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Q.2.
A.2.
gs =
pbl
a ( p b l)
capital markets through the market values of equity and debt. Thus, shareholder
value is:
Shareholder value = Market value of the firm Market value of debt
The market value of the shareholders equity is directly observable from
the capital markets. In theory, the market value should be equal the warranted
economic value of the firm. The true economic value of a firm or business or
division or project or any strategy depends on the cash flows and the appropriate
discount rate (commensurate with the risk of cash flows).When the value of a firm
or a business over a planning horizon is calculated, then an estimate of the
terminal cash flows or value (TV) will also be made.
Three most commonly advocated methods of shareholder value creation
are as follows:
The first method, called the free cash flow method, uses the weighted
average cost of debt and equity (WACC) to discount free cash flows. Free cash
flows are calculated as follows:
FCF = PBIT(1 T) + DEP ONCI NWC CAPEX
where PBIT = profit before interest and tax, T = corporate tax rate, DEP =
tax depreciation, ONCI = other non-cash items, NWC = change in net working
capital (i.e. stocks plus trade debtors minus trade creditors), and CAPEX =
incremental investment.
The second method calculates the economic value of a firm or business in
two parts: the economic value of unlevered firm and the economic value of the
financing effects. The value of an unlevered firm over its planning period is given
as follows:
FCFt
TVn
+
t
t =1 (1 + k )
(1 + k u ) n
u
n
Vu =
Notice that ku is the cost of capital of an unlevered firm. For the levered
firm, the second part includes the value of interest tax shield (VITS):
n
VITS =
t =1
ITS t
(1 + k d )
Define MVA? How is it calculated? What are its pros and cons?
In terms of market and book values of shareholder investment, shareholder value
creation (SVC) may be defined as the excess of market value over book value.
SVC is also referred to as the market value added (MVA):
Market value added = Market value invested capital (capital employed)
Market value is also referred to as the enterprise value. It is the total of
the firms market value (MV) of debt and market value of equity. MVA may also
be calculated as the difference between market value of equity and invested equity
capital. Managers must aim at earning higher MVA for shareholders.
There is conceptual problem with MVA. Invested capital is at historical
value. Considering the alternative opportunities of equivalent risk, the economic
value of the invested capital would be much higher today. Yet another problem
with MVA is that it ignores cash flows received by shareholders in the form of
dividends and share buyback and cash contributed by them as additional share
capital.
Q.5.
A.5.
Q.6.
A.6.
Q.7.
A.7.