Management and processing of firms’ value during  financial recession  

 

Pavel Marinič

ŠKODA AUTO Vysoka škola, Mladá Boleslav, Czech republic

pavel.marinic@skoda-auto.cz

 

ABSTRACT    

The one of many indicators’ in measurement of the financial efficiency is finally value of firm. By process of financial planning have to be main target’s estimated qualitative and quantitative so, that the value of firm on the end of planning’s period will be higher than on the beginning of this period. For measurement is possible to use the tools of value management.

Key words:   Financial planning process; Value of firm; Intrinsic value; Economic value added; Value based management; Controlling.

Classification: G3.

 

1   Introduce

 

Economies are accompanied to a certain extent by periodic cycles which are, on the one hand expansive, these cause economic euphoria. On the other hand, the cycles bring economic recessions, which can grow into depressions characterised by high unemployment, low volume of production and investment, weaken de confidence in the market, dropping prices and widespread bankruptcy. Depressions always preceed recessions, but a depression need not necessarily follow a recession. Enterprises should deal with recessions on their own because of the possible positive effects on the economy, and on the businesses themselves, because such action demands restructuralisation and changes in business behaviour. This has the effect of increasing the supply and demand on the market, thus granting the surviving firms a qualitatively new existence in the changed conditions. A depression cannot be overcome without regulation and state intervention (sometimes even by associations of states), and this problem is bigger than the issue of company financial management, which we are dealing with here. The main sign of an economic recession at microeconomic level is reduced financial liquidity among businesses as well as among consumers, which leads to decreased demand from producers resulting in less sales and lowered cash flow to businesses with the consequence sufficient resources for financing the firm’s needs. One consequence of the unavailability of external funds, and in combination with the unsuitable capital structure, is that firms face collapse, and, in the case of long-term, intense, influence of the aforementioned factors, firms will cease to exist completely. All recessions have their embryos in the euphoria which accompanies expansion. Every rational investor tries to increase the value of his available capital and invest it in such a way as to bring the greatest possible profit.

 

2   Sources of value

 

On the developed financial markets, one of the main, decisive, criteria is that of the Market Value (MV) of firms, which is the given through price of the shares and the number of shares issued according to the relation:

 

 

                                                              MV  =  P * a                                                  (1)

 

where:

       a – amount of issued shares,

       P – actual  share price.

 

The basic aim of the business is to maximise its market value through the minimum growth of its capital input, which we express like so:

 

                                                         MV / BV = MV/ E                                                     (2)

 

      where:

       MV – Market Value of firm,

       BV – Booked Value of Equity,

       E – Shareholder´s  Equity.

 

The relationship MV/BV is an expression of market value added, and it can be written as a share of the market value of the firm along with its own capital, as can be seen in the following relation:

                                                                MV/E = (P*a)/E                                                 (3)

 

Share price P can be written with the help of the indicator P/E (price - earning ratio) expressing the risk of a concrete share, as a component (relation) of the already mentioned risk and profit of the given share in the following way [1]:

 

                                                               P = E * (P/EPS)                                           (4)

 

where:

       EPS – earning per share,

       P – actual share price,

       P/E – price-earning ratio.

 

The algebraic amendment, putting P=E* (P/EPS) into the equation MV/E=(P*a)/E, we conclude that the market value added MV/E is equal:

 

                                                   MV/E = E * (P/EPS) * (a / E) =

                                                        = E * (a / E) * (P / EPS)                                      (5)

 

the assumption that the profit component per share and the number of issued shares equal clear profit after tax for the given business according to the relation:

 

                                                                   EPS*a=EAT                                            (6)

where:

       EPS – earning per share,

       a –  amount of issued shares,

       EAT – Earnig after Taxes,

 

it holds that market value added is a component of the profitability of Equity (EAT/E=ROE) and the risk expressed in the abovementioned indicator P/EPS:

 

                                     MV/E = (EAT / E) * (P/EPS) = ROE * (P / EPS)                    (7)

 

where:

       EPS – earning per share,

       P –  actual share price,

       ROE  –  Return on Equity,

       EAT – Earnig after Taxes,

      P/EPS – price-earnig ratio

 

Two facts emerge from the above analysis. Investors demand (expect) a higher profit from their higher priced investments, and, higher expectations of profit increase demand for the given investment titles, which presses the price on growth. 

 The opposite relation can be seen in the indicator P/EPS, which shows profitability as well as the risks associated with the concrete titles EPS / P = rexp.

The situation where demand outstrips supply, market price of titles and, consequently, that of firms does not correspond to the objective “real” value of the business, rather, it expresses the “subjective” value set by investor’s expectations, markets and owners; corresponding to the intrinsic value of the firm.

Then the market share price according to the relation P=EPS*[P/EPS] is substituted by investor’s expectations (intrinsic value – IV) according to the relation:

 

                                                      IV = EPSexp * ( P / EPS )exp                                 (8)

 

where:

       EPSexp – expected Earnig per Share,

      ( P/EPS)exp –  expected P/EPS,

       IV – intrinsic share value.

 

A firms value based on the expected value of shares will also be an expectation - the intrinsic value of the firm - IVF,  and it can be seen after the adjustment of the relation MV=P*a and in the following form:

                                                     IVF = IV * a = (EPS / rexp) * a                               (9)

 

Where: IVF – Intrinsic Value of firm,

        IV – intrinsic share value,

        EPS – Earnig per Share

        a – amount of issued shares

        rexp – return expected  reflective risk

 

From which comes the fact that the intrinsic value of the firm given by the capitalisation of profit according to the relation:

 

                                                              IVF = EAT / rexp                                                                (10)

where :

EAT – Earning after Taxes current period,

rexp – Return on Equity expected.

 

If the expected profitability (rexp) and the expected profit (EATexp) does not correspond to the reality measured by the ratio: Intrinsic value of the firm/Accounting value of Equity for the relevant period according to the relation:     

 

                                                             IVF/BV = IVF / E                                         (11)

where:

IVF/BV – relation Intrinsic Value of firm /Booked Value of Equity,

IVF – Intrinsic Value of firm,

E – Equity value,

we discover over valuation of the intrinsic value of the firm above the accounting value of Equity. If the surplus of free capital on the market causes‚ “inflationary pressure‘‘, and prices dramatically stop corresponding to real value, investors change their behaviour and start selling, which increases supply and the disequilibrium, consequently, causes distrust in investors, which is the start of the recession, which then spreads to the whole economy. 

Demand decreases, consumers start saving and banks stop‚ “advantageously” lending.

Firms try to overcome the problems associated with declining income and insufficient funds for financing their needs, but they also want to make a profit. So, in line with the theory on returns, they reduce prices, expenses and overheads by cutting production, reducing the workforce and by selling off unnecessary property, sometimes even underpriced, but in such a way as to preserve profits. Limiting purchasing and reducing the workforce is counterproductive because measures having the effect of decreasing the flow of money to households, and suppliers drive down demand even further.

The attempts to solve banks liquidity problems and the insolvency of firms by the present passive policy whereby the state pumps vast amounts of the tax payer’s money into the affected businesses will either solve the problem or just make it worse.

Such measures, as a rule, have only a short-term effect; where the recession is long lasting they are an insufficient remedy, they cause irreparable changes at business level in the property structure of the firm, reduce the firm‘s potential, which, upon revival of the economy could help start development and expansion, thus helping the firm gain the advantage over its rivals within the frame of economic competition.

In the case that such a firm survives the crisis, its new status can only be initiated by later investments and increased costs for the renewal of the production infrastructure.

Do that mean, then, that firms should not save and reduce costs? Not, at all. Firms should, however, instead of ad hoc cuts with once-off, short-term effects, look to conceptual measures arising from changes in behaviour and expectations of future profits, and redefine these expectations and so strive to achieve real objectives.

A relatively reliable indicator of the firm’s development under conditions of expansion is the resulting value of the firm, assuming that the resulting value of the firm at the end of the period observed, subtracted from the following year is higher that the current value of the firm at the beginning of the period observed according to the relation:

 

                                                               Vt – V0  >  0                                               (12)

where:

Vt – Value of firm at the end of period,

V0 – Value of firm at the beginning of period.

 

Under recession conditions the „real“ worth of the firm, generated from its overall potential, which is insurance against the firm’s collapse, while at the same time having the potential to help with eventual restructuralisation and revitalisation, thus ensuring the continued operation of the firm in the changed conditions of the post crisis period. The prime objective of the firm after the crisis is, therefore, to have minimum demands in order to maintain its value, so that:          

 

                                                              Vt – V0  =  0                                                (13)

Where:

Vt – Value of firm at the end of period,

V0 – Value of firm a  the beginning of period.

The problem is how to objectively express this value. The simplest method of expressing a firm’s value under stable market conditions, with prices reflecting real value, is by comparing the firm’s market value at the end of the observed period with its market value at the beginning of the said period. 

 

                                                           MVt – MV0  >  0                                                   (14)

Where:

MVt – Market Value of firm at the end of period,

MV0 – Market Value of firm at the beginning of period.

 

Market value under recession conditions, where demand goes down, despite falling prices, as a rule, does not reflect real value; so, the application of market given value in such situation is misleading, and therefore, this concept cannot be used. It is not possible to apply this approach even in firms which are not joint stock companies, i.e. their shares are not traded on the securities market.

In this lies the substance of the firm’s “real” value. One way out of this problem is to express value according to the following relation, in which is depicted the lower value of the property and its resulting growth in investment, as well as a decrease in income to the firm for the relevant period in the form of reduced cash flow.

 

Firm’s value = Value of its essential property + Reduced profit value = (Current value of investment capital + NPV i.e. essential property)+NPV cash flow. [2]

                                                                                           n

                                 V = ( NPVC +essential property) + ∑    CFn / (1 + i)n                    (15)

                                                                                       t=1

Where:

NPVC +essential property]– firm’s property value  in the period under study,

CFn / (1 + i)n – clear cash flow for the period under study.

 

If the discount factor is set at the level of the average capital cost (WACC) and that this sets the firm’s value at a higher level at the end of the period under study than the firm’s value as expressed in the accounting value of its own capital at the start of the period under study, then, this is the value of the essential property for the given period.

In times of recession, in a short-term crisis, it is most acceptable for firms to treat their value in such a way that it does not go below the accounting value of its own capital. 

There is another way to express a firm’s value, which arises from the philosophy that Free Cash Flow (FCC) represents the total financial resources which are at the disposal of the owners and creditors for paying all investment assets.

This free cash flow is not exactly the same as the cash flows generated by documents on cash flows, rather, they reflect the fact that the part of the cash which is generated by the firm’s business activities must be returned to the firm in the form of investment expenses in order to support the firm’s future development.

According to some foreign authors, e.g., Higgins [3], this free cash flow is expressed in the following way:

 

                              FCFF = EBIT × (1 – t) + D – I + IP – ∆ NWC – dNWC              (16)

where:

FCFF – free cash flow,

EBIT – Earning before Interesting and Taxes,

t – Taxes rate,

D – depreciation,

I – investment,

IP – income from sales of fixed assets,

∆ NWC – increase of net working capital,

dNWC – decrease of net working capital.

 

Then, the current value of the firm’s own capital [4] would be expressed by the relation:

                                                                                         n      FCFFi

                                                PV =   ∑—————— – D          (17)

                                                                                        t=1    (1 + r)i

where:

PV – present value of equity,

FCFFi – assume of future free cash flow,

r – discounted rate ( WACC),

D – present value of debt.

 

In this relation, the current value of foreign capital is deducted from the current value of the future free cash flow. The reason for this is to attempt to arrive at the value of the firm’s own capital, which for the owner represents a firm free from debts (unencumbered by external capital).

 

3   Application value management in planning process

 

Another important criterion for the acceptability of the long-term financial plan is the development of economic added value, which we can express with the aid of the expected (desirable) height of evaluation of the firm’s own capital in the following way:

                                                            rexp = EATexp / E                                            (18)

 

where:

rexp – rexp – Return on Equity expected,

E – Equity,

EATexp – Earning after Taxes expected,

 

and:

                                           NOPAT = EBIT (1 – t) = EAT + I × (1 – t)                      (19)

 

where:

NOPAT – Net Operating Profit after Taxes,

EBIT – Earning before Interest and Taxes

t – taxes rate

I – paid interest

EAT– Earning after Taxes ,

 

and furthermore:

                                                    rd × (1 – t) = I × (1 – t) / D                                     (20)

where:

rd – average interest rate,

D – pay interest debt,

                                                                       

When we place the WACC according to the model CAPM, with the interest taxed at a rate expressed with the help of the previous relations and costs of the firm’s own capital as an expression of that capital’s planned profitability; we get the following:

 

 

 

                                                                         D                                E

                                  WACC = I × (1– t) / D × ——  + EATexp / E ×  ——                (21)

                                                                      C                                  C

 

where:

WACC – weighted average cost of capital,

E – Equity

C- Capital invested

 

After adjustment we can write the average capital costs like so:

 

                                               WACC × C = EATexp × I × (1– t)                                (22)

 

When it is placed in the relation for the calculation of economic added value – EVA [5], we get:

 

                                                  EVA = NOPAT – WACC × C =

                                       = EATa + I×(1 – t) – ((EATexp × I ×(1 – t)) =                       (23)

                                                         EVA = EATa – EATexp

 

From this formula it emerges that the economic added value - EVA, is the difference between pure profit and planned profit.

Planned profit on the basis of the following formula can also be expressed as a component of the real profit of the period of commencement and as an index of changes in planned and real profit of the firm’s own capital:

 

                                                             EATexp = rexp × E

                                                                E = EATa / ra                                             (24)

                                                      EATexp =  EATa × rexp / ra

 

where:

EVA- ekonomic value added

ra – actual Return on Equity,

EATa – actual Earning after Taxes

EATexp – expected Earning after Taxes

 

When we put planned profit according to the previous formula into the relation EVA = EATa – EATexp, we get:

 

                                                      EVA = EATa – EATa × rexp / ra                            (25)

and furthermore :

                                              EVA = EATa – EATexp = E × ra –  E × rexp                   (26)

 

If we simply extract the value of the firm’s own capital in front of the brackets we are expressing the economic added value as a component of the real, increased, firm’s own capital and spread [extent] profitability [6]. Then:

 

                                                          EVA =  E × (ra – rexp)                                      (27)

 

We can express Market Value Added [MVA] with the index:

 

                                                             MVA = EVA / rexp                                         (28)

 

In the case that the economic added value exceeds the expected valuation rate of the firm’s own capital, then the firm may, or may not, create firm added value.

 

The value of firm added value based on economic added value (EVA) - VEVA   is then:

 

                                                             VEVA = E + MVA                                           (29)

 

The development of value is acceptable on the assumption that:

 

                                                             EVAt / EVA0 > 1                                           (30)

 

Or, more precisely:

                                                            VEVAt / VEVA 0 > 1                                           (31)

 

Under recession conditions, as was mentioned in the foreword,  in consequence of the redefinition of the firm’s expectations, it should be content with the fact that there will not be a reduction of value, and so: 

 

                                                               EVAt / EVA0 = 1                                         (32)

 

 

and furthermore that:

 

                                                               VEVAt / VEVA 0 = 1                                       (33)

 

Where:

VEVAt – EVA based Value of firm at the end of period,

VEVA0 – EVA based Value of firm a  the beginning of period.

 

Which will happen, if the firms give up on the growth of profit EAT1 = EAT0

 and  “sacrifice” it as an investment in getting over the crisis.  However, if the crisis merits the sacrifice of even a part of the economic added value ‚‘created during the expansion period‘‘, then it is so that rexp  of the demanded (expected) rate of value of the firm’s own capital does not go below the average of the taxed interest rate of the foreign capital. If the firm starts making long-term losses, then there is no other option but restructuralisation and the consequent revitalisation of the firm. In conditions of global depression even this measure may be insufficient. But that is an extreme situation calling for state intervention. In any case, however, financial intervention in the firm’s favour must be linked to obligations to maintain employment and purchasing power; therefore it is an investment in the demand side as an essential presumption for starting future expansion.

 

4   Conclusion

 

The possible objection that this concept does not necessarily solve immediate liquidity is justified.  Liquidity can be solved with the standard instruments (trade deficit management), maybe even by super standard instruments, e.g. by offering advantageous pricing of the firm’s own product range by means of instalment and other easy payment plans to suppliers and employees. Business is going through an alternating cycle caused by turbulence in external influences at work in certain macroeconomic environments. As can be seen from the previous article, a reliable regulator which can predict future parameters, prevent undesirable developments and which can give timely warning, are firms’ profits. As they are one of the decisive generators for the creation of value (value driver), and can be reliably regulated with the aid of instruments of control. 

 

 

 

 

 

 

References

 

[1]    Arzac, R, E. (2008): Valuation for Mergers, Buyouts, and Restructuring. 2th edition: Hoboken, New Jersey, John Wiley and Sons, Inc, s. 83-95, 2008.

[2]    Beninnga, Z, S. – Sarig, H, O. (1997): Corporate Finance a Valuation Approach. 1th edition: New York, St.Louis, The McGraw-Hill Companies, Inc , s. 238-242, 1997.

[3]    Damodaran, A. (2006): Damodaran on Valuation: Security Analysis for Investment and Corporate Finance. 2th edition: Hoboken, New Jersey, John Wiley and Sons, Inc, s. 238-253, 2006.

[4]        Grünwald, R. – Holečková, J. (2007): Finanční analýza a plánování podniku. Praha, Ekopress, 2007. Str. 222

[5]        Higgins, R. C. (2004): Analysis for Financial Management. New York, McGraw-Hill, 2004, s. 328.

[6]        Marinič, P. (2008): Plánování a tvorba hodnoty firmy. Praha, Grada Publishing, 2008, str.183.

[7]        Mařík, M. aj. (2007): Metody oceňování podniku. Proces ocenění, základní metody a postupy. Praha, Ekopress, 2007.

[8]    Stowe, D, J. – Robinson, R, T. – Pinto, E, J. – McLeavey, W, D. (2007): Equity Asset Valuation. 2th edition: Hoboken, New Jersey, John Wiley and Sons, Inc, s. 191-201, 2007.