1. Investment and value

The accounting rules we looked at in Chapter 4 showed us that an investment is a use of funds, but not a reduction in the value of assets. We will now go one step further and adopt the viewpoint of the financial manager for whom a profitable investment is one that increases the value of capital employed.

We shall see that a key element in the theory of markets in equilibrium is the market value of capital employed. This theory underscores the direct link between the return on a company’s investments and that required by investors buying the financial securities issued by the company.

The true measure of an investment policy is the effect it has on the value of capital employed. This concept is sometimes called “enterprise value”, a term our reader should not confuse with the value of equity (capital employed less net debt). The two are far from the same!

Hence the importance of every investment decision, as it can lead to three different outcomes:

• Where the expected return on an investment is higher than that required by investors, the value of capital employed rises instantly. An investment of 100 that always yields 15% in a market requiring a 10% return is worth 150 (100 × 15%/10%). The value of capital employed thus immediately rises by 50.
• Where the expected return on the investment is equal to that required by investors, there is neither gain nor loss. The investors put in 100, the investment is worth 100 and no value has been created.
• Where the expected return on an investment is lower than that required by investors, they have incurred a loss. If, for example, they invested 100 in a project yielding 6%, then the value of the project is only 60 (100 × 6%/10%), giving an immediate loss in value of 40.
• Value remains constant if the expected rate of return is equal to that required by the market.
• An immediate loss in value results if the return on the investment is lower than that required by the market.
• Value is effectively created if the expected rate of return is higher than that required by the market.

The resulting gain or loss is simply the positive or negative net present value that must be calculated when valuing any investment. All this means, in fact, is that if the investment was fairly priced, then nothing changes for the investor. If it was “too expensive”, the investors take a loss, but if it was a good deal, they earn a profit.

The graph below shows that value is created (the value of capital employed exceeds its book value) when return on capital employed exceeds the weighted average cost of capital, i.e. the rate of return required by all suppliers of funds to the company.

2. The relationship between companies and the financial world

In the preceding chapters we examined the various financial securities that make up the debt issued by a company from the point of view of the investor. We shall now cross over to the other side to look at them from the issuing company’s point of view.

• Each amount contributed by investors represents a resource for the company.
• The financial securities held by investors as assets are recorded as liabilities in the company’s balance sheet.
• And, most importantly, the rate of return required by investors represents a financial cost to the company.

At the financial level, a company is a portfolio of assets financed by the securities issued on financial markets. Its liabilities, i.e. the securities issued and placed with investors, are merely a financial representation of the industrial or operating assets. The financial manager’s job is to ensure that this representation is as transparent as possible.

What is the role of the investor?

Investors play an active role when securities are issued, because they can simply refuse to finance the company by not buying the securities. In other words, if the financial manager cannot come up with a product offering a risk/reward trade-off acceptable to the financial market, then the lack of funding will eventually push the company into bankruptcy.

We shall see that when this happens, it is often too late. However, the financial system can impose a sanction that is far more immediate and effective: the valuation of the securities issued by the company.

Financial markets continuously value the securities in issue. In the case of debt instruments, rating agencies assign a credit rating to the company, thus determining the value of its existing debt and the terms of future loans. Similarly, by valuing the shares issued the market is, in fact, valuing the company’s equity.

So how does this mechanism work?

If a company cannot satisfy investors’ risk/reward requirements, it is penalised by a lower valuation of its capital employed and, accordingly, its equity. Suppose a company offers the market an investment of 100 that is expected to yield 10 every year over a period long enough to be considered to perpetuity.¹ However, the actual yield is only 5. The disappointed investors who were expecting a 10% return will try to get rid of their investment. The equilibrium price will be 50, because at this price investors receive a return of 10% (5/50) and it is no longer in their interests to sell. But by now it is too late.

Investors who are unhappy with the offered risk/reward trade-off sell their securities, thus depressing the value of the securities issued and of capital employed, since the company’s investments are not profitable enough with regard to their risk. True, the investor takes a hit, but it is sometimes wiser to cut one’s losses.

In doing so, he is merely giving tit for tat: an unhappy investor will sell off his securities, thus lowering prices. Ultimately, this can lead to financing difficulties for the company.

The “financial sanction” affects first and foremost the valuation of the company via the valuation of its shares and debt securities.

As long as the company is operating normally, its various creditors are fairly well protected.² Most of the fluctuation in the value of its debt stems from changes in interest rates, so changes in the value of capital employed derive mainly from changes in the value of equity. We see why the valuation of equity is so important for any normally developing company. This does not apply just to listed companies: unlisted companies are also affected whenever they envisage divestments, alliances, transfers or capital increases.

The role of creditors looms large only when the company is in difficulty. The company then “belongs” to the creditors, and changes in the value of capital employed derive from changes in the value of the debt, by then generally lower than its nominal value. This is where the creditors come into play.

3. Implications

Since we consider that creating value is the overriding financial objective of a company, it follows that:

• A financial decision harms the company if it reduces the value of capital employed.
• A decision is beneficial to the company if it increases the value of capital employed.

A word of caution, however! Contrary to appearances, this does not mean that every good financial decision increases earnings or reduces costs.

Remember, we are not in the realm of accounting, but in that of finance – in other words, value. An investment financed by cash from operations may increase earnings, but could still be insufficient with regard to the return expected by the investor who, as a result, has lost value.

Certain legal decisions, such as restricting a shareholder’s voting rights, have no immediate impact on the company’s cash, yet may reduce the value of the corresponding financial security and thus prove costly to the holder of the security.

We cannot emphasise this aspect enough, and insist that you adopt this approach before immersing yourselves further in the raptures of financial theory.

1. A clear theoretical foundation

We have just said that a company is a portfolio of assets and liabilities, and that the concepts of cost and revenue should be seen within the overall framework of value. Financial management consists of assessing the value created for the company’s fund providers.

Can the overall value of the company be determined by an optimal choice of assets and liabilities? If so, how can you be sure of making the right decisions to create value?

You may already have raised the following questions:

• Can the choice of financing alone increase the value of the firm? Is capital employed financed half by debt and half by equity worth more than if it were financed wholly through equity?
• Can the entrepreneur increase the value of capital employed – that is, influence the market’s valuation of it – by either combining independent industrial and commercial investments or implementing a shrewd financing policy?

If your answer to all these questions is yes, you attribute considerable powers to financial managers. You consider them capable of creating value independently of their industrial and commercial assets.

And yet, the equilibrium theory of markets is very clear:

We now provide a more formal explanation of the above rule, which is based on arbitrage.

To this end, let us simplify things by imagining that there are just two options for the future: either the company does well or it does not. We shall assign an equal probability to each of these outcomes.

We shall see how the free cash flow of three companies varies in our two states of the world:

FREE CASH FLOW

Note that the sum of the free cash flows of companies A and B is equal to that of company G. We shall demonstrate that the share price of company G is equal to the sum of the prices of shares of B and A.³ To do so, let us assume that this is not the case, and that V _A + V _B > V _G (where V _A, V _B and V _G are the respective share prices of A, B and G).

You will see that no speculation is necessary here to earn money. Taking no risk, you sell short one share of A and one share of B and buy one share of G. You immediately receive V _A + V _B − V _G > 0; yet, regardless of the company’s fortunes, the future negative flows of shares of A and B (sold) and positive flows of shares of G (bought) will cancel each other out. You have realised a gain through arbitrage.

The same method can be used to demonstrate that V _A + V _B < V _G is not possible in a market that is in equilibrium. We therefore deduce that V _A + V _B = V _G. It is thus clear that a diversified company, in our case G, is not worth more than the sum of its two divisions A and B.

Let us now look at the following three securities:

FREE CASH FLOW

According to the rule demonstrated above, V _C + V _D = V _E. Note that security D could be a debt security and C share capital. E would then be the capital employed. The value of capital employed of an indebted company (V _(C+D)) can be neither higher nor lower than that of the same company if it had no debt (V _E).

The additivity rule is borne out in terms of risk: if the company takes on debt, then financial investors can stabilise their portfolios by adding less risky securities. Conversely, they can go into debt themselves in order to buy less risky securities. So why should they pay for an operation they can carry out themselves at no cost?

This reasoning applies to diversification as well. If its only goal is to create financial value without generating industrial and commercial synergies, then there is no reason why investors should entrust the company with the diversification of their portfolio.

2. Illustration

Are some asset combinations worth more than the value of their individual components, regardless of any industrial synergies arising when some operations are common to several investment projects? In other words, is the whole worth more than the sum of its parts (2 + 2 = 5)?

Or again, is the required rate of return lower simply because two investments are made at the same time?

Company managers are fuzzy on this issue. They generally answer in the negative, although their actual investment decisions tend to imply the opposite. Take Kuka (a ­German robot manufacturer group), for example, which was bought by Midea (a Chinese appliance manufacturer) in 2016. If financial synergies exist, one would have to conclude that the required rate of return in the robot manufacturing segment differs depending on whether the company is independent or part of a group. Kuka would therefore appear to be worth more as part of the Midea group than on a standalone basis.

The question is not as specious at it seems. In fact, it raises a fundamental issue. If the required return on Kuka has fallen since it became part of Midea, its financing costs will have declined as well, giving it a substantial, permanent and possibly decisive advantage over its competitors.

Diversifying corporate activities reduces risk, but does it also reduce the rate of return required by investors?

Suppose the required rate of return on a company producing a single product is 10%. The company decides to diversify by acquiring a company of the same size on which the required rate of return is 8%. Will the required rate of return on the new group be lower than (10% + 8%)/2 = 9% because it carries less risk than the initial single-product company?

We must not be misled into believing that a lower degree of risk must always be matched by a lower required rate of return. On the contrary: markets only remunerate systematic or market risks, i.e. those that cannot be eliminated by diversification. We have seen that unsystematic or specific risks, which investors can eliminate by diversifying their portfolios, are not remunerated. Only non-diversifiable risks related to market fluctuations are remunerated. This point was discussed in Chapter 18.

Since diversifiable risks are not remunerated, a company’s value remains the same whether it is independent or part of a group. Kuka is not worth more now that it has become a division of Midea. All else being equal, the required rate of return in the robot sector is the same whether the company is independent or belongs to a group.

On the other hand, Kuka’s value will increase if, and only if, Midea’s management allows it to improve its return on capital employed.

Value is created only when the sum of cash flows from the two investments is higher because they are both managed by the same group. This is the result of industrial synergies (2 + 2 = 5), and not financial synergies, which do not exist.

The large groups that indulged in a spate of financial diversifications in the 1960s have since realised that these operations were unproductive and frequently loss-making. Diversification is a delicate art that can only succeed if the diversifying company already has expertise in the new business. Combining investments per se does not maximise value, unless industrial synergies exist. Otherwise, an investment is either “good” or “bad” depending on how it stacks up against the required rate of return.

In other words, managers must act on cash flows; they cannot influence the discount rate applied to them unless they reduce their risk exposure.

3. A first conclusion

The value of the securities issued by a company is not connected to the underlying financial engineering. Instead, it simply reflects the market’s reaction to the perceived profitability and risk of the industrial and commercial operations.

The equilibrium theory of markets leads us to a very simple and obvious rule, that of the additivity of value, which in practice is frequently neglected. Regardless of developments in financial criteria, in particular earnings per share, value cannot be created simply by adding (diversifying) or reducing value that is already in equilibrium.

We emphasise that this rule applies to listed and unlisted companies alike, a fact that the latter are forced to face at some point. Capital employed always has an equilibrium value, and the entrepreneur must ultimately recognise it.

This approach should be incorporated into the methodology of financial decision-making. Some strategies are based on maximising other types of value, for example the capability to cause harm to competitors. They are particularly risky and are outside the conceptual framework of corporate finance.

Does this mean that, ultimately, financing or diversification policies have no impact on value?

Our aim is not to encourage nihilism, merely a degree of humility.

1. Limits of the equilibrium theory of markets

The equilibrium theory of markets offers an overall framework, but it completely disregards the immediate interests of the various parties involved, even if their interests tend to converge in the medium term.

Since the equilibrium theory demonstrates that finance cannot change the size of the capital employed, but only how it is divided up, it follows that many financial problems stem from the struggle between the various players in the financial realm.

First and foremost we have the various parties providing funding to the company. To simplify matters, they can be divided into two categories: shareholders and creditors. But we shall soon see that, in fact, each type of security issued gives rise to its own interest group: shareholders, preferred creditors, ordinary creditors, investors in convertible bonds, etc. Further on in this chapter, we shall see that interests may even diverge within the same funding category.

One example should suffice. According to the equilibrium theory of markets, investing at the required rate of return does not change the value of capital employed. But if the investment is very risky and, therefore, potentially very profitable, creditors, who earn a fixed rate, will only see the increased risk without a corresponding increase in their return. The value of their claims thus decreases, to the benefit of shareholders whose shares increase by the same amount, the value of capital employed remaining the same. And yet, this investment was made at its equilibrium price.

This is where the financial manager comes into play! His role is to distribute value between the various parties involved. In fact, the financial manager must be a negotiator at heart.

But let’s not forget that the managers are stakeholders as well. Since portfolio theory presupposes good diversification, there is a distinction between investors and managers, who have divergent interests with different levels of information (internal and external). This last point calls into question one of the basic tenets of the equilibrium theory, which is that all parties have access to the same information (see Chapter 15).

2. Signalling theory and asymmetric information

Signalling theory is based on two basic ideas:

• the same information is not available to all parties: the managers of a company may have more information than investors;
• even if the same information were available to all, it would not be perceived in the same way, a fact frequently observed in everyday life.

Thus, it is unrealistic to assume that information is fairly distributed to all parties at all times, i.e. that it is symmetrical as in the case of efficient markets. On the contrary, asymmetric information is the rule.

This can clearly raise problems. Asymmetric information may lead investors to undervalue a company. As a result, its managers might hesitate to increase its capital because they consider the share price to be too low. This may mean that profitable investment opportunities are lost for lack of financing, or that the existing shareholders find their stake adversely diluted because the company has launched a capital increase anyway.

This is where the communication policy comes into its own. Basing financial decisions on financial criteria alone is not enough: managers also have to convince the markets that these decisions are wise.

The cornerstone of the financial communications policy is the signal the managers of a company send to investors.

Contrary to what many financial managers and CEOs believe, the signal is neither an official statement nor a confidential tip. It is a real financial decision, taken freely and which may have negative financial consequences for the decision-maker if it turns out to be wrong.

After all, investors are far from naive and they take each signal with the requisite pinch of salt. Three points merit attention:

Investors’ first reaction is to ask themselves why the signal is being sent, since nothing comes for free in the financial world. The signal will be perceived negatively if the issuer’s interests are contrary to those of investors. For example, the sale of a company by its majority shareholder would, in theory, be a negative signal for the company’s growth prospects. Managers must therefore persuade the buyer of the contrary or provide a convincing explanation for the disposal.

Similarly, owner-managers cannot fool investors by praising the merits of a capital increase without subscribing to it!

However, the market will consider the signal to be credible if it deems that it is in the issuer’s interest that the signal be correct. This would be the case, for example, if the managers reinvest their own assets in the company.

• The reputation of management and its communications policy certainly play a role, but we must not overestimate their importance or lasting impact.
• The market supervisory authorities stand ready to impose penalties on the dissemination of misleading information or insider trading. If investors, particularly international investors, believe that supervision is effective, they will factor this into their decisions. That said, some managers may be tempted to send incorrect signals in order to obtain unwarranted advantages. For example, they could give overly optimistic guidance on their company’s prospects in order to push up share prices. However, markets catch on to such misrepresentations quickly and react to incorrect signals by piling out of the stock.

In such a context, the “watchdog” role played by the market authorities is crucial and the recent past has shown that the authorities intend to assume it in full. Such rigour is essential if we are to have the best possible financial markets and the lowest possible financing costs.

Financial managers must therefore always consider how investors will react to their financial decisions. They cannot content themselves with wishful thinking, but must make a rational and detailed analysis of the situation to ensure that their communication is convincing.

Signalling theory says that corporate financial decisions (e.g. financing, dividend payout) are signals sent by the company’s managers to investors. It examines the incentives that encourage good managers to issue the right signals and discourage managers of ailing companies from using these same signals to give a misleading picture of their company’s financial health.

• investments are not maximised because the cost of financing is too high;
• the choice of financing is skewed in favour of sources (such as debt) where there is less information asymmetry.

Stephen Ross initiated the main studies in this field in 1977.

3. Agency theory

Agency theory says that a company is not a single, unified entity. It considers a company to be a legal arrangement that is the culmination of a complex process in which the conflicting objectives of individuals, some of whom may represent other organisations, are resolved by means of a set of contractual relationships.

On this basis, a company’s behaviour can be compared to that of a market, insofar as it is the result of a complex balancing process. Taken individually, the various stakeholders in the company have their own objectives and interests that may not necessarily be spontaneously reconcilable. As a result, conflicts may arise between them, especially since our modern corporate system requires that the suppliers of funds entrust the managers with the actual administration of the company.

Agency theory analyses the consequences of certain financial decisions in terms of risk, profitability and, more generally, the interests of the various parties. It shows that some decisions may go against the simple criteria of maximising the wealth of all parties to the benefit of just one of the suppliers of funds.

To simplify, we consider that an agency relationship exists between two parties when one of them, the agent, carries out an activity on behalf of the other, the principal. The agent has been given a mandate to act or take decisions on behalf of the principal. This is the essence of the agency relationship.

This very broad definition allows us to include a variety of domains, such as the resolution of conflicts between:

• executive shareholders/non-executive shareholders;
• non-shareholder executives/shareholders;
• creditors/shareholders.

Shareholders give the company executives a mandate to manage to the best of their ability the funds that have been entrusted to them. However, their concern is that the executives could pursue objectives other than maximising the value of the equity, such as increasing the company’s size at the cost of profitability, minimising the risk to capital employed by rejecting certain investments that would create value but could put the company in difficulty if they fail, etc.

One way of resolving such conflicts of interest is to use stock options, performance shares (shares offered to management depending on certain targets being reached) or free shares, thus linking management compensation to share performance (see Chapter 43).

Debt plays a role as well, since it has a constraining effect on managers and encourages them to maximise cash flows so that the company can meet its interest and principal payments. Failing this, the company risks bankruptcy and the managers lose their jobs. Maximising cash flows is in the interests of shareholders as well, since it raises the value of shareholders’ equity. Thus, the interests of management and shareholders converge. Maybe debt is the modern whip! This is sometimes referred to as “the discipline of debt”.

The diverging interests of the various parties generate a number of costs called “agency costs”. These comprise:

• the cost of monitoring managers’ efforts (control procedures, audit systems, ­performance-based compensation) to ensure that they correspond to the principal’s objectives. Stock options and free shares represent an agency cost since they are exercised at less than the going market price for the stock;
• the costs incurred by the agents to vindicate themselves and reassure the principals that their management is effective, such as the publication of annual reports, the organisation of regular meetings with investors;
• residual costs.

Ang et al. (2000) have shown that the margins and asset turnover rates of small and medium-sized American firms tend to be lower in companies managed by non-shareholding CEOs, and in which managers have little stake in the capital and many non-executive shareholders.

The main references in this field are Jensen and Meckling (1976), Grossman and Hart (1980) and Fama (1980). Their research aims to provide a scientific explanation of the relationship between managers and shareholders and its impact on corporate value.

This research forms the intellectual foundation on which the concept of corporate governance was built (see Chapter 43).

4. Free riders

We saw above that the interests of the different types of providers of funds may diverge, but so may those of members of the same category.

This means, first, that there must be several – usually a large number – of investors in the same type of security and, second, that a specific operation is undertaken implying some sort of sacrifice, at least in terms of opportunity cost, on the part of the investors in these securities.

As a result, when considering a financial decision, one must examine whether free riders exist and what their interests might be.

Below are two examples:

• Responding to a takeover bid: if the offer is motivated by synergies between the bidding company and its target, then the business combination will create value. This means that it is in the general interest of all parties for the bid to succeed and for the shareholders to tender their shares. However, it would be in the individual interest of these same shareholders to hold on to their shares in order to benefit fully from the future synergies.
• Bank A holds a small claim on a cash-strapped company that owes money to many other banks. It would be in the interests of the banks as a whole to grant additional loans to tide the company over until it can pay them back, but the interest of our individual bank would be to let the other banks, which have much larger exposure, advance the funds themselves. Bank A would thus hold a better-valued existing claim without incurring a discount on the new credits granted.

Questions