## Finance For Executives: Managing for Value Creation, Sixth Edition

By Gabriel Hawawini and Claude Viallet

**Contents**

PART i Financial Concepts and Techniques 1

chapter 1 Financial Management and Value Creation: An Overview 1

The Key Question: Will Your Decision Create Value? 2

The Importance of Managing for Value Creation 3

The Saturn Story 4

The Fundamental Finance Principle 5

Measuring Value Creation with Net Present Value 5

Only Cash Matters 6

Discount Rates 6

A Proposal’s Cost of Capital 7

Applying the Fundamental Finance Principle 8

The Capital Budgeting Decision 8

The Payout Policy 10

The Capital Structure Decision 11

The Business Acquisition Decision 11

The Foreign Investment Decision 12

The Role of Financial Markets 12

The Equity Market 13

The Vioxx Recall 14

External Versus Internal Financing 15

The **Business Cycle** 15

HLC’s Financial Statements 17

The Balance Sheet 17

A Variant of the Standard Balance Sheet: The Managerial

Balance Sheet 19

The Income Statement 20

How Profitable Is the Firm? 21

The Profitability of Equity Capital 21

The Profitability of Invested Capital 22

How Much Cash Has the Firm Generated? 22

Sources and Uses of Cash 23

The Statement of Cash Flows 23

How Risky Is the Firm? 23

Has the Firm Created Value? 25

The Role of the Chief Financial Officer 26

Key Points 26

Further Reading 27

Self-Test Questions 27

chapter 2 The Time Value of Money 31

Present Values and Future Values 32

Compounding 33

Discounting 34

Using a Financial Calculator to Solve Time Value of Money Problems 35

Using a Spreadsheet to Solve Time Value of

Money Problems 36

Interest Rate Quotation and Calculation 36

The Annual Percentage Rate Versus the Effective Annual Rate 37

Nominal Versus Real Rates 38

The Present Value of a Stream of Future Cash Flows 38

The Net Present Value (NPV) Rule 39

The Internal Rate of Return (IRR) Rule 39

The Present Value of a Perpetual Cash-Flow Stream 40

The Present Value of a Growing Perpetuity 41

The Present Value of a Standard Annuity 42

The Present Value of a Growing Annuity 44

The Future Value of an Annuity 46

Key Points 47

Appendix 2.1 Proof of Formula 2.9 and Formula 2.6 49

Further Reading 49

Self-Test Questions 49

Review Questions 50

chapter 3 Risk and Return 53

Measures of Return 54

Realized Returns 54

Expected Return 55

Annualized Returns 55

Measures of Risk 55

Measuring Risk with the Variance of Returns 55

Measuring Risk with the Standard Deviation of Returns 56

Variance versus Standard Deviation 56

Annualized Measures of Risk 56

Return Distributions 57

Mean-Variance Analysis 57

Attitudes Toward Risk 60

Evidence from Financial Markets 61

Combining Two Stocks into a Portfolio 61

Portfolio Expected Return 63

Portfolio Risk and Correlations 63

Diversification Can Reduce Risk and Raise Return 65

The Opportunity Set of a Two-Stock Portfolio 65

The Optimal Portfolio of a Risk-Averse Investor 68

Changes in the Correlation Coefficient 68

Combining More Than Two Stocks into a Portfolio 68

Portfolio Expected Return 69

Portfolio Risk and Diversification 69

Portfolio Diversification in Practice 72

Firm-Specific Risk versus Market Risk 73

The Opportunity Set with More Than Two Stocks 74

Optimal Portfolios when there is a Riskless Asset 75

The Efficient Investment Line 75

The Sharpe Ratio 76

Making Optimal Investment Choices 77

The Market Portfolio and the Capital Market Line 79

The Expected Return of the Market Portfolio 79

Proxies for the Market Portfolio 80

The Sharpe Ratio and the Efficiency of the Market Portfolio 80

The Capital Market Line 80

Modern Investment Management: Allocation Beats Selection 82

A Closer Look at Systematic Risk 83

Beta and the Market Model 84

Calculating Beta 84

The Properties of Beta 85

Estimated Stock Betas 85

Portfolio Beta 86

The Capital Asset Pricing Model 87

The Expected Return of an Individual Stock 87

Using the CAPM to Estimate a Company’s Cost of Equity Capital 88

Using the CAPM to Evaluate Investment Performance 89

Using the CAPM to Test the Informational Efficiency of Stock

Markets 90

Key Points 91

Further Reading 92

Appendix 3.1 How to Get the SML Equation 93

Self-Test Questions 94

Review Questions 95

PART ii Assessing Business Performance 99

chapter 4 Interpreting Financial Statements 99

Financial Accounting Statements 99

The Balance Sheet 100

Current or Short-Term Assets 101

Noncurrent or Fixed Assets 105

Current or Short-Term Liabilities 107

Noncurrent Liabilities 108

Owners’ Equity 110

The Managerial Balance Sheet 110

Working Capital Requirement 111

The Income Statement 114

Net Sales or Turnover 116

Gross Profit 116

Operating Profit 117

Earnings Before Interest and Tax (EBIT) 117

Earnings Before Tax (EBT) 118

Earnings After Tax (EAT) 118

Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) 118

Reconciling Balance Sheets and Income Statements 119

The Structure of the Owners’ Equity Account 120

The Statement of Cash Flows 121

Preparing a Statement of Cash Flows 122

Net Cash Flow from Operating Activities 123

Net Cash Flow from Investing Activities 125

Net Cash Flow from Financing Activities 126

The Statement of Cash Flows 127

Problems with the Statement of Cash Flows 127

Free Cash Flow 128

Key Points 129

Appendix 4.1 Obtaining the Net Cash Flow from Operating Activities Using

Balance Sheet and Income Statement Accounts 132

Measuring Cash Inflow from Sales 132

Measuring Cash Outflow from Operating Activities 132

Cash Outflow from Purchases 132

Cash Outflow from SG&A and Tax Expenses 133

Cash Outflow from Net Interest Expense 134

Net Cash Flow from Operating Activities 134

Appendix 4 . 2 Specimen Financial Statements 136

The GlaxoSmithKline (GSK) Financial Statements 136

GSK’s Balance Sheets and **Managerial Balance Sheets** 136

GSK’s Balance Sheets 136

Gsk’s Managerial Balance Sheets 139

GSK’s Income Statements 140

GSK’s Statements of Cash Flows 142

Further Reading 144

Self-Test Questions 145

Review Questions 148

Chapter 5 Analyzing Operational Efficiency and Liquidity 153

The Structure of the Managerial Balance Sheet 154

The Three Components of a Firm’s Invested Capital 154

The Two Components of a Firm’s Capital Employed 158

The Structure of OS Distributors’ Managerial Balance Sheet 158

The Matching Strategy 158

A Measure of Liquidity Based on the Funding Structure of Working

Capital Requirement 160

Improving Liquidity through Better Management of the

Operating Cycle 163

The Effect of the Firm’s Economic Sector on Its Working Capital

Requirement 163

The Effect of Managerial Efficiency on Working Capital Requirement 165

The Effect of Sales Growth on Working Capital Requirement 167

Traditional Measures of Liquidity 168

Net Working Capital 168

The Current Ratio 170

The Acid Test or Quick Ratio 171

Key Points 171

Appendix 5.1 Financing Strategies 173

Appendix 5.2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

Gsk’s Liquidity Position 176

Gsk’s Management of the Operating Cycle 177

Further Reading 179

Self-Test Questions 180

Review Questions 182

chapter 6 Analyzing Profitability, Risk, and Growth 189

Measures of Profitability 190

Return on Equity 190

Measuring Return on Equity 190

The Effect of Operating Decisions on ROE 191

The Effect of Financing Decisions on Return on Equity 197

The Incidence of Taxation on Return on Equity 199

Putting It All Together: The Structure of a Firm’s Profitability 200

The Structure of ROE Across Industries 202

Other Measures of Profitability 203

Earnings Per Share (EPS) 203

The Price-to-Earnings Ratio (P/E) 203

The Market-to-Book Ratio 204

Financial Leverage and Risk 204

How Does Financial Leverage Work? 205

Two Related Caveats: Risk and the Ability to Create Value 206

Self-Sustainable Growth 207

Key Points 211

Appendix 6.1 Glaxosmithklines Profitability 213

GSKs Profitability Structure 213

Return on Equity 213

The Effect of Operating Margin on GSK’s Operating Profitability 213

The Effect of Invested Capital Turnover on GSK’s Operating Profitability 217

The Effect of GSK’s Financial Policy on Its Return on Equity 218

The Effect of Taxation on GSK’s Return on Equity 219

Further Reading 219

Self-Test Questions 219

Review Questions 222

PART iii Making Investment Decisions 227

chapter 7 Using the Net Present Value Rule to Make Value-Creating

Investment Decisions 227

The Capital Investment Process 228

Would You Buy This Parcel of Land? 230

The Alternative Investment 230

The Opportunity Cost of Capital 231

The Net Present Value Rule 232

A One-Period Investment 232

A Two-Period Investment without an Intermediate

Cash Flow 234

A Two-Period Investment with an Intermediate Cash Flow 235

Multiple-Period Investments 236

Applying the Net Present Value Rule to a Capital Investment

Decision 237

Why the NPV Rule is a Good Investment Rule 238

NPV Is a Measure of Value Creation 239

NPV Adjusts for the Timing of the Project’s Cash Flows 240

NPV Adjusts for the Risk of the Project’s Cash Flows 240

NPV Is Additive 244

Special Cases of Capital Budgeting 246

Comparing Projects of Unequal Size 246

Comparing Projects with Unequal Life Spans 248

Limitations of the Net Present Value Criterion 251

Managerial or Real Options Embedded in Investment Projects 251

Dealing with Managerial Options 253

Key Points 254

Further Reading 256

Self-Test Questions 256

Review Questions 257

chapter 8 Alternatives to the Net Present Value Rule 261

The Payback Period 261

The Payback Period Rule 262

Why Do Managers Use the Payback Period Rule? 265

The Discounted Payback Period 267

The Discounted Payback Period Rule 268

The Discounted Payback Period Rule versus the Ordinary Payback

Period Rule 269

The Internal Rate of Return 270

The IRR Rule 271

The IRR Rule May Be Unreliable 273

Why Do Managers Usually Prefer the IRR Rule to the NPV Rule? 276

The Profitability Index 277

The Profitability Index Rule 277

Use of the Profitability Index Rule 278

The Average Accounting Return 279

The Average Accounting Return Rule 280

Key Points 280

Further Reading 282

Self-Test Questions 282

Review Questions 283

chapter 9 Identifying and Estimating a Project’s Cash Flows 287

The Actual Cash-Flow Principle 287

The With/Without Principle 288

The Designer Desk Lamp Project 290

Identifying a Project’s Relevant Cash Flows 292

Sunk Costs 292

Opportunity Costs 293

Costs Implied by Potential Sales Erosion 293

Allocated Costs 294

Depreciation Expense 294

Tax Expense 294

Financing Costs 295

Inflation 296

Estimating a Project’s Relevant Cash Flows 297

Measuring the Cash Flows Generated By a Project 298

Estimating the Project’s Initial Cash Outflow 299

Estimating the Project’s Intermediate Cash Flows 303

Estimating the Project’s Terminal Cash Flow 304

Should SMC Launch the New Product? 305

Sensitivity of the Project’s NPV to Changes in the Lamp Price 306

Sensitivity of NPV to Sales Erosion 306

Key Points 307

Further Reading 308

Self-Test Questions 308

Review Questions 310

PART iV Making Financing Decisions 315

chapter 10 Valuing Bonds and Stocks 315

What Are Bonds and Common Stocks? 316

Bond Features and Terminology 316

Common Stock Features and Terminology 317

The Discounted Cash Flow (DCF) Model 318

Valuing Bonds 320

Finding the Price of a Bond when its Yield Is Known 320

How Changes in Yield Affect Bond Prices 321

Bond Price versus Face Value 322

Finding the Yield of a Bond When Its Price Is Known 322

The Market Yield of a Bond Is the Cost of Debt to the Firm 323

Price Quotation and Yield Conventions 323

The Case of Zero-Coupon Bonds 324

The Case of Perpetual Bonds 326

A Closer Look at Bond Yields snd Risk 327

Risk Is the Major Determinant of a Bond’s Yield 327

Credit Risk, Credit Ratings, and Credit Spreads 327

The Term Structure of Interest Rates 329

Finding the Price and the Yield of a Bond If the

Spot Rates are Known 333

Interest-Rate Risk 334

Duration as a Measure of Interest-Rate Risk 335

Valuing Common Stocks 336

Valuation Based on the Dividend-Discount Model (DDM) 336

Valuation Based on Discounted Free Cash Flows 339

Valuing PEC with the Discounted Free Cash Flow Model 341

Valuation Based on Discounted Cash Flows to Equity Holders 343

Comparing the Three Discounted Cash Flow Models 345

Valuation Based on Comparable Firms 345

Direct Valuation of a Firm’s Equity Based on the

Price-to-Earnings Ratio 346

Direct Valuation of a Firm’s Equity Based on the Price-to-Book

Ratio 347

Indirect Valuation of a Firm’s Equity Based on the EV-to-EBITDA Ratio 347

Key Points 348

Appendix 10 .1 The Properties of Duration 350

Further Reading 353

Self-Test Questions 354

Review Questions 355

chapter 11 Raising Capital and Paying Out Cash 359

Estimating the Amount of Required External Funds 360

The Financial System: Its Structure and Functions 364

Direct Financing 364

Indirect or Intermediated Financing 364

Securities Markets 367

How Firms Issue Securities 371

Private Placement 371

Public Offerings 371

Raising Debt Capital 375

Borrowing through Bank Loans 376

Borrowing through Lease Agreements 376

Borrowing by Issuing Short-Term Securities 379

Borrowing by Issuing Corporate Bonds 379

Raising Equity Capital 383

Preferred Stocks 383

Tracking Stock 385

Equity Warrants 385

Contingent Value Rights 385

Distributing Cash to Shareholders 386

Observed Payout Policies 386

How and Why Firms Pay Dividends and Buy Back their Shares 390

How Firms Pay Dividends 391

How Firms Repurchase their Shares 391

Differences Between Dividend Payments and Share Repurchases 392

Does a Firm Payout Policy Affect Its Share Price and the Wealth of Its

Shareholders? 394

Paying an Immediate Special Dividend of $250 Million 396

Buying Back $250 Million of Shares in the Open Market 397

Issuing $100 Million of New Equity to Pay an Immediate Dividend of

$350 Million 398

Investing $250 Million in a Project 399

Payout Policy Is Irrelevant in a Perfect Market Environment as Long as the

Firm’s Investing and Financing Policies do not Change 399

Payout Policy with Market Imperfections 400

Key Points 402

Further Reading 405

Self-Test Questions 406

Review Questions 407

chapter 12 Estimating the Cost of Capital 411

Identifying Proxy or Pure-Play Firms 412

Estimating the Cost of Debt 413

Estimating the Cost of Equity 415

Estimating the Cost of Equity Using the Dividend-Discount Model 415

Estimating the Cost of Equity Using the Capital Asset Pricing Model 417

Estimating the Cost of Capital of a Firm 426

What Is a Firm’s Cost of Capital? 426

The Firm’s Target Capital Structure 427

The Firm’s Costs of Debt and Equity 429

Summary of the Firm’s WACC Calculations 430

Estimating the Cost of Capital of a Project 430

The Project’s Risk Is Similar to the Risk of the Firm 430

The Project’s Risk Is Different from the Risk of the Firm 431

Three Mistakes to Avoid When Estimating a Project’s Cost of

Capital 434

Key Points 438

Further Reading 439

Self-Test Questions 439

Review Questions 440

chapter 13 Designing a Capital Structure 445

The Capital Structure Decision in a World without Corporate Income

Tax and Financial

Distress Costs 446

Effects of Borrowing on the Firm’s Profitability (No Corporate Income Tax

and No Financial

Distress Costs) 446

Understanding the Trade-Off Between Profitability and Risk 449

Effect of Borrowing on the Value of the Firm’s Assets and Its Share Price

(No Corporate Income Tax and No Financial Distress Costs) 450

Effect of Borrowing on the Firm’s Cost of Capital (No Corporate Income

Tax and No Financial Distress Costs) 453

The Capital Structure Decision in a World with Corporate Income Tax

but without Financial Distress Costs 455

Effect of Borrowing on the Value of a Firm’s Assets (with Corporate

Income Tax and No Financial Distress Costs) 456

Effect of Borrowing on the Firm’s Market Value of Equity (with Corporate

Income Tax and No Financial Distress Costs) 460

Effect of Borrowing on the Firm’s Share Price (with Corporate Income Tax

and No Financial Distress Costs) 460

Effect of Borrowing on the Cost of Capital (with Corporate Income Tax

and No Financial Distress Costs) 461

The Capital Structure Decision when Financial Distress is

Costly 464

Formulating a Capital Structure Policy 467

A Closer Look at the Trade-Off Model of Capital Structure 467

Factors Other Than Taxes That May Favor Borrowing 470

Factors Other Than Financial Distress Costs That May Discourage

Borrowing 473

Is There a Preference for Retained Earnings? 475

Putting It All Together 476

Key Points 479

Appendix 13.1 Capital Structure and Systematic Risk (Beta) 481

How to Extract Unlevered Betas from Levered Betas 481

Case 1: The Debt-to-Equity Ratio (D/E) is Constant

Over Time 482

Case 2: The Amount of Debt (D) is Constant Over Time 482

Which Formula Should Be Used to Get Unlevered Betas? 483

Further Reading 484

Self-Test Questions 484

Review Questions 485

PART V Making Business Decisions 487

chapter 14 Valuing and Acquiring a Business 487

Alternative Valuation Methods 488

Valuing a Firm’s Equity Using Comparable Firms 489

Direct Estimation of a Firm’s Equity Value Based on the Equity Value of

Comparable

Firms 492

Indirect Estimation of a Firm’s Equity Value Based on the Enterprise

Value of Comparable Firms 494

Valuing a Firm’s Business Assets and Equity Using the Discounted Cash

Flow (DCF) Method 496

Estimation of OS Distributors’ Enterprise and Equity Values 497

Step 1: Determination of the Length of the Forecasting Period 498

Step 2: Estimation of the Free Cash Flow from Business Assets 498

Step 3: Estimation of the Weighted Average Cost of Capital 502

Step 4: Estimation of the Terminal Value of Business Assets at

the End of Year 5 503

Step 5: Estimation of the DCF Value of Business Assets (Enterprise Value) 504

Step 6: Estimation of the DCF Value of Equity 504

Comparison of DCF Valuation and Valuation by Comparables 505

Estimating the Acquisition Value of OS Distributors 505

Identifying the Potential Sources of Value Creation in an Acquisition 505

Why Conglomerate Mergers Are Unlikely to Create Lasting Value Through

Acquisitions 508

The Acquisition Value of OS Distributors’ Equity 510

Estimating the Leveraged Buyout Value of OS Distributors 514

Estimating the Leveraged Buyout Value of Business Assets Using the

Adjusted Present Value Method (the APV Method) 516

Will OS Distributors Be Able to Service Its Debt? 520

Key Points 523

Further Reading 525

Self-Test Questions 525

Review Questions 526

chapter 15 Managing Corporate Risk 531

What Is Risk? 532

Why Should Firms Manage Risk? 533

Risk Management Can Reduce Corporate Income Tax Payments 534

Risk Management Can Lower the Cost of Protection Against Risk 534

Risk Management Can Lower Financial Distress Costs 534

Risk Management Can Provide Clearer Information to Investors About the

Firm’s Core Activities 534

Risk Management Can Lower Agency Costs 534

Corporate Risk Management 535

Risk Netting 535

Cost Savings 535

Risk Policy 536

Risk Learning 536

The Risk Management Process 536

Step 1: Risk Identification 537

Step 2: Risk Measurement 545

Step 3: Risk Prioritization 546

Step 4: Risk Policy 547

Step 5: Risk Monitoring 551

Key Points 551

Further Reading 552

Self-Test Questions 552

Review Questions 553

chapter 1 6 Understanding Forward, Futures, and Options and Their

Contribution

to Corporate Finance 555

Forward Contracts 556

Price Risk 556

Counterparty Risk 556

Liquidity Risk 557

Futures Contracts and Markets 557

How Futures Markets Mitigate Counterparty Risk 557

How Futures Markets Mitigate Liquidity Risk 558

Available Futures Markets and Contracts 559

Hedging Risk with Futures Contracts 559

The Pricing of Forward and Futures Contracts 562

The Relationship Between the Spot Price and the Forward Price 562

The Relationship Between the Expected Spot Price and the Forward Price 565

Option Contracts 566

Option Contracts Defined 567

Over-The-Counter (OTC) Options Versus Traded Options 567

European versus American Options 567

Option Buyers and Option Writers 568

Call Options 568

Put Options 571

The Put-Call Parity Relationship 574

Getting Option Prices with the Black and Scholes Formula 577

The Price of a European Call on a Non-Dividend-Paying Stock 577

The Price of a European Put on a Non-Dividend-Paying Stock 577

Using a Spreadsheet to Calculate the Price of European Options 577

The Price of European Options on Dividend-Paying Stocks 579

The Price of American Options 579

Response of Option Prices to Changes in Input Values 581

Implied Volatility 582

How Good Is the Black-Scholes Model? 583

Delta: A Measure of the Sensitivity of Option Prices to Changes in the

Underlying Stock Price 583

An Investment in an Option Is Always Riskier Than the Same Investment

in the Underlying Stock 584

Option-Based Investment Strategies 585

Speculating on a Rise in Stock Price with Naked Calls 585

Hedging Against a Drop in Stock Price with Protective Puts 585

Insuring Equity Portfolios 587

Writing Covered Calls to Generate Income 587

Collars: Covered Calls with Protective Puts 587

Hedging Stock Price Volatility with Long Straddles 587

Arbitraging Option Prices with Money Spreads or Time Spreads 588

Securities with Option Features 588

Equity as a Call Option on the Firm’s Assets 588

Corporate Bonds As Risk-Free Bonds and Short Puts on the Firm’s

Assets 591

Collateralized Loans 591

Right Issues, Warrants and Contingent Value Rights 591

Callable and Convertible Bonds 592

Real Options and Strategic Investment Decisions 592

Expanding Abroad 593

Calculating the Project’s NPV with the Option Value 595

Discussion 596

Different Types of Real Options Embedded in Projects 597

Key Points 597

Appendix 16.1 The Binomial Option Pricing Model 601

Creating a Riskless Covered Call Position 601

Finding the Call Price Based on the Riskless Covered Call Position 602

Further Reading 602

Self-Test Questions 602

Review Questions 605

chapter 17 Making International Business Decisions 609

The Firm’s Risk Exposure from Foreign Operations 610

Accounting, or Translation, Exposure 610

Economic Exposure 610

Managing Currency Risk 612

The Foreign-Exchange Market 613

Hedging Contractual Exposure to Currency Risk 614

Hedging Long-Term Contractual Exposure to Currency Risk with Swaps 620

Factors Affecting Changes in Exchange Rates 622

How Differences in Inflation Rates Affect Exchange Rates: The Purchasing

Power Parity Relation 623

The Relationship between Two Countries’ Inflation Rates and Interest

Rates: The International Fisher Effect 624

How Differences in Interest Rates Affect Exchange Rates: The Interest-Rate

Parity Relation 625

The Relation between Forward Rates and Future Spot Rates 626

Putting It All Together 627

Analyzing an International Investment Project 628

The Net Present Value Rule: A Brief Review 628

Surf and Zap Cross-Border Alternative Investment Projects 629

Managing Country Risk 635

Invest in Projects with Unique Fveatures 635

Use Local Sourcing 635

Choose a Low-Risk Financial Strategy 636

Design a Remittance Strategy 636

Consider Buying Insurance Against Country Risk 636

Key Points 637

Appendix 17.1 Translating Financial Statements with the Monetary/Nonmonetary

Method and the All Current Method 639

The Monetary/Nonmonetary Method 639

The All Current Method 640

Which Method Is Better? 642

Appendix 17.2 The Parity Relations 643

The Law of One Price 643

The Purchasing Power Parity Relation 644

The International Fisher Effect 644

The Interest-Rate Parity Relation 645

Strategy 1: Investment in US Dollars 645

Strategy 2: Investment in Euros 646

Further Reading 647

Self-Test Questions 647

Review Questions 648

chapter 18 Managing for Value Creation 653

Measuring Value Creation 654

Estimating Market Value Added 654

Interpreting Market Value Added 657

A Look at the Evidence 658

Identifying the Drivers of Value Creation 660

Linking Value Creation to Operating Profitability, the Cost of Capital,

and Growth Opportunities 661

Only Value-Creating Growth Matters 663

Linking Value Creation to Its Fundamental Determinants 664

Linking Operating Performance and Remuneration to Value Creation 665

Mr. Thomas Hires a General Manager 666

Has the General Manager Achieved His Objectives? 667

Economic Profits Versus Accounting Profits 669

Designing Compensation Plans That Induce Managers to Behave Like Owners 670

Linking the Capital Budgeting Process to Value Creation 671

The Present Value of an Investment’s Future EVA Is Equal to Its MVA 672

Maximizing MVA Is the Same as Maximizing NPV 672

Putting It All Together: The Financial Strategy Matrix 675

The Business Is a Value Creator but Is Short of Cash 676

The Business Is a Value Creator with a Cash Surplus 676

The Business Is a Value Destroyer with a Cash Surplus 677

The Business Is a Value Destroyer That Is Short of Cash 677

Key Points 677

Appendix 18 .1 Adjusting Book Values to Estimate the Amount of Invested Equity

Capital and Operating Profit 679

Adjusting the Book Value of Equity Capital 679

Adjusting Earnings Before Interest and Tax 680

Appendix 18.2 Estimating Market Value Added (MVA) when Future Cash Flows

are Expected to Grow at a Constant Rate in Perpetuity 682

Further Reading 683

Self-Test Questions 683

Review Questions 685

Answers to Self-Test Questions 691

Glossary 741

Credits 763

Index 765