Corporate Value Creation
Corporate Value Creation is one of those two issues that are not only important and critical for all companies, but this is also related to that extremely critical variable that we call the cost of capital. So we will 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 on whether you should go ahead with a project or not.
Today, the cost of capital will be a critical variable in determining whether we are 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 are, creating value needs to be related to the return required by those capital providers. And we are going to get a little bit fancier than this, but in fact, if you keep that very basic idea in mind then you will have gone a long way towards where we are going. Because at the end of the day we’re not going to say something that is far more sophisticated than 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. Therefore, 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 are going to call EVA or economic value added there are three things that I would like to discuss with you.
- 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.
So issue number one.
- This distinction between shareholder value and stakeholder value.
And let us first define both of them. First, remember 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. Therefore, 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 are very many and particular, if we have some other jobs, we cannot actually run the corporation on a day-to-day basis. Therefore, 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. Then they actually tell managers well, this is what we expect from you. We will get back to this in, in just a minute, but the owners, the shareholders, are the owners of the company.