Refresher on Economics and Valuation from a Strategic Management Perspective

Supplemental Material for Strategic Management Classes

Refresher on Economics and Valuation from a Strategic Management Perspective

Role of a Manager in Finance

  • As a manager or Senior Executive, you will need to:
    • Create and manage a budget.
    • Make decisions on how to spend the company’s money.
  • Responsibilities include evaluating and approving:
    • Projects
    • Investments
    • Acquisitions
    • Divestitures
  • Importance of Understanding Finance:
    • Essential for successful decision-making.
    • A working knowledge of financial and economic concepts is critical.
    • Familiarity with these concepts is expected to be taught before this capstone class.
    • The course will focus on providing just enough knowledge about value and valuation for informed managerial decisions, emphasizing it is not a finance class.

Topics Covered in This Supplement

  • Valuation and Basic Economic Drivers of Valuation
  • Project Evaluation (Practical Application)
    • Differences between Accounting and Economic Value
    • Importance of Discount Rates
    • Net Present Value (NPV) and Internal Rates of Return (IRR)

Valuation

  • Definition of Valuation:

    • Valuation is the analytical process of estimating the current (or projected) worth of an asset or a company.
    • Critical for starting negotiations or setting expectations for transactions.
    • Knowledge is fundamental for C-level executives to determine the feasibility of deals.

  • Key Concepts:

    • Value is known only when a voluntary transaction occurs; otherwise, it is an estimate.
    • Extrinsic vs. Intrinsic Value:
    • No extrinsic value until a transaction takes place.
    • If unable to find a willing buyer or seller, one may need to lower value expectations or cease attempts at selling.

Estimating Value

  • Strategies for estimating value include:
    • Evaluating capital structure (Book Value)
    • Analyzing future earnings (Price/Earnings growth)
    • Using market comparables (Previous transactions)
    • Assessing Market Capitalization versus Enterprise Value
    • Noting that publicly traded companies are easier to estimate than privately held ones.
  • Fundamental Analysis and Discounted Cash Flows are crucial for project valuation, considered the best approach if data is available.

Economics (Preamble)

  • Importance of Economics:
    • Foundation for business aspects like pricing, human behavior, and corporate strategy.
    • Often cited as poorly understood and highly politicized.
  • This course will teach Classical Economics, not any other school such as Keynesianism or Marxism.

Definition of Economics

  • Economics Defined:
    • Traditionally, economics is defined as the study of the allocation of scarce resources.
    • Revised definition: the study of human behavior relating to the allocation of scarce resources.
    • Focus is on interactions that satisfy needs and wants amid scarcity.
  • Economics drives behavior based on human nature and contrasts stated values with actual actions in situations where one is not observed.

Notable Economists

  • Recommended Reading from esteemed economists includes:
    • Thomas Sowell - advocate for Classical Economics.
    • Other notable figures: Milton Friedman, Walter Williams, George Stigler, Gary Becker, Robert Lucas (all associated with the Chicago School of Economics).

Historical Context

  • 1776 – “The Wealth of Nations” by Adam Smith:

    • Influential work asserting ideas of Free Trade and Limited Government.
    • Introduced concepts like “Enlightened Self-Interest” and “The Invisible Hand.”
    • Not equated with laissez-faire.
    • Developed a framework to understand national wealth generation and reasons behind wealth disparities among nations.

  • Key Elements of Classical Economics:

    • Free Enterprise/Capitalism underpins benefits of voluntary transactions, private property, and competitive markets.

Classical Economics

  • Goal:

    • To maximize total utility or satisfaction across society's members using scarce resources.
    • Not necessarily focused on equal wealth distribution but achieving highest aggregate living standards.
    • Altruism exists naturally within a free enterprise system; coerced altruism does not.

  • Private Property Concept:

    • Ownership decides resource allocation, pivotal for executive decision-making.

Real-World Examples

  • Illustrations of economic theories:
    • Comparison: North Korea vs. South Korea
    • East Germany vs. West Germany
    • Economic disparities visible through satellite images of night-time illumination.

Utility, Prices, Value, and Project Valuation

  • Understanding value begins with concepts of utility and economics.

Economic Utility

  • Definition of Economic Utility:
    • Focuses on the satisfaction derived from goods/services based on consumer needs.
    • Total Utility: Total satisfaction received from consumption of a good/service.
    • The Law of Diminishing Marginal Utility states that as consumption of a good increases, the additional satisfaction per unit decreases.
    • Example: Overconsumption of a Snickers bar results in decreased satisfaction from each additional bar consumed.

How Prices Are Set

  • Under free market conditions:
    • Prices are determined by supply and demand after covering minimum costs.
    • Demand reflects consumer interest; supply reflects availability within a defined timeframe.
    • Government intervention disrupts this balance and reduces total utility.

Market Failures

  • Situations Where Free Markets Fail:
    • Rare occurrences include Natural Monopoly (e.g., power companies with high entry barriers) or True Public Goods (e.g., lighthouses that are non-excludable and non-depletable).

Free Markets and Capitalism

  • Need for Free Markets:
    • Fundamental to establish fair, competitive prices based on utility and value.
  • Preconditions for Free Market Systems (Four Elements):
    • VPCL:
    1. Voluntary Transactions
    2. Private Property
    3. Competition
    4. Laws Against Fraud and Theft
    • Capitalism is the aggregation of voluntary transactions in a competitive framework, not merely a political concept.

Project Evaluation

  • Practical application of valuation insights in the business context must be established.

Accounting Value vs. Economic Value

  • Accounting value is grounded in structured rules but can be manipulated, influencing investor perceptions.
    • Definition of Accounting:
    • Cumulative set of rules and processes for recording, analyzing, retrieving, and reporting financial transactions.

Economic Value

  • Defined by cash flows which directly correlate to the utility of goods/services to consumers.
  • Measuring Economic Value:
    • Best proxy to measure economic value is cash flows rather than accounting metrics due to potential manipulation.
    • Adjustments for relative risk are necessary (risk-adjusted value).

Discount Rates in Financial Evaluations

  • Discount Rate:

    • Key tool for accounting for relative risk in financial projections.

    • Larger discount rates imply lower present value of future cash flows.

    • Common types of discount rates include:

    • Weighted Average Cost of Capital (WACC):
      WACC = (E/V imes Re) + [D/V imes Rd imes (1-T_c)]

      • Where:
      • Re = Cost of equity
      • Rd = Cost of debt
      • E = Market value of equity
      • D = Market value of debt
      • V = E + D (Total market value of financing)
      • E/V = Percentage of financing that is equity
      • D/V = Percentage of financing that is debt
      • T_c = Tax rate
      • Minimum return needed at the company level to avoid bankruptcy.

    • Hurdle Rate:

      • Minimum required return adjusted for risk for specific investments or projects.
      • Distinction between company-level criteria (WACC) and project-level criteria (Hurdle Rate) is essential for investment decisions.

NPV vs IRR

  • Net Present Value (NPV):

    • Difference between present value of future net cash inflows and initial investment capital.
    • Determines if an investment generates economic value based on selected discount rates (WACC or Hurdle Rate).

  • Internal Rate of Return (IRR):

    • The discount rate that sets NPV to zero; expressed in percentage terms.
    • Comparison against Hurdle Rate simplifies investment valuation, guiding decision-making on project viability.