One of the main duties of the financial manager (FM) is to create value using the resources available to the business in an ever changing business environment. Perhaps creating value is underplaying the importance of value creation; stated better, the objective is to maximise the value of the firm not just to create value. As an agent of shareholders, managers are responsible to ensure sufficient returns are generated to compensate for the risks that the shareholders take.
Financial management focuses on principles of decision-making. There are hardly any exact solutions available to any financial management problem as the future is unpredictable. The financial manager must constantly make future estimations on the basis of the information available at the time. With hindsight, such decisions may prove to have been less than optimal. However, it must be constantly borne in mind that decision-making requires acting without perfect knowledge of the outcome. Various models are available to assist the FM of which the time value of money models and concepts are probably the most important. These models try to convert estimated future returns from the investment to a return today for comparison with the capital outlay required and the return required by funders.
The question to ask before making any investment or financing decision is whether it will lead to an increase in shareholder value. Further aspects to consider is how the decision relates to ethics, corporate governance and the roles of other stakeholders such as employees, government, the community, suppliers and customers. For example, a company that continues to drive down the cost of its inputs by placing increasing pressure on its suppliers may find that its suppliers will either go out of business or will reduce the quality of their products in order to achieve lower prices. This may not be in the interests of the company in the longer term.
The term indicates that there is an expectation that the actual outcome of a project may differ from the expected outcome. The magnitude of the possible difference reflects the magnitude of the risk. As a general rule shareholders will prefer less risk and will value a company not only in terms of its future cash flows, but also in terms of the risk of those cash flows. Finance decisions are based on the concept that investors will prefer low risk investments and therefore will require higher returns from projects with higher risk.
Risk is normally measured statistically by looking at the deviation from the expected outcomes over time. Volatility in share prices is often used to measure the exposure to risk. Risk can further be measured by comparing the risk of one investment with that of the market as a whole. This risk comparison is denoted by a firm’s Beta which measures the relative volatility of a share to the market. The market is assigned a Beta score of 1.0 and every share has a score that can be measured against this norm. If a firm’s beta is greater than 1.0 it means that the firm’s shares are more volatile than the market.
Two variables on which financial management focuses as the primary inputs in decision-making are expected return and perceived risk. This may be expressed as follows: Required return = Risk-free rate + Risk premium. The risk premium will depend on all the factors influencing the perceived risk from a stakeholder’s perspective. Shareholders will compare the risk to that of alternative investments available to them and determine the risk premium on that basis. From a company’s point of view the FM must ensure that the returns achieved by the company are sufficient to cover the expectations from shareholders and other stakeholders. This expected return is referred to as the cost of capital of the company. Returns achieved equal to or higher than the cost of capital ensure wealth maximisation.
Capital structure and impact on cost of capital
The cost of capital is directly influenced by the finance mix between equity and debt in a company. Shareholders normally require a much higher return because of the risks they are exposed to, as compared to the providers of debt funding. In most cases securities are provided to debt providers thereby limiting their exposure to losses (risk).. As such they are prepared to accept a lower return on the funding that they provide. The the company’s perspective, the tax deductibility of interest paid to providers of debt funding reduces the cost of debt financing.
The diagram below describes the relationship between return on investment achieved by a company and the required returns expected by the providers of funding.
The FM is constantly looking for investment opportunities and constantly making decisions regarding the source of funds to be used in order to finance the investment projects. The objective, when sourcing financing would be to obtain funds at the lowest cost. The cost of finance from the perspective of the investor will usually be determined by the risk associated with the investment. Finance is obtained in different forms depending on the needs of the company – by going to the capital markets and attracting long-term finance, by making use of suppliers’ credit, by going to the money markets and using short-term finance, or by retaining profits which could otherwise be paid to shareholders in the form of dividends.
As stated previously each source of capital will perform their own risk assessment of the company and based on the outcome derive an expected return. The mix of funding will impact the Weighted Average Cost of Capital (WACC) of the company.
Value creation and maximisation
Economic Value Added (EVA) is a measuring instrument that quantifies the value created or eroded by management over a period as compared to the cost of capital providing returns for the providers of funding. This means that the cost of financing is deducted from the company’s after-tax operating profit. For example, assume that a company has reported operating profits of R115m after tax. If the company’s investment in assets amounts to R800m and its after-tax cost of capital is 13%, then the company’s EVA will be determined as follows:
Operating profit after tax R115 m
Less: Cost of capital (R800m X 13%) -R104 m
Economic value added R 11 m
Should the cost of capital be 15% it will give a negative EVA of R5m. It is important to note that although the company made excellent profits at R115m, it may not be sufficient to cover the risk related return of the financiers (shareholders and debt funders).
Management needs to make investments that offer a return that exceeds the cost of capital if they want to maximise the value of the company and as such the role of the financial manager is to explore investment opportunities within the context of the type of business operation in which the company is engaged. Such opportunities are then evaluated in order to establish whether they are profitable by determining whether they are likely to increase the value of the business. The financial manager is required to evaluate the possibilities against the inherent risks of the opportunity and the company, and rank them in order of potential profitability.
Ensuring that EVA is positive (Return on Assets greater than WACC) will maximise the value of the company and the value of its shares.