Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

a) Creation of shareholder value has become a generally accepted corporate objective. To facilitate the realization of this objective, value based management systems (VBMs) which integrate finance theory and strategic management thinking have been developed scholars.

Required:
i) Explain the main determinants of shareholder value
ii) Discuss tile factors that have stimulated the increased interest companies in value based management systems

b) Madawa Company Limited, a public quoted company, intends to raise additional share capital through a rights issue. The number of issued ordinary shares currently stands at 100 million shares. Each shareholder will have a right to purchase one share for every five shares currently held. The current market price per share is Sh.60 while the rights price has been fixed at Sh.50 per share.

Required:

i) Calculate the theoretical value of a right in Madawa Company Limited
ii) Determine the theoretical ex-rights price of a share in the company
ANSWER
The concept of shareholders value (SV) was developed in 1986 Alfred Rappaport. He made simplifying assumptions about the patterns of future free cash flows and how the various cash flow elements interact. Corporate value is the sum of:

1. Present value (PV) of free cash flow (FCF) from operation
2. Value of marketable securities

FCF is the amount of cash that remains after taking care of investment needs.

FCF = Operating Incremental    Incremental
Investment in – Tax – Investment in – Profits
Fixed Assets Working Capital

The company‟s risk adjusted discounting rate is used to determine the present value of FCF. Marketable securities are short term investment which could be disposed off for cash without affecting the operations of the firms.
Shareholders‟ value = Corporate value – Value of debt capital
= (PV of FCF + Value of Marketable Securities) – Value of debt capital

To increase SV, managers should increase corporate value or reduce the value of debt capital.

Drivers of shareholders‟ value

The key factors that are fundamental to improving SV are called value drivers. Rappaport has identified the seven SV drivers as:

a) Increase in sales growth rate. Higher profitable sales growth will boost free cash flow. This could be achieved acquisition of rivals and enjoying economies of scale.
b) Increase in operating profit margin: This can be achieved through reduction in expenses,promotion of innovation, customer care and good marketing strategies, rationalization, activity based costing etc.

c) Reduce income tax rate: This would improve SV since it concerns the profit for shareholders rather than giving it away to the government.
d) Reduce increamental investment in fixed assets: Substantial investments in new capital assets will deplete FCF and hence SV. The firm should strive to make same or more sales with less assets keeping assets which are cash generators and selling off under performing ones. The firm should consider franchising and joint ventures.
e) Reduce increamental investment in working capital. The firm should make more sales with less stock and debtors. This could be done putting in place an efficient credit policy and stock management techniques like just in time (JIT) and manufacturing requirement planning (MRP) among others. Over capitalization (excessive investment in working capital) would reduce FCF and SV.
f) Lengthen the planning period (value growth duration). If the firm can forecast growth over along period, it is able to forecast a longer stream of FCF and hence high corporate value and SV

g) Reduce required rate of return (cost of capital). There exist an inverse relationship between discounting rate and present value. There exist an inverse relationship between discounting rate and present value. Therefore, the lower cost of capital, the higher the present value of FCF and the higher the SV.

ii) Why the keen interest in Shareholder Value Analysis (SVA)?

SVA is also called Value Based Management (VBM) which is a methodology that involves managing all aspects of the business in accordance with the desire to create and maximize the wealth of shareholders. The impetus for adoption of VBM comes from several directions.

1. Emergence of aggressive shareholders– There is growing “activism” among many shareholders demanding value for money. A group of shareholders will spot firms with ineffective management and buy shares. They will draw attention to shortcomings of the management to provoke changes in BOD or for purpose of takeover the
2. Problems in assessing the impact of new management techniques:- There are numerous new, long term management techniques such as JIT, business processing re-engineering value chain management, in-sourcing, TQM, relationship management etc. The conventional investment appraisal techniques or profit measures of performance cannot adequately evaluate these techniques hence the need to ensure that value is being created through such techniques.
3. Divorce of ownership from control:- While shareholders are the owners of the firm, they are not involved in the day to day management and control of their company. To ensure that the appointed agents in the name of managers do not transfer wealth from owners (principal) to themselves through “golden parachutes”, “empire building” consumption of perquisites and bonuses, shareholders need to be sure that value is created the managers (agents).
4. Adoption of VBM Investment Analysts:- Investment analyst use their selection skills to identify undervalued firms which become easy targets of take-over clients of the analysts. Since managers would want to avoid takeovers and boardroom shake-ups, they manage their businesses on VBM lines.
5. Marketing effort professional consultants:- Most accounting firms have identified the weaknesses of ROI and other metrics of value measures. They have impelled BOD to find better measures of value. They have also developed their own measures which they are marketing aggressively.
6. Managerial compensation:- Greater attention is now being paid to link management compensation to firms performance in terms of shareholders‟ value created.
7. Actions of Large Multinational Companies:- Many leading firms such as Coca-Cola and Siemens have now accorded value creation a central place in their corporate planning thus acting as role models for others.

Apart from SVA, other mechanisms have been developed as measures of value. These are Economic Value Added (EVA) which is profit based measure and market value added (MVA) which is market value based measure. SVA is a discounted FCF measure.

b) One for 5 rights issue.

5 existing shares @ Sh.60 = 300 1 new shares @ Sh.50 = 50
6 shares Shs.350

Ex-right M.P.S = Sh. 350 = Sh.58.333
6
Value of a right = Sh.60 cum-right – Sh.58.333 = Sh.1.667

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