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8.6. Summary and Conclusions

Modern finance theory reduces future uncertainty to quantifiable risk so we can estimate an investment's prospective yield using classical probability theory. This approach is based on a fundamental proposition, namely the efficient market hypothesis (EMH) that assumes investor rationality and freedom of information in reasonably perfect markets with few barriers to trade. But if nothing else, geo-political and economic events post-millennium, culminating in global financial meltdown and recession, should convince us otherwise. So whilst the material presented in this text provides a framework for the analysis of investment and finance decisions it remains to be seen whether it is a "castle built on sand".

Part One chronicled why academics and analysts throughout the twentieth century gravitated towards a normative objective of strategic financial management based on shareholder wealth maximisation using the opportunity cost of capital concept as an investment criterion.

Part Two focused on the managerial investment decision with only oblique reference to derivation of its cut-off rate. We observed that moving from a world of certainty to uncertainty; corporate wealth maximisation should be equivalent to the expected NPV maximisation of all a firm's projects, using probability and utility theory. Turn to recent world events, however, and serious questions arise as to how far corporate management have embraced wealth maximisation criteria.

Part Three introduced the impact of the finance decisions on investment decisions for all-equity firms wishing to fund new projects through retained earnings. We modeled dividends and earnings to derive the market capitalisation of equity as a project cut-off rate under growth and non-growth conditions and explained their equivalence. Moving on to firms financed by a miscellany of funds, the objective was to derive an overall marginal cost of capital (WACC) as an appropriate cut-off rate. We concluded that the use of WACC for project appraisal must satisfy three conditions. New projects must be homogenous with respect to the firm's current business risk (otherwise investor returns will change). The capital structure must remain stable (otherwise the weightings applied to investor returns will change. The project must be marginal relative to the scale of the firm's existing operations to minimise possible losses.

Part Four modeled an alternative to NPV maximisation using the value added concept based on freedom of information. We confirmed that if a company creates EVA from project investment then total market value should increase by an equal amount (MVA) which is equivalent to project NPV. Because negative EVA means wealth is destroyed it should alert investors to negative NPV associated with unacceptable decisions taken by management on their behalf. Value added therefore represents an external control on the consequences of managerial action that companies ignore at there peril.

Finally, if you wish to visualize all the pieces of the puzzle put together, take a look at the diagram below. Reproduced from Chapter One, it should be familiar but hopefully, it should now make more sense.

Strategic Financial Management

Figure 1.3: Strategic Financial Management

8.7. Selected References

1. Fisher, I., The Theory of Interest, MacMillan (London), 1930.

2. Hill, R.A., "Capital Budgeting: The Cut-Off Rate for Investment", The Singapore Accountant, November 1988.

3. Gordon, M.J., "Optimal Investment and Financing Policy", The Journal of Finance, Vol. 18, No. 2, May 1963.

4. Keynes, J.M., The General Theory of Employment, Interest and Money, MacMillan (London), 1936.

5. Modigliani, F. and Miller, M.H., "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review, Vol. XLVIII, No. 3, June, 1958.

6. Dunning, J.H. and Rowan, D.C., "Inter-firm Efficiency Comparisons: US and UK Manufacturing Enterprises in Britain", Banca Nationale del Lavaro Quarterly Review, No. 85, June, 1968.

7. I.C.A.E.W., "The Corporate Report", ASSC, (London), 1975.


9. Stern, J., Shiely, J. and Ross, I., The EVA Challenge-Implementing Value Added Change in an Organisation, John Wiley and Sons Inc. (New York), 2001.

10. Young, S.D. and O' Byrne, S.F., EVA and Value Based Management: A Practical Guide to Implementation, McGraw-Hill (New York), 2001.

11. Neale, B. and McElroy, T., Business Finance: A Value Added Approach, Pearson Education (Harlow), 2004.

12. Stewart, G.B., The Quest for Value, Harper Business (New York), 1991.

13. Weaver, S.C., "Measuring Economic Value Added: A Survey of the Practices of EVA Proponents", Journal of Applied Finance, Vol. 11, No. 1, Fall/Winter, 2001.

14. Griffith, J.M., "The True Value of EVA", Journal of Applied Finance, Vol. 14, No. 1, Fall/ Winter, 2004.

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