Maximizing Shareholder Value Through Value-Based Management And Capital Investment Essay.

What do you understand by the term ‘value based management’ (VMB)?

To what extent is it possible for managers to consistently invest funds that generate a return on capital that exceeds the cost of capital shares.

Value-Based Management and its Philosophy

Value based management are regarded as the approach that makes sure that the companies are performing consistently to maximize the value of shareholder. The value based management is regarded as the philosophy of management and approach which enables and backs the maximum value creation for the firm (Balance 2014). Value based management incorporates the procedure of creation, management and measurement of value. The procedure of value creation needs an understanding of the appeal of market and industry where an individual competes with one’s competitive position that is in relation to the other market players. Once the understanding is created and is associated with the significant value chain drivers of cash flow, cost-effectiveness and competitive strategy can be formed or altered to increase the forthcoming returns.

Return on invested capital is regarded as one of the most reliable source of understanding the performance metric for determining the superiority of investment (Lan, Moneta and Wermers 2016). Importantly for managers in determining the higher return on capital beyond the cost of shares the return on invested capital is a vital to measure for comparing the level of comparative profitability for the businesses.

Managers that work reliably with the long term method yield higher return on invested capital (Kahn and Lemmon 2014). To continuously produce return on the capital beyond the cost of share the managers look to invest in long term investment idea and concentrated portfolios with higher amount of active shares to engage in the organizations long term strategic and apportionment of resources. This enables producing long term value creation along with the fund depositors. It is the ability of the managers to derive the cash flow at the lower risk and assign the cash flow on rational basis that helps in driving value for shareholder over the time.

For the managers capitalizing on the value of investment needs an understanding of the proper return on capital to stockholders (Mao and Zhu 2015). The managers better understand that when their anticipated return on invested capital from investment or acquisition is greater than the cost of capital they would use those investment or acquisition that would yield a higher worth of return. If the marginal cost of capital is higher than the return on invested capital, returns can be derived with the help of reinvestment or acquisition and then financing in those profit yielding projects that would provide higher return (Davis and Lleo 2015). In such kind of circumstances, the shareholders will be in the position of deriving higher return on capital through reinvesting the fund in the business.

Return on Invested Capital: A Reliable Performance Metric

Managers may discover some of the plans that value investment but not essentially adequate to make use of the free cash flow. For these businesses, it is logical to make investment in some of the projects whereas at the same time returning back a number of free cash flow to stockholders (Cremers et al. 2016). Netting the stockholder return makes the use of the free cash flow in an orderly manner to apply the philosophy of investment. Importantly the managers measure the capital investment project based on the impact on the earnings per share. Even when everything goes according to the plan it can be confusing. This is because the accrual accounting postpones the identification of the actual expenditure. 

In determining the higher return on invested capital from the cost of share managers are given with the choice of selecting among the market value and book value. Managers often choose to proceed with the market value (Walden 2015). Managers uses the cost of capital by using the market value weights for debt and equity. The computation of accounting return is conceivably the only place in investment for managers where they return back to book value.

In generating the higher return on capital from the cost of shares the managers try to compute the return on invested capital in the current asset they assume that the book value of the debt and equity efficiently measures the capital investment (Zaher 2017). The managers mark up the value of the current assets to determine their power of earning. Alternatively, even though there are no growth assets making the use of the market value of the current investment helps in generating improved result for the managers which is equivalent to the cost of capital. The primary reason where the manager derives higher return on investment the managers uses the operating income in deriving the cost of capital (Chandra 2017). The return on capital determines the return on capital invested for an asset the managers places their focus on return on equity as the noteworthy component of investment. This is because it is associated with the earnings that are left over for the equity financiers following the debt service cost have been factored in the equity-invested asset.

The return on equity for an invested fund represent that an organization is therefore providing composite return on all the assets and cash operating. Based on the extent that the cash is different both in respect of the return and risk the operating assets, the return on equity for a firm having significant amount of cash balance would be depressed by the lower and less risky return derived by cash earnings. One of the most sensible course of action that is undertaken by the manager is not to take into the account the earnings and book value as stated but to adjust those returns in order to obtain better measure of the returns derived by an investor on its investment (Levy 2015). The purpose of the manager is not to project the last year return with total precision but arriving with the measure of return which can be helpful in determining the future performance.

Long-Term Investment and Concentrated Portfolios

The manager to optimize the return on invested from the cost of capital the manager is required to make sure that the portfolio is originally invested in line with the stated time horizon and objective of risk (Yuniningsih, Widodo and Wajdi 2017). This would require the manager to allocate more amount of capital to the real asset such as infrastructure and real estate. It might represent that greater amount of weight is placed on the strategies within the given class of asset and on long term value creation of the asset.

Finally, the asset is required to assure that their internal investment and the external fund managers remain committed to the long term investment horizon. Mutual structures for compensation should be made to reward the managers for their long term investment. Several investors have placed their focus on encouraging the long-term return beyond the cost of shares because careful analysis would enable the managers in deriving longer return for their investment (Harris et al. 2016). It is often found that managers are recommended to make an investment only when the return on possible venture is higher than the organizations weighted average cost of capital. Even though the investors do not get dividends, the shareholders are anticipated to derive the return on investment based on the rise of the stock price. Managers are under the obligation of maximizing their return to the shareholders by allocating the capital adequately. When the managers have the opportunities of making an investment they would earn a higher return on invested capital than the marginal cost of the capital required to fund the investment.    

Reference List: 

Balance, P.A., 2014. Investment management. City.

Chandra, P., 2017. Investment analysis and portfolio management. McGraw-Hill Education.

Cremers, M., Ferreira, M.A., Matos, P. and Starks, L., 2016. Indexing and active fund management: International evidence. Journal of Financial Economics, 120(3), pp.539-560.

HA Davis, M. and Lleo, S., 2015. Risk-Sensitive Investment Management.

Harris, E.P., Northcott, D., Elmassri, M.M. and Huikku, J., 2016. Theorising strategic investment decision-making using strong structuration theory. Accounting, Auditing & Accountability Journal, 29(7), pp.1177-1203.

Kahn, R.N. and Lemmon, M., 2014. The Asset Manager’s Dilemma: How Strategic Beta Is Disrupting the Investment Management Industry. Working paper, BlackRock.

Lan, C., Moneta, F. and Wermers, R., 2016. Holding Horizon: A New Measure of Active Investment Management.

Levy, H., 2015. Stochastic dominance: Investment decision making under uncertainty. Springer.

Mao, S. and Zhu, T., 2015. The Technique and Management of Investment Control in Metro Engineering. In Information Technology and Mechatronics Engineering Conference, China(pp. 207-211).

Walden, M.L., 2015. Active versus passive investment management of state pension plans: Implications for personal finance. Journal of Financial Counseling and Planning, 26(2), pp.160-171.

Yuniningsih, Y., Widodo, S. and Wajdi, M.B.N., 2017. An analysis of Decision Making in the Stock Investment. Economic: Journal of Economic and Islamic Law, 8(2), pp.122-128.

Zaher, T., 2017. The Value of Active Investment Strategies(No. 2017-WP-02). Indiana State University, Scott College of Business, Networks Financial Institute.