Corporate Financial Policy and Shareholders Return

K.C.College

CHAPTER 1: SUMMARY Competitor, or peer, firms play a central role in shaping a variety of corporate policies ranging from executive compensation to product market strategy. However, most research on corporate financial policy

assumes

that

firms

choose

their

capital

structures

independently of their peers. That is, researchers typically assume that a firm's capital structure is determined by a function of its marginal tax rate, expected deadweight loss in default, information environment, or incentive conflicts among claimants. Thus, the role for competitor firms' behavior in affecting corporate capital structures is often ignored, or at most an implicit one through its unmeasured impact on these firm specific determinants.

Corporate liquidity comes at a cost, however, since interest earned on corporate cash reserves is often taxed at a higher rate than interest earned by individuals. Furthermore, cash may provide funds for managers to invest in projects that offer non-pecuniary benefits but destroy shareholder value.

Firms that face greater financing constraints, especially those with valuable investment opportunities, the marginal value of cash should be higher than for firms that can easily raise additional capital. While financial

constraints

are

often

associated

with

information

asymmetries between firms and capital providers, they can be thought of as tantamount to higher transactions costs in accessing Corporate Financial Policy and Shareholders’ Return

Page 1

K.C.College

external capital. In such a context, an additional dollar of internal funds enables a constrained firm to avoid these higher costs of raising funds, thereby, rendering additional internal funds relatively more valuable.

Corporate Financial Policy and Shareholders’ Return

Page 2

K.C.College

CHAPTER 2: INTRODUCTION Financial Management is nothing but management of the limited financial resources the organization has, to its utmost advantage. Resources are always limited, compared to its demands or needs. This is the case with every type of organisation. Proprietorship or limited company, be it public or private, profit oriented or even nonprofitable organisation.

2.1 Finance function– importance In general, the term ―Finance‖ is understood as provision of funds as and when needed. Finance is the essential requirement –sine qua non– of every organisation. Required Everywhere: All activities, be it production, marketing, human resources development, purchases and even research and development, depend on the adequate and timely availability of finance both for commencement and their smooth continuation to completion. Finance is regarded as the life-blood of every business enterprise. Efficient utilization More Important: Finance function is the most important function of all business activities. The efficient management of business enterprise is closely linked with the efficient management of its finances. The need of finance starts with the setting up of business. Its growth and expansion require more funds. The funds have to be raised from various sources. The sources have to be selected keeping in relation to the implications, in particular, risk attached. Rising of money, alone, is not important. Terms and Corporate Financial Policy and Shareholders’ Return

Page 3

K.C.College

conditions while raising money are more important. Cost of funds is an important element. Its utilization is rather more important. If funds are utilised properly, repayment would be possible and easier, too. Care has to be exercised to match the inflow and outflow of funds. Needless to say, profitability of any firm is dependent on its cost as well as its efficient utilization.

2.2 Financial management The term financial management has been defined, differently, by various authors. Some of the authoritative definitions are given below: ―Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds‖ —Solomon ―Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short-term and long-term credits for the firm‖ —Phillioppatus ―Business finance is that business activity which is concerned with the conservation and acquisition of capital funds in meeting financial needs and overall objectives of a business enterprise‖ —Wheeler

Financial Management is the process of financial-decisions. There are three types of financial decisions:  Financing Decisions: such decisions involve estimating the requirement of funds, deciding about leverage, evaluating various sources of finance and finally raising the finance in such a way that the cost of capital is minimum and the risk is at optimum level.


Page 4

K.C.College

 Investment Decisions: such decisions involve investments in working capital and fixed assets and evaluating the projects under consideration. The management should be guided by getting the maximum return by keeping the risk at optimum level.  Dividend Decisions: such decisions involve the consideration of profit, liquidity, shareholder requirements, tax aspect and need of the funds for reinvestment purposes. The management has to decide about retaining the funds for further investment plans without compromising the various income requirements of innumerable shareholders.

The aim of a company is to create value for its shareholders. Although the other stake holders are also important, the shareholder is the most important stakeholder. The overall objective of the financial Management is to apply the financial management policies and principles for maximizing the wealth of the shareholders in the long run. This can be achieved by maximizing the EPS and keeping the risk at optimum levels.

The shareholders expect a rate of return based on the risk they perceive. By maximizing their wealth we mean providing better than the return they expect. How can a company earn more than the return the shareholders and other stake holders expect in a hard-core competitive arena? The answer is that this can be achieved by creating a sustainable competitive advantage through exploiting the market imperfections tapping the opportunities and identifying the possible threats in advance. Also all the market players do not have Corporate Financial Policy and Shareholders’ Return

Page 5

K.C.College

same expectations and risk perception and it is here the financial Management blooms i.e. they create value for shareholders through appropriate level of trading on equity. 2.3 Nature of financial management Financial management refers to that part of management activity, which is concerned with the planning and controlling of firm‘s financial resources. Financial management is a part of overall management. All business decisions involve finance. Where finance is needed, role of finance manager is inevitable. Financial management deals with raising of funds from various sources, dependant on availability and existing capital structure of the organization. The sources must be suitable and economical to the organization. Emphasis of financial management is more on its efficient utilization, rather than raising of funds, alone. The scope and complexity of financial management has been widening, with the growth of business in different diverse directions. As business competition has been increasing, with a greater pace, support of financial management is more needed, in a more innovative way, to make the business grow, ahead of others.

2.4 Aims of finance function The following are the aims of finance function: Acquiring Sufficient and Suitable Funds: The primary aim of finance function is to assess the needs of the enterprise, properly, and procure funds, in time. Time is also an important element in meeting the needs of the organization. If the funds are not available as and when required, the firm may become sick or, at least, the profitability Corporate Financial Policy and Shareholders’ Return

Page 6

K.C.College

of the firm would be, definitely, affected. It is necessary that the funds should be, reasonably, adequate to the demands of the firm. The funds should be raised from different sources, commensurate to the nature of business and risk profile of the organization. When the nature of business is such that the production does not commence, immediately, and requires long gestation period, it is necessary to have the long-term sources like share capital, debentures and long term loan etc. A concern with longer gestation period does not have profits for some years. So, the firm should rely more on the permanent capital like share capital to avoid interest burden on the borrowing component. Proper utilization of Funds: Raising funds is important, more than that is its proper utilization. If proper utilization of funds were not made, there would be no revenue generation. Benefits should always exceed cost of funds so that the organization can be profitable. Beneficial projects only are to be undertaken. So, it is all the more necessary that careful planning and cost-benefit analysis should be made before the actual commencement of projects. Increasing

Profitability:

Profitability

is

necessary

for

every

organization. The planning and control functions of finance aim at increasing profitability of the firm. To achieve profitability, the cost of funds should be low. Idle funds do not yield any return, but incur cost. So, the organization should avoid idle funds. Finance function also requires matching of cost and returns of funds. If funds are used efficiently, profitability gets a boost. Maximising Firm‘s Value: The ultimate aim of finance function is maximizing the value of the firm, which is reflected in wealth Corporate Financial Policy and Shareholders’ Return

Page 7

K.C.College

maximization of shareholders. The market value of the equity shares is an indicator of the wealth maximization.

2.5 Functions of finance Finance function is the most important function of a business. Finance is, closely, connected with production, marketing and other activities. In the absence of finance, all these activities come to a halt. In fact, only with finance, a business activity can be commenced, continued and expanded.

Finance exists

everywhere,

be it

production, marketing, human resource development or undertaking research activity. Understanding the universality and importance of finance, finance manager is associated, in modern business, in all activities as no activity can exist without funds. Financial Decisions or Finance Functions are closely inter-connected. All decisions mostly involve finance. When a decision involves finance, it is a financial decision in a business firm. In all the following financial areas of decision-making, the role of finance manager is vital. We can classify the finance functions or financial decisions into four major groups: 1. Investment Decision or Long-term Asset mix decision 2. Finance Decision or Capital mix decision 3. Liquidity Decision or Short-term asset mix decision 4. Dividend Decision or Profit allocation decision

Investment Decision Investment decisions relate to selection of assets in which funds are to be invested by the firm. Investment alternatives are numerous. Resources are scarce and limited. They have to be rationed and Corporate Financial Policy and Shareholders’ Return

Page 8

K.C.College

discretely used. Investment decisions allocate and ration the resources

among

the

competing

investment

alternatives

or

opportunities. The effort is to find out the projects, which are acceptable. Investment decisions relate to the total amount of assets to be held and their composition in the form of fixed and current assets. Both the factors influence the risk the organisation is exposed to. The more important aspect is how the investors perceive the risk. The investment decisions result in purchase of assets. Assets can be classified, under two broad categories: Long-term investment decisions: The long-term capital decisions are referred to as capital budgeting decisions, which relate to fixed assets. The fixed assets are long term, in nature. Basically, fixed assets create earnings to the firm. They give benefit in future. It is difficult to measure the benefits as future is uncertain. The investment decision is important not only for setting up new units but also for expansion of existing units. Decisions related to them are, generally, irreversible. Often, reversal of decisions results in substantial loss. When a brand new car is sold, even after a day of its purchase, still, buyer treats the vehicle as a second-hand car. The transaction, invariably, results in heavy loss for a short period of owning. So, the finance manager has to evaluate profitability of every investment proposal, carefully, before funds are committed to them.

Short-term

investment

decisions:

The

short-term

investment

decisions are, generally, referred as working capital management. The finance manger has to allocate among cash and cash equivalents, receivables and inventories. Though these current Corporate Financial Policy and Shareholders’ Return

Page 9

K.C.College

assets do not, directly, contribute to the earnings, their existence is necessary for proper, efficient and optimum utilization of fixed assets.

Finance Decision Once investment decision is made, the next step is how to raise finance for the concerned investment. Finance decision is concerned with the mix or composition of the sources of raising the funds required by the firm. In other words, it is related to the pattern of financing. In finance decision, the finance manager is required to determine the proportion of equity and debt, which is known as capital structure. There are two main sources of funds, shareholders‘ funds (variable in the form of dividend) and borrowed funds (fixed interest

bearing).

These

sources

have

their

own

peculiar

characteristics. The key distinction lies in the fixed commitment. Borrowed funds are to be paid interest, irrespective of the profitability of the firm. Interest has to be paid, even if the firm incurs loss and this permanent obligation is not there with the funds raised from the shareholders. The borrowed funds are relatively cheaper compared to shareholders‘ funds, however they carry risk. This risk is known as financial risk i.e. Risk of insolvency due to non-payment of interest or non-repayment of borrowed capital. On the other hand, the shareholders‘ funds are permanent source to the firm. The shareholders‘ funds could be from equity shareholders or preference shareholders. Equity share capital is not repayable and does not have fixed commitment in the form of dividend. However, preference share capital has a fixed commitment, in the form of dividend and is redeemable, if they are redeemable preference shares. Barring a few Corporate Financial Policy and Shareholders’ Return

Page 10

K.C.College

exceptions, every firm tries to employ both borrowed funds and shareholders‘ funds to finance its activities. The employment of these funds, in combination, is known as financial leverage. Financial leverage provides profitability, but carries risk. Without risk, there is no return. This is the case in every walk of life! When the return on capital employed (equity and borrowed funds) is greater than the rate of interest paid on the debt, shareholders‘ return get magnified or increased. In period of inflation, this would be advantageous while it is a disadvantage or curse in times of recession.

Return on equity (ignoring tax) is 20%, which is at the expense of debt as they get 7% interest only. In the normal course, equity would get a return of 15%. But they are enjoying 20% due to financing by a combination of debt and equity. The finance manager follows that combination of raising funds which is optimal mix of debt and equity. The optimal mix minimizes the risk and maximizes the wealth of shareholders.


Page 11

K.C.College

Liquidity Decision Liquidity decision is concerned with the management of current assets. Basically, this is Working Capital Management. Working Capital Management is concerned with the management of current assets. It is concerned with short-term survival. Short term-survival is a prerequisite for long-term survival. When more funds are tied up in current assets, the firm would enjoy greater liquidity. In consequence, the firm would not experience any difficulty in making payment of debts, as and when they fall due. With excess liquidity, there would be no default in payments. So, there would be no threat of insolvency for failure of payments. However, funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability. Profitability would suffer with more idle funds. Investment in current assets affects the profitability, liquidity and risk. A proper balance must be maintained between liquidity and profitability of the firm. This is the key area where finance manager has to play significant role. The strategy is in ensuring a trade-off between liquidity and profitability. This is, indeed, a balancing act and continuous process. It is a continuous process as the conditions and requirements of business change, time to time. In accordance with the requirements of the firm, the liquidity has to vary and in consequence, the profitability changes. This is the major dimension of liquidity decision working capital management. Working capital management is day to day problem to the finance manager. His skills of financial management are put to test, daily.


Page 12

K.C.College

Dividend Decision Dividend decision is concerned with the amount of profits to be distributed and retained in the firm. Dividend: The term ‗dividend‘ relates to the portion of profit, which is distributed to shareholders of the company. It is a reward or compensation to them for their investment made in the firm. The dividend can be declared from the current profits or accumulated profits. Which course should be followed – dividend or retention? Normally, companies distribute certain amount in the form of dividend, in a stable manner, to meet the expectations of shareholders and balance is retained within the organisation for expansion. If dividend is not distributed, there would be great dissatisfaction to the shareholders. Non-declaration of dividend affects the market price of equity shares, severely. One significant element in the dividend decision is, therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid to the shareholders. The dividend decision depends on the preference of the equity shareholders and investment opportunities, available within the firm. A higher rate of dividend, beyond the market expectations, increases the market price of shares. However, it leaves a small amount in the form of retained earnings for expansion. The business that reinvests less will tend to grow slower. The other alternative is to raise funds in the market for expansion. It is not a desirable decision to retain all the profits for expansion, without distributing any amount in the form of dividend. There is no ready-made answer, how much is to be


Page 13

K.C.College

distributed and what portion is to be retained. Retention of profit is related to • Reinvestment opportunities available to the firm. • Alternative rate of return available to equity shareholders, if they invest themselves. 2.6 Corporate finance Corporate finance is the field of finance dealing with financial decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).


Page 14

K.C.College

The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms ―corporate finance‖ and ―corporate financier‖ may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses. The field of corporate finance has undergone a tremendous mutation in the past twenty years. A substantial and important body of empirical work has provided a clearer picture of patterns of corporate financing and governance, and of their impact for firm behavior and macroeconomic activity. To the extent that financial claims‘ returns depend on some choices such as investments, these choices, in the complete market paradigm are assumed to be contractible and therefore are not affected by moral hazard. Furthermore, investors agree on the distribution of a claim‘s returns; that is, financial markets are not plagued by problems of asymmetric information. The key issue for financial economists is the allocation of risk among investors and the pricing of redundant claims by arbitrage.


Page 15

K.C.College

2.7 Role of finance in corporate strategy

The role of finance is obviously greater in financing decisions. Finance plays a major role in formulating the financing strategy, evaluating the alternatives, and monitoring the outcomes. The objective of the financing strategy is to raise capital at the lowest cost, which in turn increases shareholder value. At first glance, it might appear that these decisions are the purview of the CFO and others need not get involved in them. However, just as operating decisions have an impact on financing policies, so financing decisions can affect operating strategies. For example, a company whose financing decisions have led it into too much debt might not have the financial flexibility to raise capital quickly enough for needed growth. Or, on a Corporate Financial Policy and Shareholders’ Return

Page 16

K.C.College

positive note, a company whose financial policies include good risk management might be able to create a competitive advantage for itself by offering products that limit customer risk as well. Therefore, a general manager with a clear understanding of financial policies can leverage them to create value for shareholders. The role of finance in performance evaluation is identical to its role in operating decisions: valuation and monitoring.


Page 17

K.C.College

CHAPTER 3: FINANCIAL POLICY In the simplest terms, financial policy relates to two key choices that firms make:  How much of their capital structure to support by debt, rather than equity  How much of their earnings to retain for use as internal equity finance, rather than distributing dividends and raising new equity in the market. A portfolio consisting of a little risky equity and a lot of safe debt should have the same value as a second portfolio with a lot of less risky equity and a little safe debt if the underlying risk of the two portfolios is comparable. We should go beyond terms like ―debt‖ and ―equity‖ to consider the characteristics of the claims themselves. Over the years, this lesson has been emphasized by the evolution of financial instruments such as leases, which may act as substitutes for debt, and options, the valuation of which can, once again, be understood by constructing comparable portfolios with and without options and requiring that they have the same value.

A challenge to analyzing the impact of taxation on firm decisions, though, is that the tax system is based in large part on formal labels, and only indirectly on underlying asset characteristics. Thus, equity faces one set of tax rules and debt another, often more favorable, so special rules are needed regarding the treatment of the risky debt that more closely resembles equity. Equity repurchases are treated more Corporate Financial Policy and Shareholders’ Return

Page 18

K.C.College

favorably than are dividends but, again; restrictions exclude from this favorable treatment share redemptions that too closely resemble dividends. Evaluating the impact of taxes on firm behavior requires that we understand the rules that apply in distinguishing among different types of assets. Financial policy decisions often amount to choosing the optimal trade-off between distortions to financial policy and the tax benefits such distortions generate. Indeed, a major tax avoidance activity consists of trying to improve this trade-off, constructing assets and transactions to permit corporations to characterize their financial decisions in a manner most favorable from the tax standpoint. The impact of taxation, then, depends not only on the tax system itself, but also on where the tax system‘s definitional lines are drawn and how well they can be ―moved‖ through tax avoidance activity.

3.1 Corporate Strategy Value creation is at the heart of corporate strategy. Strategies are means to ends. Corporate Strategy is supposed to be the means by which an organization achieves and sustains success. It is about enabling an organization to achieve and sustain superior overall performance and returns. It involves the activities of:  Defining and refining the corporate vision, mission and objectives  Problem identification  Alternatives generation  Evaluation/selection


Page 19

K.C.College

It is a core responsibility of the top management including CEO, CFO and the Directors. There are three levels of corporate strategy: (i) Corporate level, (ii) Business level, and (iii) Functional level.

Corporate (Top) level managers decide what businesses to invest. Decisions regarding the sources of funds and their allocation are also taken at this level. This level strategy focuses on two dimensions:  Growth  Liquidity

Growth dimension refers to growth in sales, growth in assets and growth of growth opportunities. The top level managers would need to plan what types of growth strategies suit their market orientation. They will need to effectively choose the optimal growth strategy from the various alternatives like expansion into existing businesses, diversification into new businesses, modes of growth, internal development, acquiring firms, and collaborative ventures. Liquidity refers to level of cash flows required to the business efficiently.

Business level strategy lays down the ways in which a company would seek to attain competitive advantage through effective positioning. Forming a successful business strategy involves creating a first-rate competitive strategy. It concerns strategic decisions about choice of products, quality of products, meeting needs of customers, Corporate Financial Policy and Shareholders’ Return

Page 20

K.C.College

gaining advantage over competitors, exploiting or creating new opportunities etc. The strategy needs to be frequently reviewed against prevailing external and internal environment Functional level strategies are those strategies that are initiated by support centers of an organization like human Relations department, IT department. To be competitively superior to other firms, functional level managers strategize to attain superior efficiency, superior quality, superior customer responsiveness, and superior innovation.


Page 21

K.C.College

CHAPTER 4: CORPORATE FINANCIAL POLICIES Corporate financial policy determines how the corporation will invest its funds (the investment decision), how the corporation will obtain money to purchase assets (the financing decision), and what it will do with its net income (the dividend decision). These three types of decisions are made in concert to maximize the value of the firm. 4.1 Investment Decision Financial policy begins with the investment decision---if the company cannot identify profitable investments, it will not need to raise funds. In deciding whether to invest in an asset, a company will value the cash flows it projects the asset will earn, net of the cost of the asset. Because the cash flows will be received over time, the company has to account for the time value of money and the riskiness of the cash flows. It does so by "discounting" the cash flows at a "discount" or "hurdle" rate. 4.2 Discount Rates Discount rates have two components: one reflects the current riskless interest rates (normally taken to be the rate of return on Treasury bonds, termed Rf) and the other reflects the riskiness of the business. The "risk premium," or the difference between the discount rate and the riskless rate, also has two components: the required risk premium on the market as a whole (termed Rm) and the co-movement of the


Page 22

K.C.College

company's returns with the returns on the market as a whole (termed beta). 4.3 Financing Decision There are two types of financing decisions made by corporations: how to fund asset purchases and how to fund the daily operations. In terms of funding daily operations, firms often operate on lines of credit from banks or other financial institutions and may issue shortterm commercial paper. In terms of funding asset purchases, firms generally go to 'the market,' and issue either corporate bonds or equity securities. 4.4 Long-Term Debt and Equity Corporations do not directly issue corporate bonds and equity securities; rather, these issues are "underwritten" by investment banks. The banks are responsible for setting interest rates for bonds and prices for stocks and are responsible for the actual selling of the securities. The investment banks are generally responsible for purchasing any of the issue that cannot be sold at the announced price. 4.5 Long-Term Debt Corporate bonds tend to be long-term instruments (30 years is not uncommon) and pay interest rates that are above those paid by the U.S. Treasury. Corporate bonds are "rated" by agencies such as Moody's in terms of their riskiness: a bond rated Aaa is safer than a Corporate Financial Policy and Shareholders’ Return

Page 23

K.C.College

bond rated Baa, which is safer than one rated Bbb. The better the rating on the bond, the lower will be the required interest rate, all other things equal. 4.6 Equity There are two types of equity securities: common stock and preferred stock. Common stock represents an ownership share in the corporation. Common shareholders have a right to vote at shareholder meetings and may or may not receive dividends from the company. The value of their shares will fluctuate depending on the fortunes of the company and the economy a whole. Preferred stock is non-voting stock on which dividends are paid at a contractual rate and may be convertible into common stock. 4.7 Dividend Decision Companies can do two things with their net income: invest it in the business or pay it to shareholders. Monies that are reinvested in the business are termed "retained earnings." Companies can pay money to shareholders in two ways: they can pay dividends, or they can repurchase stock from shareholders. Some companies are known for paying consistent dividends, whereas other companies pay no dividends.


Page 24

K.C.College

CHAPTER 5: THEORIES 5.1 Efficient Market Theory The efficient market hypothesis holds that a market is efficient if it is impossible to make economic profits by trading on available information. Cowles (1933) documents the inability of forty-five professional agencies to forecast stock price changes. Other early work in the field by statisticians such as Working (1934), Kendall (1953), and Osborne (1959; 1962) document that stock and commodity prices behave like a random walk, that is, stock price changes behave as if they were independent random drawings. This means that technical trading rules based on information in the past price series cannot be expected to make above-normal returns.

Samuelson (1965) and Mandelbrot (1966) provide the modern theoretical rationale behind the efficient markets hypothesis that unexpected price changes in a speculative market must behave as independent random drawings if the market is competitive and economic trading profits are zero. They argue that unexpected price changes reflect new information. Since new information by definition is information that cannot be deduced from previous information, new information must be independent over time. Therefore, unexpected security price changes must be independent through time if expected economic profits are to be zero. In the economics literature, this hypothesis has been independently developed by Muth (1961). Termed the rational expectations hypothesis, it has had a dramatic Corporate Financial Policy and Shareholders’ Return

Page 25

K.C.College

impact on macroeconomic analysis. The efficient markets hypothesis is perhaps the most extensively tested hypothesis in all the social sciences. An important factor leading to the substantial body of empirical evidence on this hypothesis is the data made available by the establishment of the Center for Research in Security Prices (CRSP) sponsored by Merrill Lynch at the University of Chicago. The center created accurate computer files of monthly closing prices, dividends, and capital changes for all stocks on the New York Stock Exchange since 1926 and daily closing prices of all stocks on the New York and American stock exchanges since 1962 [Lorie and Fisher (1964) describe the basic data and its structure.] Consistent with the efficient markets hypothesis, detailed empirical studies of stock prices indicate that it is difficult to earn above-normal profits by trading on publicly available data because it is already incorporated insecurity prices. Fama (1970; 1976) provides reviews of the evidence. However the evidence is not completely one-sided; see, for example, Jensen (1978), who provides a review of some anomalies. If capital markets are efficient, then the market value of the firm reflects the present value of the firm‘s expected future net cash flows, including cash flows from future investment opportunities. Thus the efficient markets hypothesis has several important implications for corporate finance. First, there is no ambiguity about the firm‘s objective function: managers should maximize the current market value of the firm. Hence management does not have to choose between maximizing the firm‘s current value or its future value, and there is no reason for management to have a time horizon that is too short. Second, there is no benefit to manipulating earnings per share. Corporate Financial Policy and Shareholders’ Return

Page 26

K.C.College

Management decisions that increase earnings but do not affect cash flows represent wasted effort. Third, if new securities are issued at market prices which reflect an unbiased assessment of future payoffs, then concern about dilution or the sharing of positive net present value projects with new security holders is eliminated. Fourth, security returns are meaningful measures of firm performance. This allows scholars to use security returns to estimate the effects of various corporate policies and events on the market value of the corporation. Beginning with the Fama, Fisher, Jensen and Roll (1969) analysis of the effect of stock splits on the value of the firm‘s shares, this empirical research has produced a rich array of evidence to augment positive theories in corporate finance.

5.2 Portfolio Theory Prior to Markowitz (1952; 1959), little attention was given to portfolio selection.

Security

analysis

focused

on

picking

undervalued

securities; a portfolio was generally taken to be just an accumulation of these securities. Markowitz points out that if risk is an undesirable attribute for investors, merely accumulating predicted ―winners‖ is a poor portfolio selection procedure because it ignores the effect of portfolio diversification on risk. He analyzes the normative portfolio question: how to pick portfolios that maximize the expected utility of investors under conditions where investors choose among portfolios on the basis of expected portfolio return and portfolio risk measured by the variance of portfolio return. He defines the efficient set of portfolios as those which provide both maximum expected return for a given variance and minimum variance for a given expected return. Corporate Financial Policy and Shareholders’ Return

Page 27

K.C.College

His mean-variance analysis provides formal content to the meaning of diversification, a measure of the contribution of the covariance among security returns to the riskiness of a portfolio, and rules for the construction of an efficient portfolio. Portfolio theory implies that the firm should evaluate projects in the same way that investors evaluate securities. For example, there are no rewards or penalties per se associated with corporate diversification. (Of course, diversification could affect value by affecting expected bankruptcy costs and thus net cash flows.)

5.3 Capital Asset Pricing Theory Treynor (1961), Sharpe (1964), and Lintner (1965) apply the normative analysis of Markowitz to create a positive theory of the determination of asset prices. Given investor demands for securities implied by the Markowitz mean-variance portfolio selection model and assuming fixed supplies of assets, they solve for equilibrium security prices in a single-period world with no taxes. Although total risk is measured by the variance of portfolio returns, Treynor, Sharpe, and Lintner demonstrate that in equilibrium an individual security is priced to reflect its contribution to total risk, which is measured by the covariance of its return with the return on the market portfolio of all assets. This risk measure is commonly called an assets ―systematic‖ risk.

5.4 Option Pricing Theory The capital asset pricing model provides a positive theory for the determination of expected returns and thus links today‘s asset price Corporate Financial Policy and Shareholders’ Return

Page 28

K.C.College

with expected future payoffs. In addition, many important corporate policy problems require knowledge of the valuation of assets which, like call options, have payoffs that are contingent on the value of another asset. Black and Scholes (1973) provide a key to this problem in their solution to the call option valuation problem. An American call option gives the holder the right to buy a stock at a specific exercise price at any time prior to a specified exercise date. They note that a risk-free position can be maintained by a hedge between an option and its stock when the hedge can be adjusted continuously through time. To avoid opportunities for riskless arbitrage profits, the return to the hedge must equal the market riskfree rate; this condition yields an expression for the equilibrium call price. Black/Scholes note that if the firm‘s cash flow distribution is fixed, the option pricing analysis can be used to value other contingent claims such as the equity and debt of a levered firm. In this view the equity of a levered firm is a call option on the total value of the firm‘s assets with an exercise price equal to the face value of the debt and an expiration date equal to the maturity date of the debt. The Black/Scholes analysis yields a valuation model for the firm‘s equity and debt. An increase in the value of the firm‘s assets increases the expected payoffs to the equity and increases the coverage on the debt, increasing the current value of both. An increase in the face value of the debt increases the debtholder‘s claim on the firm‘s assets, thus increasing the value of the debt, and since the stockholders are residual claimants, reduces the current value of the equity; An increase in the time to repayment of the debt or in the risk less rate lowers the present value of the debt and Corporate Financial Policy and Shareholders’ Return

Page 29

K.C.College

increases the market value of the equity. An increase in the variance rate or in the time to maturity increases the dispersion of possible values of the firm at the maturity date of the debt. Since the debt holders have a maximum payment which they can receive, an increase in dispersion increases the probability of default, lowering the value of the debt and increasing the value of the equity.

5.5 Agency Theory Narrowly defined, an agency relationship is a contract in which one or more persons engage another person to perform some service on their behalf which involves delegating some decision-making authority. Spence and Zeckhauser (1971) and Ross (1973) provide early formal analyses of the problems associated with structuring the compensation of the agent to align his or her incentives with the interests of the principal. Jensen and Meckling (1976) argue that agency problems emanating from conflicts of interest are general to virtually all cooperative activity among self-interested individuals whether or not it occurs in the hierarchical fashion suggested by the principal-agency analogy. Jensen and Meckling define agency costs as the sum of the costs of structuring contracts (formal and informal): monitoring expenditures by the principal, bonding expenditures by the agent, and the residual loss. The residual loss is the opportunity cost associated with the change in real activities that occurs because it does not pay to enforce all contracts perfectly. They argue that the parties to the contracts make rational forecasts of the activities to be accomplished and structure contracts to facilitate those activities. At the time the contracts are negotiated, the actions motivated by the Corporate Financial Policy and Shareholders’ Return

Page 30

K.C.College

incentives established through the contracts are anticipated and reflected in the contracts‘ prices and terms. Hence, the agency costs of any relationship are born by the parties to the contracting relationship. This means that some individuals) can always benefit by devising more effective ways of reducing them. Jensen and Meckling use the agency framework to analyze the resolution of conflicts of interest between stockholders, managers, and bondholders of the firm.

The development of a theory of the optimal contract structure in a firm involves construction of a general theory of organizations. Jensen (1983) outlines the role of agency theory in such an effort. Fama (1980) and Fama and Jensen (1983a; 1983b) analyze the nature of residual claims and the separation of management and risk bearing in the corporation and in other organization forms. They provide a theory based on tradeoffs of the risk sharing and other advantages of the corporate form with its agency costs to explain the survival of the corporate form in large-scale, complex non-financial activities. They also explain the survival of proprietorships, partnerships, mutuals, and nonprofits in other activities. Since the primary distinguishing characteristic among these organizational forms is the nature of their residual or equity claims, this work addresses the question: What type of equity claim should an organization issue? This question is a natural predecessor to the question of the optimal quantity of debt relative to equity—the capital structure issue—that has long been discussed in finance. One factor contributing to the survival of the corporation is the constraints imposed on the investment, financing, Corporate Financial Policy and Shareholders’ Return

Page 31

K.C.College

and dividend decisions of managers by what Manne (1965) calls the market for corporate control. Jensen and Ruback (1983) argue that this market is the arena in which alternative management teams compete for the rights to manage corporate resources, with stockholders playing a relatively passive role accepting or rejecting competing takeover offers. In the last ten years, there has been extensive examination of the stock price effects associated with corporate takeovers through mergers, tender offers, and proxy fights. The evidence indicates that successful tender offers produce approximately 30 percent abnormal stock price performance in target firms‘ shares and 4 percent abnormal stock price performance in bidding firms‘ shares, while for mergers the numbers are 20 percent and 4 percent.


Page 32

K.C.College

CHAPTER

6:

FINANCIAL

THEORY

AND

CORPORATE POLICY The central purpose of a corporation is to provide value for the shareholders. Simply put, it is to make money. The discipline that studies money, markets and their operation with an eye to practical application is called finance. Thus, financial theory has a significant impact on the decisions made by the leaders of corporations. 6.1 Finance Accountants have been described as historians. They record how much is spent, earned and invested. They sort, classify and organize. However, what these actions mean, in a greater sense is not their primary concern. Economists, on the other hand, are concerned with the more general questions of how markets operate, why they operate thus and what this means for individuals, businesses and nations. Financial professionals stand in the middle ground. While they must stay in touch with the accounting and have a keen understanding of the real-world operations of the firm, they also attempt to understand the esoteric aspects of economic theory. 6.2 Theory Because finance requires that decisions be made, as opposed to the decisions' impact being recorded, predictions and estimations must be made. However, unlike economics, which addresses such general questions, finance professionals use theories, models and statistical Corporate Financial Policy and Shareholders’ Return

Page 33

K.C.College

tools to answer specific questions. An economist may ask the question, "Is this industry expanding its operations, and if so, at what rate?" The financial professional may use some of the same tools, but is more likely to ask, "Should our company expand operations, and if so, when?" 6.3 Overlap If the distinction between finance and economics is a matter of scale, then it is only natural that there exists some overlap between the disciplines and indeed, some of the most esteemed names in financial theory are great economists. John Maynard Keynes, William Sharpe and Oskar Morgenstern were responsible for innovations like the capital asset pricing model and modern portfolio theory. However, these scholars are almost universally referred to as economists, not financial theorists. 6.4 Impact on Policy While financial theory, like all theory, is imperfect, it does provide rational guidance for dealing with uncertainty. For example, analysts may regard the company's stock price as too low. This may lead the directors of the corporation to purchase shares of the stock from shareholders, allowing the firm to retain more of its profits as it would not have to pay dividends on shares that it repurchased. Another possibility would be theorists predicting significant changes in the interest rates demanded by credit markets. The corporation may then hasten, or delay, obtaining needed credit lines. Corporate Financial Policy and Shareholders’ Return

Page 34

K.C.College

6.5 Problems The greatest challenge to financial theory is the reliance on reason. While objective assessment of measurable facts and application of proven formulas may seem unassailable, as Publius Syrus said "Everything is worth what its purchaser will pay for it." Pricing models, market statistics and economic data may be invaluable for providing predictions, but sometimes a particular product, company or brand name may fall into fashion or out of favor for reasons that may be apparent only in retrospect or forever remain inscrutable.


Page 35

K.C.College

CHAPTER

7:

FINANCIAL

OBJECTIVES

OF

CORPORATE FINANCE THEORY Corporate finance theory takes specific models and applies them to specific corporate finance decisions. By and large, these decisions have financial goals, but occasionally, there are other types of goals as well, such as good community relations. Nevertheless, corporate finance theory has several specific goals in mind relative to both the structure of the firm as well as the returns on assets. 7.1 Rational Choice Rational Choice is the main model of finance theory. It is the basic, "classical model" that holds a firm seeks to maximize its return on capital. In this case, the financial goal is very clear: profit maximization through direct methods and indirect methods, such as increasing market share. This model sees the firm as a unified entity and the financial goals are calculated with this in mind. 7.2 Control Firms have different centers of control. Stockholders, managers, labor unions, creditors and investors all have interests and different levers of power to use and manipulate. In this model, the final idea is to satisfy these different interests and hence, the financial goal is really about spreading earnings to as many different centers of power as possible. While this remains a part of rational choice, it is a highly decentralized version of the approach that spreads out who is doing Corporate Financial Policy and Shareholders’ Return

Page 36

K.C.College

the choosing over many factors. In this model, the firm is not a unified entity. 7.3 Debt More specific is the creation of an optimal debt/equity ratio. The financial goal here is to maximize the tax benefits of debt financing, while maintaining strong growth in equity. Investors do not like to see huge debt, but the real goal here is to see how capital is performing. If capital is performing well and cash flow is growing, then the debt can be carried and hence, it is not an issue for investors. The basic balance is the final goal: to use enough debt to finance projects cheaply while maintaining solid cash flows. 7.4 Expansion In any set of investment decisions, one additional goal is the option to expand. A decision might come down to issuing dividends on stock versus reinvesting that cash in expansion projects to increase cash flow and the ability to carry debt. This might be termed an indirect model of rational choice, since it sees cash flow as the result of good decisions over time, not an immediate need to satisfy stockholders and investors.


Page 37

K.C.College

CHAPTER 8: SHAREHOLDER VALUE CREATION Creating shareholder value is the key to success in today's marketplace. There is increasing pressure on corporate executives to measure, manage and report the creation of shareholder value on a regular basis. In the emerging field of shareholder value analysis, various measures have been developed that claim to quantify the creation of shareholder value and wealth. More than ever, corporate executives are under increasing pressure to demonstrate on a regular basis that they are creating shareholder value. This pressure has led to an emergence of a variety of measures that claim to quantify value-creating performance. Creating value for shareholders is now a widely accepted corporate objective. The interest in value creation has been stimulated by several developments.  Capital markets are becoming increasingly global. Investors can readily shift investments to higher yielding, often foreign, opportunities. Institutional investors, which traditionally were passive investors, have begun exerting influence on corporate managements to create value for shareholders.  Corporate governance is shifting, with owners now demanding accountability from corporate executives. Manifestations of the increased assertiveness of shareholders include the necessity for


Page 38

K.C.College

executives to justify their compensation levels, and well-publicized lists of under performing companies and overpaid executives.  Business press is emphasizing shareholder value creation in performance rating exercises.  Greater attention is being paid to link top management compensation to shareholder returns. Defining Shareholder Value and – Wealth Creation From the economist's viewpoint, value is created when management generates revenues over and above the economic costs to generate these revenues. Costs come from four sources: employee wages and benefits; material, supplies, and economic depreciation of physical assets; taxes; and the opportunity cost of using the capital. Under this value-based view, value is only created when revenues exceed all costs including a capital charge. This value accrues mostly to shareholders because they are the residual owners of the firm. Shareholders expect management to generate value over and above the costs of resources consumed, including the cost of using capital. If suppliers of capital do not receive a fair return to compensate them for the risk they are taking, they will withdraw their capital in search of better returns, since value will be lost. A company that is destroying value will always struggle to attract further capital to finance expansion since it will be hamstrung by a share price that stands at a discount to the underlying value of its assets and by higher interest rates on debt or bank loans demanded by creditors. Corporate Financial Policy and Shareholders’ Return

Page 39

K.C.College

Wealth creation refers to changes in the wealth of shareholders on a periodic (annual) basis. Applicable to exchange-listed firms, changes in shareholder wealth are inferred mostly from changes in stock prices, dividends paid, and equity raised during the period. Since stock prices reflect investor expectations about future cash flows, creating wealth for shareholders requires that the firm undertake investment decisions that have a positive net present value (NPV). Although used interchangeably, there is a subtle difference between value creation and wealth creation. The value perspective is based on measuring value directly from accounting-based information with some adjustments, while the wealth perspective relies mainly on stock market information. For a publicly traded firm these two concepts are identical when (i) management provides all pertinent information to capital markets, and (ii) the markets believe and have confidence in management. 8.1 Approaches for measuring shareholder value: 8.1.1 Marakon Approach: Marakan Associates, an international management-consulting firm founded in1978, has done pioneering work in the area of value-based management. This measure considers the difference between the ROE and required return on equity (cost of equity) as the source of value creation. This measure is a variation of the EV measures. Instead of using capital as the entire base and the cost of capital for calculating the capital charge, this measure uses equity capital and Corporate Financial Policy and Shareholders’ Return

Page 40

K.C.College

the cost of equity to calculate the capital (equity) charge. Correspondingly, it uses economic value to equity holders (net of interest charges) rather than total firm value. According to Marakan model shareholder wealth creation is measured as the difference between the market value3 and the book value of a firm's equity. Thee book value of a firm's equity, B, measures approximately the capital contributed by the shareholders, whereas the market value of equity, M, reflects how productively the firm has employed the capital contributed by the shareholders, as assessed by the stock market. Hence, the management creates value for shareholders if M exceeds B, decimates value if m is less than B, and maintains value is M is equal to B. According to the Marakon model, the market-to-book values ratio is function of thee return on equity, the growth rate of dividends, and cost of equity. For an all-equity firm, both EV and the equity-spread method will provide identical values because there are no interest charges and debt capital to consider. Even for a firm that relies on some debt, the two measures will lead to identical insights provided there are no extraordinary gains and losses, the capital structure is stable, and a proper re-estimation of the cost of equity and debt is conducted. A market is attractive only if the equity spread and economic profit earned by the average competitor is positive. If the average


Page 41

K.C.College

competitor's equity spread and economic profit are negative, the market is unattractive. For an all-equity firm, both EV and the equity spread method will provide identical values because there are no interest charges and debt capital to consider. Even for a firm that relies on some debt, the two measures will lead to identical insights provided there are no extraordinary gains and losses, the capital structure is stable, and a proper re-estimation of the cost of equity and debt is conducted. A market is attractive only if the equity spread and economic profit earned by the average competitor is positive. If the average competitor's equity spread and economic profit are negative, the market is unattractive. 8.1.2 ALCAR approach The Alcar group Inc. a management and Software Company has developed an approach to value-based management which is based on discounted cash flow analysis. In this framework, the emphasis is not on annual performance but on valuing expected performance. The implied value measure is akin to valuing the firm based on its future cash flows and is the method most closely related to the DCF/NPV framework. With this approach, one estimates future cash flows of the firm over a reasonable horizon, assigns a continuing (terminal) value at the end of the horizon, estimates the cost of capital, and then estimates the value of the firm by calculating the present value of these estimated Corporate Financial Policy and Shareholders’ Return

Page 42

K.C.College

cash flows. This method of valuing the firm is identical to that followed in calculating NPV in a capital-budgeting context. Since the computation arrives at the value of the firm, the implied value of the firm's equity can be determined by subtracting the value of the current debt from the estimated value of the firm. This value is the implied value of the equity of the firm. To estimate whether the firm's management has created shareholder value, one subtracts the implied value at the beginning of the year from the value estimated at the end of the year, adjusting for any dividends paid during the year. If this difference is positive (i.e., the estimated value of the equity has increased during the year) management can be said to have created shareholder value. The Alcar approach has been well received by financial analysts for two main reasons:  It is conceptually sound as it employs the discounted cash flow framework  Alcar have made available computer software to popularize their approach However, the Alcar approach seems to suffer from two main shortcomings: (1) In the Alcar approach, profitability is measured in terms of profit margin on sales. It is generally recognized that this is not a good index for comparative purposes. (2) Essentially a verbal model, it is needlessly cumbersome. Hence it requires a fairly involved computer programme. Corporate Financial Policy and Shareholders’ Return

Page 43

K.C.College

8.1.3 McKINSEY approach: McKinsey & Company a leading international consultancy firm has developed an approach to value-based management which has been very well articulated by Tom Copeland, Tim Koller, and Jack Murrian of McKinsey & Company. According to them: Properly executed, value based management is an approach to management whereby the company's overall aspirations, analytical techniques, and management processes are all aligned to help the company maximize its value by focusing decision making on the key drivers of value. The

key

steps

in

the

McKinsey

approach

to

value-based

maximization are as follows:  Ensure the supremacy of value maximization  Find the value drivers  Establish appropriate managerial processes  Implement value-based management philosophy 8.1.4 Economic value added Consulting firm Stern Steward has developed the concept of Economic Value Added. Companies across a broad spectrum of industries and a wide range of companies have joined the EVA badwagon. EVA is a useful tool to measure the wealth generated by a company for its equity shareholders. In other words, it is a measure


Page 44

K.C.College

of residual income after meeting the necessary requirements for funds. Computation of EVA: EVA is essentially the surplus left after making an appropriate charge for capital employed in the business. It may be calculated by using following equation. EVA= Net operating profit after tax- Cost charges for capital employed EVA is net earnings in excess of the cost of capital supplied by lenders and shareholders. It represents the excess return (over and above the minimum required return) to shareholders; it is the net value added to shareholders. In the above formula Net operating profit after tax [NOPAT] is calculated as follows: NOPAT= PBIT (1-T)=PAT+INT (1-T) Chief features of EVA Approach:  It is a performance measure that ties directly, theoretically as well as empirically, to shareholder wealth creation.  It converts accounting information into economic reality that is readily grasped by non-financial managers. It is a simple yet effective way of teaching business literacy to everyone.


Page 45

K.C.College

 It serves as a guide to every decision from strategic planning to capital budgeting to acquisitions to operating decisions.  It is an effective tool for investor communication.  It is closest in both theory and construct to the net present value of a project in capital budgeting, as opposed to the IRR.  The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projects. 8.1.5 The discount cash flow approach The true economic value of a firm or a business or a project or any strategy depends on the cash flows and the appropriate discount rate (commensurate with the risk of cash flow). There are several methods for calculating the present value of a firm or a business/division or a project. In following pages we will discuss three main methods that are mostly used under discount cash flow approach.

The first method uses the weighted average cost of debt and equity (WACC) to discount the net operating cash flows. When the value of a project with an estimated economic life or of a firm or business over a planning horizon is calculated, then an estimate of the terminal cash flows or value will also be made. Thus, the economic value of a project or business is: Economic Value=Present Value of net operating cash flows+ Present value of terminal value Corporate Financial Policy and Shareholders’ Return

Page 46

K.C.College

The second method of calculating the economic value explicitly incorporates the value created by financial leverage. The steps that are involved in this method of estimation of the firm's total value are as follows: 1. Estimate the firm's unlevered cash flows and terminal value 2. Determine the unlevered cost of capital 3. Discount the unlevered cash flows and terminal value by the unlevered cost of capital. 4. Calculate the present value of the interest tax shield discounting at the cost of debt. 5. Add these two values to obtain the levered firm's total value. 6. Subtract the value of debt from the total value to obtain the value of the firm's shares. 7. Divide the value of shares by the number of shares to obtain the economic value per share. The third method to determine the shareholder economic value is to calculate the value of equity by discounting cash flows available to shareholders by the cost of equity. The present value of equity is given as below: Economic value of equity= Present value of equity cash flows+ Present value of terminal investment 8.1.6 Total shareholder return Is it sufficient to access and analyze the corporate performance only in capital markets? Is total return to shareholders (TRS) the best way Corporate Financial Policy and Shareholders’ Return

Page 47

K.C.College

to measure corporate performance? Is it always a true indicator of corporate performance? Or is there something more to corporate performance? In order to obtain an answer to these questions let us try and understand what TRS is and what role does it play in a corporate performance. TRS, as the name suggests, is a measure of total returns earned by shareholders of a company during a given period of time i.e. the sum total of appreciation in share price plus dividends declared during the period. Given the objective of maximization of shareholder returns, TRS is often assumed to be the most significant parameter governing corporate performance but that may not be the case.

Also as share price is a major determinant of TRS (returns by way of dividends are relatively smaller in value), it is imperative to know what does the share price reflect. A company‘s share price incorporates expectations of future growth and returns. The share price is driven by the difference between expected and actual performance and by changes in expectations than by the current level of performance as such. The implication of this is that actual performance is not important but it is the perception of performance which holds the key.

As a result the companies that consistently meet performance expectations but do not exceed them find it hard to deliver a high TRS. While on other hand improvements in expectations of future performance can lead to significant increase in the TRS. Thus to achieve total returns consistently greater than the cost of equity requires beating the expectations consistently. The expectation of Corporate Financial Policy and Shareholders’ Return

Page 48

K.C.College

future financial performance is similar to a treadmill. As performance of an enterprise improves, the expectations rise and the treadmill begin to turn quickly. The better the management performs, the more the market expects from them. If the company is able to beat these expectations, it accelerates the treadmill and therefore delivers superior returns to shareholders.

But the question here is for how long a company can continue to beat expectations?

The

better

the

performance,

the

higher

the

expectations become. Achieving above-average returns thus requires consistently beating the increasing expectations. As a result, simply performing better than the peer group is neither sufficient nor necessary to achieve higher capital market returns. For outstanding companies, which have performed excellently over the years, the marker expectations are very high and thus the treadmill is moving faster than that for any other company. Continuously beating the expectations would eventually become impossible and hence the company might deliver only an ordinary return to shareholders. On the other hand, for companies that are in the process of recovery, the market expectations are minimal and the expectation treadmill is not moving fast and hence only a marginal improvement in performance may lead to significant increase in share price and consequently the TRS.

For example1, over a five-year period ending Dec 2001, Sears (US based Retailer) achieved a higher TRS as compared to Wal-Mart stores (the largest fortune 500 company). Does that mean that Sears Corporate Financial Policy and Shareholders’ Return

Page 49

K.C.College

is creating more value or is performing better than Wal-Mart? No, because during the same period the Market Value Added (MVA)2, a better indicator of value creation, was higher for Wal-Mart than that of Sears. To sum up, what the expectation treadmill concept holds is that it is the delivery of surprises (as reflected by performance exceeding the expectations) that produces higher or lower total shareholder returns. Hence share price appreciation or TRS, though is a good indicator of corporate performance it cannot be applied in isolation for all companies in all situations. The performance in capital market is therefore one of the parameters of corporate performance. This has to be further reinforced or backed by performance of the enterprise along key value drivers of a company such as return on capital and growth Source: McKinsey Quarterly

Market Value implies the total of Equity and Debt. MVA is the difference between Market Value at the beginning of the period and Market Value at the end of the period. Total Shareholder Return (TSR) is a concept used to compare the performance of different companies‘ stocks and shares over time. It combines share price appreciation and dividends paid to show the total return to the shareholder. The absolute size of the TSR will vary with stock markets, but the relative position reflects the market perception of overall performance relative to a reference group.


Page 50

K.C.College

With Pricebegin = share price at beginning of period, Priceend = share price at end of period, Dividends = dividends paid and TSR = Total Shareholder Return, TSR is computed as TSR = (Priceend − Pricebegin + Dividends) / Pricebegin What Does Total Shareholder Return - TSR Mean?  The total return of a stock to an investor (capital gain plus dividends).  The internal rate of return of all cash flows to an investor during the holding period of an investment.


Page 51

K.C.College

CHAPTER

9:

INTER-RELATIONSHIP

OF

FINANCIAL POLICY & SHAREHOLDERS RETURN All the major functions or decisions – Investment function, Finance function, Liquidity function and Dividend function, are inter-related and inter-connected. They are inter-related because the goal of all the functions is one and the same. Their ultimate objective is only one – achievement of maximization of shareholders‘ wealth or maximizing the market value of the shares. All the decisions are also interconnected or inter-dependent also. Let us illustrate both these aspects with an example.

Example: If a firm wants to undertake a project requiring funds, this investment decision can not be taken, in isolation, without considering the availability of finances, which is a finance decision. Both the decisions are inter-connected. If the firm allocates more funds for fixed assets, lesser amount would be available for current assets. So, financing decision and liquidity decision are inter-connected. The firm has two options to finance the project, either from internal resources or raising funds, externally, from the market. If the firm decides to meet the total project cost only from internal resources, the profits, otherwise available for distribution in the form of dividend, have to be retained to meet the project cost. Here, the finance decision has influenced the dividend decision.


Page 52

K.C.College

So, an efficient financial management takes the optimal decision by considering the implications or impact of all the decisions, together, on the market value of the company‘s shares. The decision has to be taken considering all the angles, simultaneously.


Page 53

K.C.College

CHAPTER 10: CONCLUSIONS The finance profession has moved from a largely ad hoc, normatively oriented field with little scientific basis for decision making to one of the richest and most exciting fields in the economics profession. Financial economics has progressed through its stage of policy irrelevance propositions of the 1960s to a stage where the theory and evidence have much useful guidance to offer the practicing financial manager. The theory and evidence are now sufficiently rich that sensible analysis of many detailed problems such as the valuation of contingent claims, optimal bond indenture covenants, and a wide range of contracting problems are emerging. Science has not as yet, however, provided a satisfactory framework for resolving all problems facing the corporate financial officer. Some of the more important unresolved questions are how to decide on:  The level of the dividend payment  The maturity structure of the firm‘s debt instruments  The marketing of the firm‘s securities (i.e., public versus privately placed debt, rights versus underwritten offerings)  The relative quantities of debt and equity in the firm‘s capital structure We expect the frontiers of knowledge in corporate finance to continue to expand. The shareholder value creation approach helps to strengthen the competitive position of the firm by focusing on wealth creation. It provides an objective and consistent framework of evaluation and Corporate Financial Policy and Shareholders’ Return

Page 54

K.C.College

decision-making across all functions, departments and units of the firm. It can be easily implemented since cash flow data can be obtained by suitably adapting the firm's existing system of financial projection and planning. The only additional input needed is the cost of capital. The adoption of the shareholder value creation approach does require a change of the mind-set and educating managers about the shareholders value approach and its implementation.


Page 55

K.C.College

CHAPTER 11: REFERENCES  A perspective on corporate financial policies

Acharya, Viral V

 The cash flow sensitivity

Journal

of

Finance  Does the source of capital affect capital structure? Review of Financial Studies 19, 45–79.  Tender offers and free cash flow

The

Financial

Review  The determinants of corporate liquidity

Journal

of

Journal

of

Financial and Quantitative Analysis  Determinants of corporate borrowing Financial Economics  Financial Management

Pandey I. M.

 Financial Management Theory and Practice

Chandra

Prasanna  www.Valuebasedmanagement.com


Page 56

Corporate Financial Policy and Shareholders Return

Recommend Documents