the capital providers expect a return, and whether or not you’re creating value needs to be related to the return required by those capital providers. And we’re going to get a little bit fancier than this, but, but in fact, if you keep that very basic idea in mind then you will have gone a long way towards where we’re going. Because at the end of the day we’re not going to say something that is far more sophisticated that the return that you need to get out of the projects in which you invest needs to be higher than the cost of raising the capital to invest in those projects that we’re actually considering. So the whole issue of value creation goes through, one way or another, comparing the return that we get from all the corporate activities with the cost of raising capital in order to invest in all those products and services that corporations actually sell. Now, before we get to a formal definition of value creation to a formal definition of what we’re going to call EVA, or economic value added there are three things that I would like to discuss with you. One and the three of them we’re going to discuss a little bit in passing, but I really don’t want to go through this whole value creation discussion waving my hands completely on these three issues. One of them is this distinction between shareholder value creation and stakeholder value creation. The other is two very common and, and by common I mean that the evidence shows that the managers tend to make two mistakes that go against the process of value creation.
And the third is a fundamental difference between what we want to do and how we actually achieve that thing that we want to do. Some people refer to this as goals versus means. Well, you know, that name or another name we’re going to talk about that before we discuss EVA and value creation per se. So issue number one. This distinction between shareholder value and stakeholder value. And let’s first define both of them. first, shareholders remember, and this is sometimes easily forgotten, but shareholders are the owners of the company. When you own a little piece of paper that is a share of a company, what you own is a piece of, of the equity and liabilities of this company. Whatever is the balance between assets and liabilities you own a little bit piece of that. So shareholders are effectively the owners of the company. Now, what is the problem is actually the day to day main thing with a modern corporation is that you know? We can actually pull together a large number of vast capital to invest in a business but if we’re very many and particular, if we have some other jobs, We cannot actually run the corporation on a day to day basis. So that means that we need to delegate the day to day decisions to someone else. And this is where managers come in. You know, that are the owners of the capital. And then they actually tell managers well, this is what we expect from you. We’ll get back to this in, in just a minute, but the owners, the shareholders, are the owners of the company.
Who are the stakeholders?
Stakeholders are more or less by definition basically anybody that has a role to play in the process of value creation. So besides the shareholders, the employees have a role to play, the suppliers have a role to play, the society in which the company does business, they have a role to play. In other words, stakeholders have to do with the process of value creation, are affected by the process of value creation. And the easiest way to think about it is that shareholders are just one of the very many stakeholders. In other words, sometimes is this tension, this dichotomy between do we focus on shareholders or do we focus on stakeholders. It’s a question that is phrased in terms do we focus on this one part of the company that we call the shareholders or do we focus on a more general, a broader group of stakeholders, one of which are these shareholders. And, and it seems to be the case, and, and I emphasize that it seems to be the case that stakeholder focus would be a broader issue. And I, I, I will argue in just a minute that is not quite the case. And the reason why that is not quite the case is you may want to ask whether there’s a conflict in the first place. More often than not we tend to see as, this as an either or. Either I do things for the shareholders, or I do things for the stakeholders, and it’s not really like that. Many people would actually think about this in more proper terms than an either or the decision. And, and the easiest way to think about is put it in the following way.
Do you think you can really do good things for your shareholders?
Do you think that you can really benefit your shareholders by ignoring the interest of all the other parties that have something to do with the process of value creation? In this example, suppose that I pay really badly to my employees, and I do that on behalf of my shareholders. I am going to squeeze my employees. So I pay less, I get more profits, and then I channel those profits to my shareholder.
How smart is that policy?
Can I do that over and over and over again? Eventually people will catch up, and eventually, the only people that I will be able to hire by the very low wages that I’m attempting to pay are very unskilled people. People that are will not go to create value for shareholders, in the first place. So, so it’s important that you keep in mind that sometimes we think that we may be able to do things to the detriment of some parties and to the benefit of shareholders, but, sooner or later, we’re going to realize that that is not really the case. In other words, and to put this the other way around, only by taking care, properly, of all the people that have some participation in the process of value creation, will I be able to benefit the shareholders. So, my first point on this is it’s not so much of a conflict. Really, you cannot benefit shareholders even if that is your final, final goal. You cannot really benefit shareholders to the detriment of all the other parties that have a role to play in the process of value creation.
Now, why do we tend to focus, at least in finance, on shareholder value?
Well, there are at least three reasons for that.
Reason number one is what we mentioned in passing before. Some people think that is a narrower criterium. And they think that is a narrower criterium simply because shareholders are one of the very many stakeholders. But as we also said before, remember, you cannot really benefit the shareholders by ignoring all the other stakeholders. So at the end of the day, if you properly take care of all the stakeholders of the company, then you are going to be benefiting the shareholders. And so, although from the point of view of counting, it seems to be that stakeholders are broader. From the point of view of how do we actually think about the process of value creation by trying to benefit the shareholders, then I cannot do that without actually doing something proper to all the other stakeholders. So in other words, we focus on shareholders because we think that the only way that you’re going to benefit them is if you take into account properly, the interest and benefits of all the other stakeholders in the in the company.
Second reason why, particularly in finance, we want to focus on, shareholder value is because we can always quantify that. We can do it more than one way, and as you see there, I put in, I’m putting objectively in quotations, and I’m putting objectively in quotations because. We can always come up with a number, but of course, that number depends first on that you and I agree on how we are going to measure the process of value creation because there’s not one variable. There are many different possibilities. And, therefore, you know, if you and I disagree on what is the more proper variable to measure value creation, then we may end up with an objective number, both you and me. But these two numbers will not or may not match each other. So, on the one hand, we do not have to agree on how we actually measure the process of value creation. Or we may agree on the variable and we may disagree on the inputs. If you remember, that’s what happened with the Even if you and I agree that we can calculate a company’s cost of equity. By using the CAPM what we throw into the CAPM for the market and the beta may be different between what you think or I think or someone else actually thinks. So when we say objective, we basically mean that we mean that, that means that we can calculate a number, and that number is something that we can use to make decisions. The third and final reason why we find as we tend to focus on shareholder value is what we said at the very beginning. And that is, remember that, at the end of the day, shareholders are the owners of the company. This is a problem that in economics actually has been studied for many, many years. Which is called the principle agent problem? The principle, in this case, is the owners of the capital. Well, the owners of the capital, the shareholders, they cannot get together and actually run the company on a day to day basis. So, they delegate the day to day operations of the company. All the decisions that need to be made to the agent, and the agent, in this case, is the manager. And so the problem, what is called the principal-agent problem is basically the fact that what is good for the managers may not necessarily be good for the shareholders.
In other words, what is good for the agent may not necessarily be good for the principle, and all these issues that we’re going to discuss are, how do we bring them together?
How do we actually get managers to do what shareholders would like them to do?
But at the end of the day, always keep in mind, shareholders are the owners of the capital. They are the owners of the company and when they delegate the day to day operation of the company. The implicit mandate is very simple, make the best possible use out of this capital. And that is basically created as much value as possible with this capital. That is going to be socially good but it’s going to be also good for the corporation.http://www.capitalbudgetingtechniques.com/corporate-value-creation/Capital Budgeting TechniquesCorporate FinanceCORPORATE VALUE CREATION That as, you may remember, we mentioned in passing before that this is one of those two issues that we were going to address that not, are not only important and critical for all companies, but they're also related to that extremely critical variable that we call the cost of...Admin email@example.comAdministratorCapital Budgeting Techniques