Intermediate Financial Management (with Thomson One)

Self-Test Questions
374 • Part 2 Corporate Valuation
valuable than an 18.9 percent return on $255.3 million of capital. 5 You, or one of
Bell’s stockholders, would surely rather have an asset that provides a 50 percent
return on an investment of $1,000 than one that provides a 100 percent return on
an investment of $1. Therefore, the new plan should be accepted, even though it
lowers the Instruments division’s expected ROIC.
Sometimes companies focus on their profitability and growth, without giving
adequate consideration to their capital requirements. This is a big mistake—all the
wealth creation drivers must be taken into account, not just growth. Fortunately
for Bell’s investors, the revised plan was accepted. However, as this example
illustrates, it is easy for a company to mistakenly focus only on profitability
and growth. They are important, but so are the other value drivers—capital
requirements and the weighted average cost of capital. Value-based management
explicitly includes the effects of all the value drivers because it uses the corporate
valuation model, and they are all embodied in the model.
What are the four value drivers?
How is it possible that sales growth would decrease the value of a profitable firm?
CORPORATE GOVERNANCE AND SHAREHOLDER WEALTH
See the Web pages of
CalPERS (the California
Public Employees’
Retirement System),
http://www.calpers.org,
and TIAA–CREF (Teachers
Insurance and Annuity
Association College
Retirement Equity Fund),
http://www.tiaa.org, for
excellent discussions of
shareholder-friendly
corporate governance.
Shareholders want companies to hire managers who are able and willing to take
whatever legal and ethical actions they can to maximize stock prices. 6 This obviously
requires managers with technical competence, but it also requires managers
who are willing to put forth the extra effort necessary to identify and implement
value-adding activities. However, managers are people, and people have both
personal and corporate goals. Logically, therefore, managers can be expected to
act in their own self-interests, and if their self-interests are not aligned with those
of stockholders, then corporate value will not be maximized. Managers may
spend too much time golfing, lunching, surfing the Net, and so forth, rather than
focusing on corporate tasks, and they may also use corporate resources on activities
that benefit themselves rather than shareholders. So, a key aspect of valuebased
management is to motivate executives and other managers to actually take
the actions required under value-based management.
This section deals with corporate governance, which is defined as the set of
rules and procedures that ensure that managers do indeed employ the principles of
value-based management. The essence of corporate governance is to make sure
that the key shareholder objective—wealth maximization—is implemented. Most
corporate governance provisions come in two forms, sticks and carrots. The primary
stick is the threat of removal, either as a decision by the board of directors
or as the result of a hostile takeover. If a firm’s managers are maximizing the value
of the resources entrusted to them, they need not fear the loss of their jobs. On the
other hand, if managers are not maximizing value, they may well be removed, by
5 A potential fly in the ointment is the possibility that Bell has a compensation plan based on rates of return and not on
changes in wealth. In such a plan, which is fairly typical, the managers might reject the new proposed strategic plan if it
lowers ROIC and, hence, their bonuses, even though the plan is good for the company’s stockholders. We discuss the
effect of compensation plans in more detail later in the chapter.
6 Notice that we said both legal and ethical actions. The accounting frauds perpetrated by Enron, WorldCom, and others
that were uncovered in 2002 raised stock prices in the short run, but only because investors were misled about the companies’
financial positions. Then, when the correct financial information was finally revealed, the stocks tanked. Investors
who bought shares based on the fraudulent financial statements lost tens of billions of dollars. Releasing false financial
statements is illegal. Aggressive earnings management and the use of misleading accounting tricks to pump up reported
earnings is unethical, and executives should and will go to jail as a result of their shenanigans. When we speak of taking
actions to maximize stock prices, we mean making operational or financial changes designed to maximize intrinsic stock
value, not fooling investors with false or misleading financial reports.