Linkage of Management Decisions to Shareholder's Value: EVA Concept

Abstract

In this paper, the author investigated the influence of management decisions like capital structure, dividend policies, remunerations, credit policy decisions, and investment decisions on shareholder wealth maximization. The main objective of this paper is to increase awareness on the relationship between the management and shareholders of companies. To achieve the objective, the portfolio theory, capital asset pricing model, and modern financial theory were used to determine the link between management decisions and shareholder value. Shareholders are only concerned about the value of shares of the company and the amount of return in the form of dividend paid. Thus, in order to meet the demands of the shareholders of the company, managers need to increase their abilities and skills in meeting the organizational goals. The main goal of this paper is to discuss the role of management decisions towards increasing shareholders' wealth and meeting organizational goals.

Headnote

Abstract

In this paper, the author investigated the influence of management decisions like capital structure, dividend policies, remunerations, credit policy decisions and investment decisions on shareholder wealth maximization. The main objective of this paper is to increase awareness and relationship between management and shareholders of the companies. To achieve the objective, portfolio theory, capital asset pricing model and modern financial theory providing evidence on the linkage between management decisions to shareholder's value. Shareholders are only concerned about the value of shares of the company and the amount of return in the form of dividend paid. Thus in order to meet the demands of the shareholders of the company, managers needs to increase their abilities and skills to overcome the organizational goals. Thus the main goal of this paper is to discuss on the role of management decisions towards increasing shareholder's wealth and meet organizational goals.

Keywords: Management Decisions, Shareholder's wealth maximization, capital asset pricing model, mode rn financial theory

© 2014 Published by SSBFNET

(ProQuest: ... denotes formulae omitted.)

1. Introducti on

Continuous innovati on in the management techniques of the companies have been one of the challenges in the business environment and improve their effectiveness (De Hart and De Wet 2008). In the field of management accounting and financial management there have been number of new management concept been came into exist ence. One of the key concept that have been considered as superior by (Stewart 1991, Stern 1993, Ber ber, Pasula et al. 2012) amongst other management techniques is Economic Value Added (EVA). Shareholders are only concer ned about the value of shares of the company and the amount of return in the form of dividend paid. Thus in order to meet the demands of the shareholders of the company, manager s needs to increase their abilities and skills t o overcome the organizational goals. Thus the main goal of this paper is to discuss on the role of management decisions towards increasing shareholder's wealth and meet organizational goals. One of the key aspects of management decisi on is in the form of incentives compensations for managers. The issue of rewarding managers in the form of cash bonuses, in the form of stock compensation or stock putting options for top management executives, or restricted stock rewar d affects company goals (Sigler 2011). This study aims to investigate the role of management decisi ons on the wealth of shareholders or investors. Management decision is proxied in this study as an control variable in vestigating the relationship bet ween econ omic value added and shareholder's wealth.

Over the years man y financial indicators have been used to measure shareholder's value. Some of thes e indicators are Profit after Tax (PAT), Earnings per share (EPS), Return on Assets (ROA) and Return on Equity (ROE). All these financial indicators are being strongly criticized as they are not able to measure the cost of capital owned. Appannan and Sim (2011), mentioned that Mala ysia as a developing countr y still lack with research on dividend policy and its determinants for the listed companies. Pandey (2003), found that plantation and consumer product sectors in Malaysia are paying high dividends due to their higher surplus in cash. Thus dividend payout decisions by managers are proxied in this study for investigating enhance ment of shareholder's value. Due to market imperfections, invest ors ma y exhibit floatation costs, transaction costs and taxes. Due to asymmetric information between managers and investors there arises an agency confl ict that leads the organization awa y fr om its objectives (Kapoor 2011). OHARA (2011), stated that there wa s a need of devel opment and implementation of EVA due to the existence of gap bet ween financial statement and stock price. Profit and l oss statement and Balance Sheet are the two important financial statement reports that are ver y famous in the corpor ate to know and evaluate the performance. Profit and loss statement shows the result of normally one year of period while Balance Sheet shows the financial position of the assets, liabi lities and equity at the fiscal year end. This shows that both the statement shows the past performance of the company. But stock price i s basi cally decided by considering the future growth of the compan y; no doubt the i nvestors review the hist orical income and financial position of the compan y. As the future growth of the comp an y is not included in the profit and l oss stat ement and Balance Sheet statement, it is ver y di fficult for the investors to calculate compan y value and stock price fr om these historical financial statements.

Furthermore, Minchington and Francis (2000) found three main difficulties for the implementation of new measures in practices. Firstly there is possible lack of a wareness of new measures even if there are ver y acti ve promotions by the management con sultants. Once t he measures are being selected the barrier to the implementation includes technical difficulties like establishment of cost of capital and the capital assets. There are also som e of the or ganizational barriers like time and resistance to ch ange; organizations may encounter cultural and political difficulties in gaining acceptance and ownership of new mea sures.

Thus the main purpose of financial concept in the organization is to creat e a wareness for the shareholders to maximize its value. The alternative performance measure EVA introduced by Stern Stewert Management Services is used t o facilitate the management shareholder's relationships in the organization. EVA have already been utilized by multinational companies like Son y, Coca Cola, S eimens, and General Electric as a performance measurement tool for management system in the quest of creating value. Thus the main objecti ve of this paper is t o understand (1) the weakness of the existing traditional accounting performance mea sures; (2) Study the relationship between traditional accounting performance measures and shareholder's wealth; (3) provide an understanding to the investors in relation to the financial measurement tools and stock r eturns used in their investment decisions; (4) assess the role of m anagement decisions enhancing shareholder's wealth along with maximization of firm's value. This study also provides an immense scope as the relevance, utilit y of EVA for making economic decisions, users, investors and shareholders has not yet demonstrated this concept in this country.

2. Theoretical Background

Management financial decisions help to contribute and realize the value maximization strategy (Michalski 2013). Portfolio theor y discusses on the credit benefits decisi ons gi ven to the customers taken by management. Credit benefits enables to determine the level of accounts receivables which in turn als o increases firms net working capital and managing accounts receivables. Credit poli cy decision taken by the managers to its customers increases firms value. Cummins (2000), discussed on the level of capital allocation decisions through the approach of modern financial theor y, the capital asset pricing model (CAPM). Capital allocation is known for the determination of the firm's equit y capital for each project undertaken b y the firm. Allocation of overall cost of capital also contributes t o increase firm's value. In an emerging concept namely, econ omic value added (EVA), capital allocation decisions is considered as an important management decisions for the non-financial firms.

In the past few years it has been an ultimate goal of organization to make a revolutionary change in the measurement of performance fr om traditional profit based measures like Earning per Share (EPS), Retu rn on Capital Employed (ROCE), Return on Net Worth (RONW), Net Profit Margin (NPM), Operatin g Profit Margin (OPM), to the new modern econ omic value based performance measures like Market value Added (MVA), Shareholder's Value Added (SVA), Cash Value Added (CVA), Economi c Value Added (EVA). From the above mentioned concepts in recognition to accounting and financial literature, Economic Value Added (EVA) has recei ved high attention as an important tool t o m easure organizational performance. EVA he lps the entity to focus on how t o use capital and how to generate cash from it. Managers are able to ca re about managing assets and income and helps in bringing up balance between then through EVA.

2.1. Concept of EVA

With the globalization of competition and capital markets shareholder's value has been considered an d focused highly by executives in the organizations. Also shareholder's value has been considered t o p lay a vital role to measure business per formance (Rappaport 1999). Rana (2011) stated in their research that increasing shareholder's value is an innovative step that reflects the value that compan y provides to its shareholders. It is not so easy t o measure value and opportunity cost of capital that not only increase shareholder's value but also achieve organizational performance. Francis & Minchington (2002) provided in their research that balance sheet based measures that provides a ccounting based financial information and performance of companies often measures notional profits are not real ones.

Basic formula for EVA first proposed by Stern and Stewart Corporation is:

... (1)

Where:

NOPAT = Net Operating Profits after Taxes

Capital = Capital invested by debt holders and equity holders

Cost of Capital = Weighted average of the cost of debt and cost of equity after taxes

EVA concept has been applied in many companies like COCA-COLA, AT&T, and GE etc. EVA is closely related to Net Present Value. If the increase in EVA on a year to year basis i s achieved at the expense of the EVA of future projects to gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future periods. However there are unique relationship between EVA and fi rm value. According to Ray (2010) where there is increase in EVA is achieved by an increase in the cost of capital, the firm value may decrease even though EVA increases.

2.2. Advantages of EVA

EVA is considered as superior performance measure as compared to operating pr ofit, profit after fina nce items, EPS, ROI, and ROE. EVA is ver y simple and operatively practical. It improves profitabilit y n ormally first through improved capital turnover. EVA is ver y suitable for bonus system. One of the major goals of EVA is to improve effi ciency of managers towards their firms through an effective cost decision maki ng. Due to EVA, managers are obliged to generate value for their shareholders or investors. Mäkeläinen & Rozt ocki (1998) mentioned that EVA shows the value for the capital used or utilized and judges the efficiency. Abili ty to control the operations is the main concern of EVA and plays a s yst em of good compensation managem ent that motivates manager to generate shareholder's value. Shareholder's value is created wh en there is positive EVA. The fundamental notion of EVA is to use the resources (e.g. Money) to maximize return or at lea st pay for the cost of using the resources (Dilon and Owers 1997). It identify the restr ucturing signal for the company through a series of negative EVA. Managers are able to make decisi on due to their deeper understanding on capital and capital costs through EVA concepts and improves business performance. Overall it indicat es company's performance

2.3. Management Decision and Shareholder's Value

Shareholder's wealth maximization has been foremost priority nowa days for the organization as the ultimate goal. The concept of Economic Value Added as a measurement of wealth creation has been used by a num ber of large corporations. Econ omic Value Added not only measures per formance, but if implemented in an effective manner could leads t o provide information for an effective decision making, incr ease profitability, improve corporate governance, increases management and reward syst em. It is important for the firms to asses managerial performance evaluation, as most of the performance of the firms is identified fr om its operating activities (Marius et al, 2008). Firms operating activities generates enough cash flow for satisfact ory remuneration of the creditors; cover all the imposed taxes and most important increasing sh areholder's wealth. Thus strategies for implementation of EVA concept taken by managers play a crucial role.

The reason on emphasizing EVA as a value based measure increasing shareholder's wealth is that it works as the shareholders wants. In conventional accounting most of organizations incurs profit, but are not able to create value for shareholders. As stated by Peter Drucker "A business operates in loss until the return profit has not greater than its cost of capital". With the help of EVA, compan y actions are aligned to shareholder's value. EVA is considered as a financial measure rather than accounting measure that makes manager understand easil y raising managerial awareness. EVA takes a wa y the con fusi on of multiple goals that vary in standards and terms influencing planning, strategic and decisi on making. EVA removes such confusions by considering ultimate goal of organization to improve EVA as a comm on focus. This attempt to monitor, compensate and communicate effectively and improves all management decision along with creating value of shareholder's investment.

Managers and shareholders believed that growth in annual earnings per share and increase in return on equit y were the best measures for maximizing shareholders wealth. However more recently there has been a growing awareness that these traditional accounting measures are not reliabl y linked t o increase the value o f the company's shares. This is because earnings do not reflect changes in risk and neither inflations nor they take into account the cost of additional capital invested to finance growth (de Wet 2005, Gupta 2012).

There is a need for value to be organized in order to identify the impact on value and for their per formance to individual that can help to meet organizational goals. Bel ow figure sh ows the linkage between corporate objectives and categories of value drivers: 1) Intangibles 2) operating 3) Investment and 4) Financials.

The main objecti ve of management is to increase consistent and positive value of shareholders. Value drivers are able to determine the cash flow from operation and is influenced by operational and investment decisions taken by the management.

2.4. Capital Structure Decisions

Capital structure is the combination of equity, preferred and debt capital that aims to maximize the business value as a whol e. Capital structure is the combination of long term finance sources that leads t o l ower WACC. Capital structure is expressed usually in terms of debt t o equity ratio or debt to asset ratio. The total business value is det ermined by free cash flows of the organization, discounted at the WACC. The present value of the free cash fl ows over the planning horizon plus the present value of the residual value to ordinary s hareholders can then be cal culated by subtracting the market value of debt. The cost of capital is the combination of each source of finance. Financial sources can be categorized as own share capital, preferred share capita l and debt. The word component cost means cost of a specific source of finance. Shareholders and financial insti tutions are known as supplier of finance r equires return for the risk taken by investing in the compan y. Shareholders get their return in the form of dividends whereas the interest expense through debt finance is tax -deducta bl e for the compan y; the cost of debt is usually cheaper than the cost of equity.

The performance measurement tools are used for the improvement seen by the customers and results del ivered to other stakeholders like shareholders. Apart from the performance of the organization there is als o an important step need t o be taken for formulating the direction of the strategic activities. Pr ofitabi lity measurements through traditional financial measures are alwa ys been misleading. Traditional financial measures are not concerned about the cost of capital incurred for making investments. Cost of equit y financing is ignored focusing heavily on cost of debt financing. Thus the capital cost is not adequ atel y provided by traditional accounting measures making its shareholders ignored through these acti vities .

According to Miller-Modigilani theor y, it is assumed that there are no taxes, agency costs or capital structure is irrelevant. The value of the firm cannot be determined by the debt ratio. The theor y also states that the cost of capital of the firm does not change with leverage and the cost of equity is increased al ong with increase in firm's leverage. The decisions for the debt financing are crucial as the failure to make the payment s can lead to default due to its commitment of fixed payments.

Shareholders always expect management to generate value for them including the cost of capital. Increasing value refers to variation in the wealth of shareholders on a regular time interval. Managers must ha ve an indepth understanding of the performance variable th at drives value t o the business. Organizations when act on value for shareholders also influence on things like customer satisfaction, cost, capital expenditur e, operational expenditure etc.

2.5. Investment Decisions

Investment in the project that gives good return than the risk associated to that project is the fir st principle of the firms. Choosing the financing mix that matches the assets being financed with less risk maximize s shareholder's wealth (Damodaran, 2001). The comparison of a ccounting profit and economic profit shown by King (2009) is the cornerstone of the current transfer pricing regime. Economi c rate of return is product market is equalized under competitive conditions. According to Stewart (1991) economic value added i s the financial measurement tool that is able to calculate and capture economic profit for the company. Th e main aim of the compan y is to maximize their profits. Economic profit is calculat ed as the difference between econ omical and book profit. It is also defined as the difference bet ween revenue and econ omic costs (book cost and opportunity costs).

2.6. Dividend policy decisions

Apart from value drivers, shareholder's value is also affected by the dividend policy decisions taken by the management. Dividend policy has been an emerging issue in the financial literature. Dividends are us ually defined as the distribution of earnings among the shareholders of the firms on the basis of their owner ship (Kapoor 2011).

Dividend pa yout is usually calculated as:

... (2)

Market price of the stock represents wealth of shareholders also presenting t he decisi on of investing, financial and dividend distribution. Reddy and Rath (2005), investigated the behavior of dividends in the Indian firms and found that not all the firms paid regular dividends. All the firms were having different pattern s to pay dividend. According to the approach by two noble winners Miller and Modigiliani (M&M) the dividend p olicy does not affect the shareholder's value. The net dividend payout was the difference between earnings an d investment also consider ed as residual. This findings were based on assumptions that: Information di sclosed to invest ors are free and is available to all the invest ors, no tax distortion exists, non -existence of fl oatation and transportation costs, and non -agency cost exists (Aivazian, Booth et al. 2003).

Many researchers discussed many models in order to identify factors that influence dividend decision s from country to country. It has been an challenging issues for the identification of driver variables of dividend payout ratio in an emerging market. Issa (2012) investigated the relationship between dividend payout ratio with profitabilit y, size, growth, opportunities, and market t o book value taking 248 Malaysian firms listed in Kuala Lumpur Stock Exchange and found that return of asset, return on equity have hig h influence on dividend payout ratio.

Appannan and Sim (2011) examined the impact of dividend payout policy decision on Mala ysian companies found that dividend pa yout deci si on like profit after tax have high influence on dividend per share. The study also confirmed that debt equity ratio and past dividend per shar e are major determinant for dividend payment.

3. Previous Researches on EVA

Tong, Yao et al. (2010), build a per formance evaluation system based on Economi c Value Added and Balanced Scorecard for l ogistics enterprises empirically and found that EVA gets significantly positive Kendall's correlation with strategic objective wh ose proxy is corporate value.

Wang and Fan (2010), presented performance model based on EVA method that focus on value creati on attending comprehensive measurement of service oriented enterprises. The result showed that service center of issuing has a negative EVA alth ough its profit is positive.

Sharma & Kumar (2010) presented a narrative literature review of published papers on EVA from 1994 to 2008. They found that studies that have been conducted in advanced economy have largely found to be supporting EVA as compared to less developing econom ies.

Pratiwi (2008) examined the relationship between Economic value added and Market value added with reported earnings. The study found strong evidence on the relationship between EVA and MVA with reported earnings. MVA wa s found more significant correlations with reported earnings as compared to EVA.

Taufil et al (2008) compared value based measures with traditional / conventional performance measurement accounting tools and found that EVA is superior to ROE & ROA in Banks Stock Returns.

Bhattacharyya & Phani (2004) examined whether EVA is a superior performance measure for corporate reporting and internal govern ance. They found that EVA not able to provide additional information to the investors, but motivate and educate employees by creating shareholder's value. They also reported th at dangerous trend of reporting through EVA may mislead the invest ors.

Grant (2003) conceptualized the concept of EVA to determine the value of st ocks. The main objective of this research was t o (1) estimate EVA with other accounting measures adjustments, (2) Capitalize economic pr ofit to determine compan y's NPV (3) to estimate futur e EVA and its current market value added using published financial reports. This study applied quantitative technique i.e. linear and non -linear regression in order to find the most attractive companies in the capital market. Finally it was concluded that EVA is an approach of looking at the firm's real profitability.

4. Methodology

The current study is based on the secondary data covering a period of 7 years ranging from 2005 -2006 to 2011-2012. The purpose of considering long time period for the investigation of the study is to decrease instability and cycl es of business that might affect the results of the study.

Since construction companies in Malaysia are considered as one of the major economic sector, the aut hor had an interest in the construction industry to recognize as a basic. The sample covers construction com panies that are listed in Kuala Lumpur stock exchange. The firms in the population were selected based on the following criteria:

1. Construction companies that have been listed on Kuala Lumpur stock exchange in or before 2006.

2. They must be exi sted in KLSE till the financia l year 2012.

3. They must have positive values for average operating income during the study period.

The firms must have ability towards profitable relatively, furthermore, multinational companies, ass embling companies that are not based on infrastructure, companies comes under sick industrial companies were excluded in order to maintain comparability and consistency.

On the other hand, the construction industry is one of the core industries in the Malaysian economy and this industr y is recognized as a basic mother industry. Therefore, any achievement in this area is extendable in other industries.

To meet the objecti ve of the study the analysis is divided into the following sections:

1. The analysis that indicates position of shareholder's value creation in Mala ysian construction companies;

2. The analysis a bout economic value added for creation of shareholder's value

3. Analyze the relationship bet ween economic measures and traditional measures in addition to management decisi ons as performance measurement tools for t he creation of shareholder's value;

In order to achieve the aim of the study the researcher had utilized trend analysis into the three s ections: In the trend analysis the resear cher followed the trend of the variables such as Earnings per share (EPS), return on net worth (RONW), return on capital employed (ROCE), net profit margin (NPM), operating profit margi n (OPM), return on investment (ROI), econ omic value added (EVA), shareholder's value (SV), management investment decisi ons and management dividend decisions in construction companies of Malaysia.

Calculation of figures for the formula of the variables has been performed and the data were compared with figures, graphs and trends and the growth rate of the mentioned variables. In order to find the rela tionship between the utilized variables Pearson correlation between the variables were examined. In order to fulfill the purpose of the study, Microsoft Excel and SPSS statistical software was taken into consideration.

Furthermore, multivariate analysis was also conducted i n order to identify the influence on the measurement tools considered for the research on the enhancement of shareholder's value.

5. Conclusions

Accounting measures like EPS, earning growths, ROE, ROA dividends has been criticized with in tensity over time. Measures of corporate performance are been mislead by Earnings, earnings per share and earning s growth. The most important criticism causes earnings to diverse from cash flows and lead to a gener al amount invested in the compan y. In vest ors are more interest on company's ability to generate future cash flows including risk associated with the projects undertaken to gener ate them instead of just profit s. Due to inadequacy of a ccounting measures new reliable indicators is a t op priority for researchers, managers and investors.

The Economic profit model calculates the actual or economic profit a fter taking into account the ful l cost of all sources of capital used. It uses the WACC to know capital change and subtract it from the profit before interest and tax. This rises to an important accounting correction of the accounting profit not taki ng into account opportunity cost of equity capital used.

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