Question

Question 1: Comprehensively explain, using numerical examples, why companies create value by investing capital, from investors, to generate future cash flow at a rate of return exceeding the cost of capital.

Question 2: Comprehensively explain, using numerical examples, how, as a corollary to Fact 1, value is created by companies, for shareholders, when companies generate higher cash flows, not when rearranging investors' claims on those cash flows.

Question 3: Explain why and how a company's performance on the stock market is driven by changes in the stock market expectations, not just by the company's actual performance.

Question 4: Comprehensively explain how the value of a business depends on who is managing it and what strategy they pursue. Different owners will generate different cash flows for a given business based on their unique ability to add value.

Answer 1

Since, more than one question is mentioned and it is not mentioned clearly which ones to answer. Hence, answering the first question.

1) The companies use investors capital to generate future cashflows which should be at a rate higher than company's cost of capital, as it will make the company economically profitable.

The economic profitability means that company is generating positive cashflows after fulfilling its financial obligations which adds value for the shareholders, since, the core purpose of a business is to maximize shareholder's value.

For example, Company ABC has a Shareholder's Equity of 1 million and a debt of 1 million at a rate 10%.

Since market premium is at 5%, risk-free rate is 2% and company's beta is 1. The company's cost of equity is 7%. Ignoring tax, combined with cost of debt, company's cost of capital would 8.5% (0.5*10% + 0.5*7%).

Now the company would need a project to invest this capital which would yield a rate of return more than its cost of capital 8.5%.

Assume such a project has been found which has a NPV of 250,000. This 250,000 is 12.5% of total capital invested which is greater than cost of capital of 8.5% by 4%. This means after fulfilling its financial obligations, company would still have 4% of additional wealth at its disposal for future value creation. This increases the company's market value by the additional amount company created, hence, benefiting the shareholders with additional value.

Similar to above example, a company invests in various projects which are first analyzed for expected value creation and chose the ones creating most value for shareholders. Since, this decision lies with managers, hence, the project decisions can also be driven by manager's personal benefits, instead of shareholders.