Lecture Contemporary strategy analysis: Concepts, techniques, applications (5th edition): Chapter 2 - Robert M. Grant

• From profit maximization to value maximization —Net present value of firm = Discounted future profits. over the life of the firm.[r]

Goals, Values and Performance

• Strategy as a quest for value

• What is profit?

• The shareholder value approach

• The shareholder value and strategy

formulation

• Mission and values

OUTLINE

Strategy as a Quest for Profit

• The stakeholder approach : The firm is a coalition of

interest groups—it seeks to balance their different

objectives.

• The shareholder approach : The firm exists to maximize the

wealth of its owners.

• Why is profit maximization a reasonable goal?

(1) Boards of directors legally obliged to pursue shareholder interests.

(2) To replace assets, firm must earn return on capital > cost of capital (difficult when competition intense).

(3) To avoid acquisition, firm must achieve stock-market

value > break-up value.

What is Profit?

• Profit maximization an ambiguous goal

– Total profit vs Rate of profit

– Over what time period?

• Accounting profit versus Economic profit

• Economic Value Added (EVA) as a measure of

economic profit:

— Post-tax operating profit less cost of capital

• From profit maximization to value maximization

—Net present value of firm = Discounted future profits

over the life of the firm

Net Inc ROS ROE EVA Market Return to

Value Added Shareholders ($m) (%) (%) ($m) ($m) (%)

Procter & Gamble 3,780 10.2 12.2 61,661 102,379 15.9

How U.S Companies Perform Under Different Profitability Measures, 1998

How U.S Companies Perform Under Different Profitability Measures, 1998

Value Maximization

Maximizing the value of the firm:

Max net present value of free cash flows :

max V =

(1 + re)t

Ct

Where:

V market value of the firm

Ct free cash flow in time t

re+d weighted average cost

of capital

t

Applying Shareholder Value Maximization to Strategy Choice

Maximization to Strategy Choice

• Identify strategy alternatives

• Estimate cash flows associated with cash

strategy

• Estimate cost of capital for each strategy

• Select the strategy which generates the highest

NPV

Valuing Companies and Business Units

If net case flow growing at constant rate (g)

( r - g )

With varying cash flows which can be forecasted for 4 years:

where: VH is the horizon value of the firm after 4 years