Profit Maximization Vs Wealth Maximization Ppt

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					Goals, Values and Performance

                OUTLINE

• Strategy as a quest for value
• What is profit?
• The shareholder value approach
• The shareholder value and strategy
  formulation
• Mission and values
       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
         How U.S. Companies Perform Under
         Different Profitability Measures, 1998

                 Net Inc. ROS   ROE    EVA       Market     Return to
                                              Value Added Shareholders
                 ($m)     (%)    (%)   ($m)        ($m)        (%)
General Motors   2,956    1.8   19.7   -5,525     -17,943     21.4
General Electric 6,573    9.4   22.2    4,370    285,320      45.3
Exxon            6,370    6.3   14.6   -2,262    114,774      22.4
Philip Morris    5,450   10.3   39.0    5,180      98,657     64.8
IBM              6,328    7.7   32.6    2,541      -5,878     77.5
Coca-Cola        3,533   18.8   42.0    2,194    157,356        1.3
Wal-Mart         4,430    3.2   21.0    1,159    159,444     107.7
Procter & Gamble 3,780   10.2   12.2   61,661 102,379         15.9
Microsoft        4,490   31.0   27.0    3,776    328,257      37.5
Hewlett-Packard 2,945     6.3   17.4     -593      45,464     10.7
             Value Maximization
Maximizing the value of the firm:

Max. net present value of free cash flows :


                           Ct
max. V =                (1 + re)t
                    t

                        Where:
                        V    market value of the firm.
                        Ct free cash flow in time t
                        re+d weighted average cost
                                of capital
     Applying Shareholder Value
    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)

              V=     C1
                   (r-g)

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

  V = C0 +     C1 +     C2 +       C3 + VH
             (1 + r ) (1 + r )2 (1 + r )3 (1 + r )3

  where: VH is the horizon value of the firm after 4 years
    Problems of DCF Approaches to
          Strategy Approach
• Net Present Value of the Firm depends on option
  values as well as discounted cash flow
  expectations
• Estimating cash flows beyond 2-3 year horizon is
  hazardous---especially in dynamic markets

HENCE: Some simple guidelines for maximizing
        the value of the firm—
    • On existing assets-- maximize after-tax rate
      of return
    • On new investment-- seek after-tax rate of
      return > cost of capital
 The six levers of financial and real options
          Financial options        Real options          Comments

                                  Present value of     The greater the NPV, the
            Stock price     =      returns to the       higher the option value
                                    investment

                                                       The higher the cost, the
           Exercise price   =     Investment cost       lower the option value

                                                            Higher volatility
OPTION      Uncertainty     =       Uncertainty         increases option values
VALUE
                                                          Time = opportunity to
           Time to expiry     = Duration of option       learn about outcomes

                                   Value lost over   Loss of cash flow to fully
             Dividends        =
                                  duration of option -committed competitors
                                                          lowers option value

              Risk-free                Risk-free           Higher interest rate
                            =                            increases option value
            Interest rate            interest rate
                                                         by increasing value of
                                                          deferring investment
 Disaggregating Return on Capital Employed


                                COGS/Sales

                               Depreciation/
             Return on
                                  Sales
               Sales
                               SGA expense/
                                  Sales

ROCE                        Fixed Asset Turnover
                                 Sales/PPE
                             Inventory Turnover
                              Sales/Inventories
            Sales/Capital
                             Creditor Turnover
             Employed
                                Sales/Acct
                             Turnover of other
                              items of working
                                  capital
         Linking Value Drivers to Performance Targets
                                                                 Order Size
                                                               Customer Mix
                                               Sales
                                                               Sales/Account
                                              Targets
                                                              Customer Churn
                                                                    Rate
                                               cogs/
                               Margin                           Deficit Rates
                                               sales
                                                              Cost per Delivery
                                            Development       Maintenance cost
Shareholder                                                     New product
                                             Cost/Sales
  value       ROCE                                            development time
 creation                                                      Indirect/Direct
                                                                    Labor
                                             Inventory           Customer
       Economic                              Turnover            Complaints
         Profit                                                  Downtime
                               Capital       Capacity
                              Turnover       Utilization      Accounts Payable
                                                                   Time
                                               Cash              Accounts
                                             Turnover          Receivable Time


      CEO            Corporate/Divisional   Functional     Departments & Teams
                Balanced Scorecard for Mobil N. American Marketing & Refining
                                       Strategic Objectives                                           Strategic Measures
                   F
                   I
  Financially      N
                        F1 Return on Capital Employed                              *   ROCE
                        F2 Cash Flow                                               *   Cash Flow
                   A
  Strong                F3 Profitability                                           *   Net Margin
                   N
                        F4 Lowest Cost                                             *   Full cost per gallon delivered to customer
                   C
                        F5 Profitable Growth                                       *   Volume growth rate Vs. industry
                   I
                        F6 Manage risk                                             *   Risk index
                   A
                   L


                  CO                                                               * Share of segment in key markets
 Delight the      UM    C1 Continually delight the targeted consumer
                                                                                   * Mystery shopper rating
 Consumer         SE
                  TR                                                               * Dealer/distributor margin on gasoline
  Win-Win               C2 Improve dealer/distributor profitability
                                                                                   * Dealer/distributor survey
 Relationship     -

                                                                                   * Non-gasoline revenue and margin per square foot
                        I1 Marketing
                                                                                   * Dealer/distributor acceptance rate of new programs
                            1. Innovative products and services
  Safe and                                                                         * Dealer/distributor quality ratings
                            2. Dealer/distributor quality
  Reliable         I                                                               *   ROCE on refinery
                        I2 Manufacturing
                   N                                                               *   Total expenses (per gallon) Vs. competition
                            1. Lower manufacturing costs
                   T                                                               *   Profitability index
                            2. Improve hardware and performance
                                                                                   *   Yield index
                   E
  Competitive      R    I3 Supply, Trading, Logistics
                                                                                   Delivered cost per gallon .Vs. competitors
   Supplier                 1. Reducing delivered cost
                   N                                                               * Trading margin
                            2. Trading organization
                   A                                                               * Inventory level compared to plan & to output rate
                            3. Inventory management
Good Neighbor      L
                                                                                   * Number of incidents
                        I4 Improve health, safety, and environmental performance
                                                                                   * Days away from work
  On Spec
                        I5 Quality
  On time                                                                          * Quality index


                  L
                  E &
   Motivated            L1 Organization Involvement                                * Employee survey
                  A G
     and
                  R R
   Prepared             L2 Core competencies and skills                            * Strategic competing (?) availability
                  N O
                  I W   L3 Access to strategic information                         * Strategic information availability
                  N T
                  G H
           A Comprehensive Value Metrics Framework



 Shareholder              Intrinsic              Financial                Value
   Value                    Value                Indicators               Drivers
Measures:                                                              Sources:
                        Measures:             Measures:
• Market value of the                                                  • Market share
                        • Discounted cash     • Return on Capital
  firm                                                                 • Scale economies
                          flows               • Growth (of
•Market value added                                                    • Innovation
                        •Real option values     revenues & operating
 (MVA)                                                                 • Brands
                                                profits
•Return to
                                              •Economic profit (EVA)
  shareholders
              The Paradox of Value

The companies that are most successful in creating
long term shareholder value are typically those that:
a) Have a mission—They give precedence to goals
   other than profitability and shareholder return;
a) Have strong, consistent, ethical values.


Examples:
a) “Visionary” companies studied by Collins & Porras,
   e.g. Merck, Wal-Mart, Procter & Gamble, Disney, HP
b) Boeing — Boeing’s focus pre-1996: “to build great planes”
               with weak financial controls
           — post-1996 focus: creating shareholder value
           — after 2000, rapid decline in Boeing profitability
              Values and Mission


The role of (ethical) values :
      • Place constraints on the means by which the firm will
        pursue shareholder value max.
      • Increase the effectiveness with which the firm builds
        competitive advantage though reinforcing strategic
        intent and building internal consensus and
        commitment.

The role of mission:
      • Foundation for strategy       Statement of what the
        firm seeks to achieve and what it intends to become.

				
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