25 February 2014 MANAGERIAL POLICY A firm has a competitive advantage when it creates more economic value than its rivals
In order to generate economic value, a firm needs to invest in projects (e.g. Coke invests in a new factory)
Invest in Projects
Raise Capital
The Lower a firms (Cokes) cost of raising capital to finance a project, in comparison to rivals (Pepsi), the Higher its competitive advantage
Economic Value = Competitive Advantage
Measures of Competitive Advantage Accounting Measures Economic Measures Calculated by using information from P&L and Balance Sheet and compares return (profit) to industry averages
Examples: Profitability Ratios (ROA, ROE) Leverage Ratios (Debt to Equity)
Does NOT include the Cost of Capital Compare a firms level of return (profit) to its Cost of Capital instead of the average level of return in the industry
Cost of Capital is the rate of return a firm pays to its suppliers of capital
Weighted Average Cost of Capital (WACC) is the rate that a firm is expected to pay on average to all its security holders (debt and equity) to finance its assets
WACC is an estimate of the Cost of Capital Estimating WACC
Components A Firms Debt Rating Marginal Tax Rate B Beta C Risk Free & Market Rate D 1 Firms Capital Structure E (Stockholders Equity/Total Assets) x Cost of Equity + (Debt/Total Assets) x After-tax Cost of Debt WACC Cost of Equity = risk free rate + (market rate) x beta Cost of Debt = (1-tax rate) x (risk free rate) Managerial Policy Economic Measures Economic performance & Cost of Capital (WACC) Different levels of Economic performance: 1. Above Normal: A firm that earns ABOVE its cost of capital 2. Normal: A firm that earns EQUAL to its cost of capital 3. Below Normal: A firm that earns BELOW its cost of capital Cost of Capital: Level of performance the firm must attain to satisfy its: Debt Holders Equity Holders 1 2 Firms that have a Competitive DIS-advantage generally have Below Normal Economic Performance
3 Managerial Policy Reducing the cost of capital through capital restructuring Recommendations: Mature companies (Coke) with stable and predictable cash flows as well as limited investment opportunities should include more debt Companies that face high uncertainty (Twitter) should carry less debt
1. Strike a balance between the discipline and tax savings that debt can deliver, and the greater flexibility of equity
2. A company can reduce its after tax cost of capital by increasing debt relative to its equity
Effect on cash flow: Carrying debt imposes discipline and increases intrinsic value Too much debt can reduce intrinsic value by limiting flexibility to make value investments 3 4 Managerial Policy Making Capital Structure support Strategy McKinsey & Company Lower cost of Capital with Optimal Leverage Managerial Policy Empirical Evidence WACC = 8.38 WACC = 8.21 Pepsi has a lower WACC as compared to Coke due to a different capital structure, which gives it a competitive advantage over Coke Economic Profit is a measure of performance that compares net operating profit to the total cost of capital A positive economic profit tells us that the firm more than covered its cost of capital. The Lower the Cost of Capital, the Higher the Economic Value / Profit Invest in Projects Economic Value (Profit) = Net Operating Profit After Tax - (Capital Invested x WACC) Raise Capital 1 2 3 4 Competitive Advantage Conclusion: Net Profit and Cost of Capital Conclusion Economic measures of competitive advantage exaggerate the importance of debt/equity holders at the expense of other stakeholders (customers/suppliers/society etc.)
1. Firm earning at-least its cost of capital means that it satisfies its 2 most important stakeholders (debt/equity holders) Lack of information can create difficulties in calculating WACC (if firm is privately held) 2 3 Advantage Limitations Managerial Policy Advantages & Limitations of economic measures Thank You Managerial Policy References McKinsey on Finance (Winter 2006) Strategic Management & Competitive Advantage (Jay B Barney)