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Part 4. The Wealth Decision

8. Shareholder Wealth and Value Added


Financial analysis is not an exact science and many of the theories upon which it is based are even "bad" science. The root cause of the problem is that most theoretical models are characterized by rational human behaviour in a hypothetical world of "efficient" markets where uncertainty is reduced to measurable probability. Thus, the theory itself may be logical but if the basic hypothesis is underpinned by simplifying assumptions without any empirical evidence, then its analytical conclusions may be invalid.

For example, the English economist J.M. Keynes (1936) writing during the Great Depression pointed to "the extreme precariousness of our estimates of the basis of knowledge on which our estimates of prospective yield have to be made". We have also observed that in their quest for value, today's management have no precise definition of what wealth maximisation means to shareholders, let alone other investors. Is it a dividend stream, future earnings, or some combination of the two that incorporates capital gains? A fundamental problem is whether a firm's decision to distribute profits, rather than to retain earnings for reinvestment and go for growth, has a differential impact on share prices and equity yields. If the answer is yes; then even an all-equity firm might find it impossible to model investment decisions that satisfy all shareholders' expectations.

More worrying is that management's perception of income may differ from investors, not simply because they employ different valuation models but because their behaviour is motivated by personal greed, rather than shareholder welfare (think Enron and sub-prime mortgages). So, we should not be surprised that without insider information, markets are periodically fuelled by rumor, speculation and crowd behaviour, which makes them inherently inefficient and unstable with a propensity to crash. Certainly, this alternative hypothesis (which also runs counter to agency theory outlined in Chapter One) has emerged to explain the financial panic of 2008 and subsequent economic recession.

So, our final question is this. Without the internal cash flow data upon which management base their strategic decisions, is it possible for investors to reformulate external accounting data to measure the consequences of these decisions? If so, the capital market may have some control over managerial behaviour that conflicts with wealth maximising criteria?

8.1. The Concept of Economic Value Added (EVA)

In a perfect capital market, optimum investment-finance decision models employed by management under risk and non-risk conditions should maximise corporate wealth through the inflow of cash at minimum cost. It is a basic tenet of financial theory that the NPV maximisation of all a firm's projects satisfies this objective. However, economists have long advocated the concept of value added as an alternative measure for wealth creation. For an excellent exposition see Dunning and Rowan (1968). Since the 1980s the concept has been commercially pioneered, notably by the American management consultants Joel Stern and Bennett Stewart III, so much so that it now has a considerable body of support, as evidenced by select references at the end of this chapter

Economic value added (EVA) represents a company's periodic "real" income measured by the difference between its total distributable profits and the monetary value of its overall cost of capital. The rationale for EVA is best explained by first defining all the components in the following serial equation:

(1) EVA = (EAT + Interest) - C.K = NOPAT - C.K = NOI - C.K

Total distributable profits are defined as annual de-leveraged earnings, which equal earnings after tax (EAT) plus interest. In the literature, this figure is also termed net operating profit after tax (NOPAT) or to introduce American parlance, net operating income (NOI).

Overall monetary cost of capital equals the total amount of capital (C) raised by the firm since its inception (through share issues, retained earnings, debt and capitalized expenditure such as R and D) multiplied by an estimate of its WACC (K) using market data..

So, if distributable profit exceeds overall capital costs (i.e. EVA is positive) management have created wealth by exceeding the returns of all its stakeholders. Conversely, If EVA is negative, value has been destroyed and investors should place funds their elsewhere, unless new management is brought in.

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