Topic 1: Shareholder Value Maximisation

Question 1

What is shareholder value?

Answer 1

Shareholder value is:

• equity value
• enterprise value and invested capital

Question 2

How is shareholder value measured?

Answer 2

EV - Debt = equity

Question 3

How is shareholder value created

Answer 3

• maximise the value of the enterprise or firm
• maximise the value with the available resources
• invest in projects where returns > cost
• NPV positive projects
• good decisions

Question 4

How is shareholder value destroyed

Answer 4

• invest in projects where returns < cost
• not being able to obtain capital on time (opportunity cost, capital constrained)
• dumb decisions
• agency costs

Question 5

SHareholder value: what about other stakeholders and ethics

Answer 5

eg community, debtors

Question 5

Define:

1. Enterprise Value
2. Invested Capital or Capital Employed
3. Market Value Added. (Define, and equation)

Answer 5

1. Enterprise Value: how much business is worth. Market Value concept, combined value of equity (# shares x price) and debt
2. Invested Capital or Capital Employed: amt historically injected by capital providers. Book value concept (on B/S, eg = shareholders funds and Debt = Interest Bearing Debt)
3. Market Value Added: Difference between Mkt Val & IC
   MVA = Enterprise Value - Invested Capital

Question 6

Why is shareholder value the decision criterion (the x goal)

Answer 6

• work out by shareholder value whether smart decisions are being made

Question 7

Expected Cash flows

• in practice / adjustment
• Calculation serves several purposes (3)

Answer 7

• in practice / adjustment: uncommon to formally calculate expected CFs, more likely to estimate. Discount factor is then made higher than the cost of capital to compensate for optimism in CFs
• Calculation serves several purposes (3)
  1. incorporate potential outcomes into a single measure
  2. If prob of distrn of CFs is asymmetric then it properly weights possible outcomes
  3. forces assessment of possible risk outcomes, good discipline / realistic outcomes

Question 8

Shareholder (Equity) vs Enterprise Value - discuss transferring value

Answer 8

1. Lenders return is fixed. Shareholders receive any residual value
2. If there is significant default probability, debt holders may not get prespecified returns
3. Shareholders may have incentive to take action (step up risk, under invest) that enhance their position relative to debt holders. This is TRANSFERING VALUE from lenders rather than CREATING VALUE

Question 9

Why is shareholder value maximisation the right objective (4)

What is the goal
LT vs ST

Answer 9

1. investors provide capital to support investment. Less capital provision = less economic development
2. By following market price signal, this should also maximise value of society resources (capital flows to areas where there is most value creation potential)
3. Value is a single measure that incorporates trade-offs (eg LT vs ST)
4. If value is not maximised - could make firm potential for takeover putting the assets in the hands of those that can better maximise value

Goal: maximise the PV of future CFs. Invest in all NPV positive projects
Lt vs ST: rewards should be for long term value maximisation rather than ST share price targets

Question 10

Maximising shareholder value does not mean: (4)

Answer 10

Maximising shareholder value DOES NOT mean:

1. statement of strategy
2. unjustified overvaluation (should instead develop & implement good strategy). In LT this could be destructive
3. Does not necessarily mean the same as maximising current share price. (Too short term)
4. Not a whitewash for illegal or unethical actions (eg environmental damage)

Question 11

Alternatives to shareholder value maximisation (3)

Answer 11

alternatives: focus on:
1. corporate governance
2. tradeoff between competing stakeholders
3. Long term value creation requires a combination of governance, appropriate performance criteria and appropriate incentive structures

Question 12

Ethics of an action (3)

Answer 12

1. duty
2. virtue
3. consequences

Question 13

Agency issues

• requirements for conflict (2)
• examples
• costs incurred

Answer 13

1. principal / agent relationship
2. incentive conflict

Examples
- perks
- shirking
- lower than optimal performance management
- potentially poor investment decisions via overpayments, diversifying investments, over invetsment
Costs incurred:
-monitoring
- bonding costs
- what remains after these two costs is ‘residual’ loss

Question 14

Governance and Corporate Control

- define

Answer 14

Define:

• governance is the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations.
• Encompasses mechanisms by which companies and those in control are held to account

Question 15

Legal Obligations

• statutes
• case law

Answer 15

Legal Obligations

• statutes: main legislation is Corps Act (2001) and CLERP 9 (Corporate Law Economic Reform Program (Audit & Corp disclosure)
• case law: clarify details of relevant legislation.

Question 16

List various regulatory bodies (5)

Answer 16

1. ASX Listing Rules
2. ASIC
3. ASX
4. ASX Corporate Council
5. Takeovers Panel

Question 17

Public vs Private Equity

Answer 17

1. Private Equity: Leveraged Buy Outs and Management Buy Outs.
2. Private Eq: individual investments are made by a fund. Usually each investment:
   - managed on standalone basis
   - higher debt levels than traditional corporate
   - meaningful equity stake
   - expected holding period 5 - 7 years

Question 18

Criticisms of maximising Shareholder Value

Answer 18

1. encourage ST managerial thinking
2. condone unethical behaviour
3. geared towards ST profit maximisation at the expense of the lung run
4. share price may diverge due to business conditions (price may fall reflecting lower value NPV projects)n -> managers tempted to inflate ST share price and may destroy LT value

Question 19

Stakeholder theory

• define
• issues / examples

Answer 19

Stakeholder theory
- define: alternative to shareholder theory. Promote an enhancement of distributive justice within the confines of a basically capitalist structure. Distribute benefits of activities as equitably as possible among stakeholders in light of their respective contributions, costs & risk
- issues / examples
Employee wages - union gains can cost the firm (and employees) in the LR, stifle innovation
Patent laws - if a free for all; less people would commit capital to developing new cures / techniques
Allocation of resources.

Drawback - identity of stakeholder keeps changing. (Person who gained most may not be the one to give back future benefits

Question 20

Private Equity

- Contributors to superior returns: (5)

Answer 20

1. Willingness & ability to take on high levels of debt
2. ability to take advantage of rising stock markets to exit investment at attractive multiples
3. more intense performance management culture (stronger and simpler management incentives)
4. greater focus on cash (than reported earnings)
5. ability to conduct more radical turnarounds, free from quarterly earnings pressures. Stable shareholder base

Question 21

Pros & Cons, corporation vs private equity

Answer 21

Corporation:

• better at governance, management succession; development of staff; than PE
• legal / regulatory responsibility to all shareholders for equal access to information. Can be disparate groups.
• limited financial incentives to increase value

PE:

• concentrated on value creation; greater commitment by board members
• don’t need to spend the same amount of time presenting to investors
• shareholders are locked in; representatives are a single block
• well aligned, almost single minded focus on value creation
• clear articulation of strategic and performance priorities
• greater engagement by board members
• NEDs spend more time on business with PEs than corps. Spend more time learning - come in at same time and go through intensive learning. NEDs more interactive, their experience levered into business

Question 22

Ways to improve corporates (lessons from PE)

Answer 22

1. refocus on strategy formation and performance dialogues
2. reduce board size to encourage more effective collaboration
3. increase expected time commitment of NEDs
4. transform how boards are educated and informed about the business
5. significantly increase informal interaction with executives
6. explore ways to change remuneration for NEDs