Chapter 11

Creating Value for Shareholder

Shapiro and Balbirer: Modern Corporate Finance:

A Multidisciplinary Approach to Value Creation
Graphics by Peeradej Supmonchai

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 Learning Objectives
 Calculate a firm’s market-to-book value ratio and
indicate why it is a good measure of the value
management creates for shareholders.
 Discuss the nature of cross-subsidies within a
multidivisional firm and how value-based analysis
can eliminate these value-destroying activities.
 Discuss the nature of strategic fit and focus and
their role in creating shareholder value.
 Indicate the degree to which the market is capable
of recognizing management’s ability to implement
long-term value-creating strategies.

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 Learning Objectives (Cont.)
 Discuss the trade-offs between short- and long-term
profits and describe the methods that can be used to
encourage long-term profit maximization.
 Explain how the proper design of executive compensation
contracts can improve organizational performance.
 Discuss the challenges of measuring economic profits and
indicate how approaches like market value added (MVA)
and economic value added (EVA) can be used to assess
the wealth created by managers.
 List the synergies that can be generated by acquisitions
that are designed to exploit strategic fit.
 Capture the effects of potential synergies in valuing an
acquisition candidate.
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 Investment Opportunities and Value Creation

Projects that deliver a return greater than

the required rate of return increase
shareholder value. Conversely, shareholder
value is dissipated anytime a project’s
return is less than the required return.

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 Market-to-Book Value Ratio

Market Value P0 R  g
 
Book Value B0 k  g
Where:
P0 = the market value of the firm’s common stock
B0 = the book value of the firm’s common stock
R = the return on equity
g = the dividend growth rate
k = the cost of equity capital

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 Interpretation of Market-to-Book Value Ratio

The ratio of market-to-book value measures

the value created by the firm because it
compares the present value that shareholders
receive for each dollar they invested in the
business.

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 Excess of Market-to-Book Value

Market Value - Book Value R  k


Book Value kg

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 Estimating the Market-to-Book Value -
An Example

Ten investors each contribute $10,000 for

one share each in a new company. Earnings
at the end of the year are expected to be
$30,000, of which 40% will be retained in the
business. Future retentions will also be 40%
of earnings. The return on equity for current
and future projects is expected to be 30%,
and the required rate of return is 25%. What
is the ratio of market-to-book value?

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 Estimating the Market-to-Book Value -
An Example
Since there are 10 share of stock, earnings per share
is $3,000. With a payout of 60%, the first-year dividend
is expected to be $1,800. The dividend growth rate is
(1.0 - 0.6) x 30% = 12%. The value of a share is
therefore:

P = DIV1/(k-g) = $1,800/(0.25 - 0.12)

= $13,846

With a price/share of $13,846 and an initial investment

of $10,000, the market-to-book ratio = 1.38.

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 Value-Based Analysis

Value-based analysis stems from the idea

that you can calculate the value of each line
of business using DCF techniques. Some
lines of business may be so profitable that
they are cross-subsidizing other units that
are actually dissipating value. Such value-
destroying units should be prime candidates
for divestiture.

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 Value Creation and Strategic Fit

Strategic fit relates to the existence of synergies

across business units. If synergies exist, it is
possible to generate economies of scale or
scope through
 serving similar market or sharing channels of
distribution
 employing similar production methods
 exploiting special technical or other skills

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 Creating Value Through a Focus Strategy

By sticking to its core business,

management can create value by:
 streamlining the organizational structure

 reducing expenses

 speeding decision making

 promoting initiative

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 Performance Improvement Through
Decentralization

Exposing business units to market forces typically

improves performance. By allowing unit managers
to operate their divisions as independent profit
centers, a company can:
 identify underperforming units
 recognize and reward managers and employees
of value-creating units
 reduce the likelihood of cross-subsidization

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 Is the Stock Market Myopic?

Empirical evidence indicates that investors can

discern the effect of current management actions on
the firm’s true economic status. Some examples:
 The announcements of increased capital
expenditures is viewed as “good news,” as are
announcements of increased investment in R&D.
 Stock price reaction to short-term financial results
are often related to their longer-term implications.
 Accounting changes that effect reported earnings
but not cash flows do not affect stock prices.

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 Trade-offs between Short- and
Long- Term Profits

The following are actions that managers

take to make short-term results look better:
 postpone capital outlays
 defer operating expenses
 reduce operating expenses
 market special promotions

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 Controlling Short-Term/Long-Term Trade-offs

 Budgeting allowances that encourage long-term

maximizing behavior

 Setting realistic goals

 Emphasizing long-term goals when measuring

performance

 Linking long-term performance to pay

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 Designing Executive Compensation Contracts

 Avoid linking compensation to ac-counting

measures of performance.
 Some portion of the executive com-
pensation package should be tied to stock
returns.
 Stock options can help offset man-
agement’s natural risk aversion.
 Compensate manager or measures critical
to the firm’s strategic success.

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 Golden Parachutes

Agreements whereby a company rewards key

executives with substantial payments if they
elect to (or are forced to) leave the company
when a change of control takes place.

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 Partial Spin-offs

A partial spinoff involves a public offering of

parts of the shares in a subsidiary unit. This
allows subsidiary managers to own a stake
in their own operation thereby linking
compensation to performance.

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 Measuring Economic Profits

Part of the challenge of designing executive

compensation systems is that accounting
measures of profitability may not reflect the
economic profitability being created in a
given year. Two ways that can be used to
capture the wealth created by manager are:
 Market Value Added (MVA)
 Economic Value Added (EVA)

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 Market Value Added (MVA)

MVA measures shareholder wealth creation by looking at

the difference between the market value of the firm’s
common stock and the capital supplied by shareholders:

MVA = Market Value of the Common Stock - Equity Capital

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 Calculating MVA -
Occidental Petroleum (OXY) 1997

Market Value of Common Stock = $29.25/share

Share Outstanding = 341.126 billion

Book Value of the Common Stock = $3.109 billion

MVA = $29.25 (341.126 million shares) - $3.109 billion

= $6.869 billion

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 Economic Value Added (EVA)

EVA represents the after-tax operating

profits of a company after it has been
charged for all of the capital used to
generate those profits:

EVA = EBIT (1-T) - WACC (Capital Employed)

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 Calculating EVA -
Occidental Petroleum (OXY) 1997

EBIT = $962 million Corporate Tax Rate = 32.3%

WACC = 10.1% Invested Capital = $6.761 billion

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 Calculating EVA-
Occidental Petroleum (OXY) 1997

EVA  $962 million(0.677) - 0.101($6,761 billion)

 $651 million - $683 million
 - $32 million

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 Using EVA - The Benefits and Limitations

 Benefits
 Theoretically simple
 EVA can adjust for risk easily by estimating
risk-adjusted WACCs.
 Limitations
 EVA only measures the benefits of the assets
in place. It is not suitable for firms with
significant growth opportunities.
 EVA is a short-term measure. It doesn’t
capture the impact of actions that look bad
immediately but can create long-term value.

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