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1.2. Wealth Creation and Value Added

Modern finance theory regards capital investment as the springboard for wealth creation. Essentially, financial managers maximise stakeholder wealth by generating cash returns that are more favorable than those available elsewhere. In a mature, mixed market economy, they translate this strategic goal into action through the capital market.

Figure 1:1 reveals that companies come into being financed by external funding, which invariably includes debt, as well as equity and perhaps an element of government aid.

If their investment policies satisfy consumer needs, firms should make money profits that at least equal their overall cost of funds, as measured by their investors' desired rates of return. These will be distributed to the providers of debt capital in the form of interest, with the balance either paid to shareholders as a dividend, or retained by the company to finance future investment to create capital gains.

Either way, managerial ability to sustain or increase the investor returns through a continual search for investment opportunities should then attract further funding from the capital market, so that individual companies grow.

The Mixed Market Economy

Figure 1.1: The Mixed Market Economy

If firms make money profits that exceed their overall cost of funds (positive ENPV) they create what is termed economic value added (EVA) for their shareholders. EVA provides a financial return to shareholders in excess of their normal return at no expense to other stakeholders. Given an efficient capital market with no barriers to trade, (more of which later) demand for a company's shares, driven by its EVA, should then rise. The market price of shares will also rise to a higher equilibrium position, thereby creating market value added (MVA) for the mutual benefit of the firm, its owners and prospective investors.

Of course, an old saying is that "the price of shares can fall, as well as rise", depending on economic performance. Companies engaged in inefficient or irrelevant activities, which produce periodic losses (negative EVA) are gradually starved of finance because of reduced dividends, inadequate retentions and the capital market's unwillingness to replenish their asset base at lower market prices (negative MVA).

Figure 1.2 distinguishes the "winners" from the "losers" in their drive to add value by summarising in financial terms why some companies fail. These may then fall prey to take-over as share values plummet, or even implode and disappear altogether.

1.3. The Investment and Finance Decision

On a more optimistic note, we can define successful management policies of wealth maximisation that increase share price, in terms of two distinct but inter-related functions.

Investment policy selects an optimum portfolio of investment opportunities that maximise anticipated net cash inflows (ENPV) at minimum risk.

Finance policy identifies potential fund sources (equity and debt, long or short) required to sustain investment, evaluates the risk-adjusted returns expected by each and then selects the optimum mix that will minimise their overall weighted average cost of capital (WACC).

The two functions are interrelated because the financial returns required by a company's capital providers must be compared to its business returns from investment proposals to establish whether they should be accepted.

And while investment decisions obviously precede finance decisions (without the former we don't need the latter) what ultimately concerns the firm is not only the profitability of investment but also whether it satisfies the capital market's financial expectations.

Corporate Economic Performance, Winners and Losers.

Figure 1:2: Corporate Economic Performance, Winners and Losers.

Strategic managerial investment and finance functions are therefore inter-related via a company's weighted, average cost of capital (WACC).

From a financial perspective, it represents the overall costs incurred in the acquisition of funds. A complex concept, it embraces explicit interest on borrowings or dividends paid to shareholders. However, companies also finance their operations by utilizing funds from a variety of sources, both long and short term, at an implicit or opportunity cost. Such funds include trade credit granted by suppliers, deferred taxation, as well as retained earnings, without which companies would presumably have to raise funds elsewhere. In addition, there are implicit costs associated with depreciation and other non-cash expenses. These too, represent retentions that are available for reinvestment.

In terms of the corporate investment decision, a firm's WACC represents the overall cut-off rate that justifies the financial decision to acquire funding for an investment proposal (as we shall discover, a zero NPV).

In an ideal world of wealth maximisation, it follows that if corporate cash profits exceed overall capital costs (WACC) then NPV will be positive, producing a positive EVA. Thus:

- If management wish to increase shareholder wealth, using share price (MVA) as a vehicle, then it must create positive EVA as the driver.

- Negative EVA is only acceptable in the short term.

- If share price is to rise long term, then a company should not invest funds from any source unless the marginal yield on new investment at least equals the rate of return that the provider of capital can earn elsewhere on comparable investments of equivalent risk.

Figure 1:3 overleaf, charts the strategic objectives of financial management relative to the investment and finance decisions that enhance corporate wealth and share price.

Strategic Financial Management

Figure 1.3: Strategic Financial Management

 
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