Description
Based upon the content in Topic 1, why do businesses focus their attention on maximizing shareholder value rather than just maximizing profits?
Based upon the content in Topic 2, why do some experts consider maximizing shareholder value or wealth a dumb idea?
What should be changed to encourage firms to consider shifting their focus away from maximizing shareholder value?
Maximizing Shareholder Wealth Using Financial Valuation
Introduction
The goal of finance is to maximize an owner’s (shareholder’s) wealth. How is this accomplished? What are the key factors that affect valuation? Read this section and complete the Learning Journal below.
Finance begins with economics, which is the study of scarcity. In this world, we have a finite amount of resources: oil, time, labor, and so on. Economics studies how individuals and groups utilize these scarce resources. Finance is the application of economics, allowing for the tradeoff of various resources in the face of uncertainty, particularly over time.Managerial finance involves all financial decisions made by managers of companies for the purposes of operating a business. The primary goal of managerial finance is to maximize the wealth of the company’s shareholders (owners) by causing the value of their company stock to increase. As a result, the ability to determine the market value of an asset or liability is an important element of finance. Valuation is the process of estimating what something is worth. It is of critical importance when faced with investment and financing decisions.By financial valuation, we mean the ability to estimate the returns of an asset and to appropriately discount those returns factoring risk and opportunity cost (Figure 1.1). To determine the financial value of an asset or project, we must estimate the value of all of the future cash flows and find the present value of these cash flows by discounting them by the proper amount. For example, many investors would be willing to pay at least $100 today for an asset certain to pay $150 tomorrow; the gain of $50 over night more than compensates for their initial investment!
Figure 1.1 Factors Determining Financial Valuation
Boxes labeled Expected Cash Flow, Time, Risk, and Opportunity Cost all with arrows point to circle labeled Valuation.
© 2021 Strut Learning
There are alternative measures of value, but these typically need to be considered aside from financial value. For example, I might be willing to pay $2 for a finger painting done by my daughter, never expecting to collect anything but the enjoyment of looking at it on my office wall. Or I might refuse to buy a cheaper product because I disagree with policies of the company that produced it. Studying financial value does not eliminate the need to consider other values, but financial valuation is important because there is a cost associated with each managerial decision we make. The most important contributor to financial value is our expected cash flow. Note that we emphasize cash flow rather than the net income that an asset is expected to produce. This is because cash flow, unlike net income, cannot be distorted by depreciation or other accounting techniques. For example, depreciation tends to lower net income, but in actuality it raises cash flow. This occurs because depreciation lowers taxable income, and thus lowers taxes paid, but is itself not a cash flow (see table below).
Table 1.1 Effect of Depreciation on Cash Flows
No Depreciation With Depreciation
Before-Tax Income $100,000 $100,000
Depreciation Expense $0 $30,000
Taxable Income $100,000 $70,000
Taxes (20% Assumed Rate) $20,000 $14,000
Net Income $80,000 $56,000
Add Noncash Depreciation Expense $0 $30,000
After-Tax Cash Flow $80,000 $86,000
This simple example in Table 1.1 demonstrates that cash flow is different from net income. If this were your company, you might prefer to have the result on the right. Although the firm has $14,000 less accounting income, it actually puts $6,000 more money in its owner’s pocket. Because cash flow is a better measure of the amount of available funds that the firm generates, it is a more reliable indicator than net income of the firm’s ability to pay its bills, make its interest payments on debt, and pay dividends to its stockholders. Those are exactly the attributes that business owners value.It is pretty obvious that the economic value of an asset will be higher as its ability to generate cash flow increases. However, the next factor—risk—has the opposite effect on value.Risk is another name for uncertainty. In finance we believe that, holding other factors constant, economic value is negatively related to risk. Another way of saying this is that we assume investors are risk averse—meaning they dislike risk and try to avoid it. We can see risk aversion demonstrated every time someone voluntarily buys insurance or whenever an investor accepts a lower interest rate by choosing a government-guaranteed bank account rather than loaning money at a higher rate to a relative. Notice that we are not saying that in some circumstances the personal value one places on an activity is always negatively related to risk: Skydivers will pay a high price for the thrill they experience in this risky sport. But skydiving is a form of entertainment, and its value is based on personal taste rather than on an economic or investment criterion. In valuation for financial purposes, riskier investments have a lower value than their less risky counterparts. So, if someone were to offer to sell me an IOU (“I owe you,” or promissory note) that promised to pay its holder $100 in one year, I would pay more for that IOU if it were signed by Bill Gates than if it were signed by a recent college graduate. I would place the higher value on Gates’s IOU because I am pretty confident that he would have the ability to pay the $100 next year. On the other hand, a recent college graduate is likely to be in a less certain financial condition than Gates, so an IOU signed by him/her would have significantly less value because of this risk.A third factor that affects value is time—specifically, the time we have to wait to receive an expected cash flow. The longer we wait to receive a given cash flow, the less we would be willing to pay for the right to receive it in the future. For example, suppose I had two IOUs from Mr. Gates; so we will assume they are basically free of the risk of nonpayment (that is, they are free of default risk). Both contain his promise to pay the holder $100. But for one of the IOUs, the payment will take place in one year, and for the other the payment will take place in five years. If I were to offer to sell you either of these IOUs, which would you prefer to have? Undoubtedly, it would be the IOU that is due next year. After all, even if you think you won’t need the funds for five years, by receiving the money earlier, you can invest it for four years, and you will eventually have more funds available in year five. When doing problems that involve valuation and time, the use of timelines can be extremely helpful. Drawing timelines, therefore, is a very good habit to develop if you want to do well in this competency (and to become an astute businessperson). See the timeline below.
Figure 1.2 Timeline
Which IOU is preferred today? Using time value of money mathematics, the value of the two IOUs can each be expressed as today’s equivalent value. Then the choice becomes easy.
The key to making this choice and many other valuation problems is to estimate how much each payment is worth in today’s terms. Once they are both expressed in today’s terms, then the comparison of the two cash flows becomes easy. In order to find what IOUs are worth today, we need to calculate the present value of these two cash flows. This part of the valuation process represents a large portion of finance and is a skill that you will find very useful. Once you master time value of money mathematics, you can use this skill to solve a variety of everyday problems. For example, you will be able to easily calculate the payment on a car loan before you visit the dealership or estimate how much money you need to save each month in order to fund your child’s college education.The fourth factor that affects the value of an asset is the opportunity cost you face if you choose to make a purchase. Recall from economics that the opportunity cost is the forgone use of the money that you spend. One opportunity cost that we all face whenever we make a purchase is the interest we could earn by placing that money in a bank account. In 2012, interest rates were very low, so the opportunity cost represented by a bank deposit was very small, about 1% annually. The opportunity cost represented by alternative investments is constantly changing. For example, in 1980 banks were offering guaranteed deposits with interest rates around 16% because of the high inflation during that time.In the example presented in Table 1.2, we use those two years (1980 and 2012) to illustrate the effect of opportunity costs on value. Suppose we are offered an IOU that will pay $100 at the end of one year. The seller is asking $90 for the IOU.
Table 1.2 Effect of Opportunity Cost on Value
Bank Deposit at 1% (2012) Bank Deposit at 16% (1980) Gates IOU
Beginning of Year $90 $90 $90
Increase in Value 1% of $90 = $0.90 16% of $90 = $14.40 $10
End of Year $90.90 $104.40 $100
Let us also assume that the IOU is signed by Bill Gates, so it is essentially default-risk free. As you can see, this investment is attractive today (in 2012) because if you keep your money in the bank, it will only be worth $90.90 in one year given the interest rate of 1%.Therefore, we can safely say that the Gates IOU is worth at least the $90 asking price because it will be worth $100, well above the $90.90 that the deposit will be worth. So the IOU is a good deal when the opportunity cost is 1%. But if rates rise again to the 16% level that they were in 1980, things are different. You would be giving up a deposit that would grow to be worth $104.40 if you took money out of the bank and paid $90 for the IOU. In this case, the Gates IOU is worth less than $90, because just leaving the money in the bank yields the higher value of $104.40 at the end of the year.Note. Adapted from “Maximize Shareholder Wealth,” by Hickman, K., 2013, Essentials of Finance, Chapter 1, Section 1. Copyright 2013 Flat World Knowledge, Inc.
