Interrelationships Between Financial Performance Measures – Case Studies

Performance Review: Interplay between ROIC and Market Capitalisation

Suppose a colleague is reviewing the performance of a company. They observe that for the last 3 years, the return on invested capital (ROIC) for the company has fallen from 18% to 14%. Dividends have remained stable over this period. However, at the same time, the market capitalisation of the company has risen from $6 billion to $8 billion. Your colleague is confused, expecting a falling ROIC to be accompanied by declining market capitalisation. They have come to you to seek advice.

Provide a response to your colleague, demonstrating your understanding of the interrelationships between these performance measures.    

In the present case, the company has maintained a stable dividend policy and the ROIC has decreased over the period. For computation of ROIC, both debt and equity is considered and for considering the market capitalisation of the company only equity is considered. Accordingly, it may have happened that company has availed the benefit of trading on equity whereby additional debt has been added in the capital structure at lower cost, thereby maximising the benefit to shareholders of the company and increasing the return on equity of the company. The increase in return on equity of the company helps to increase the market capitalisation. Further, market capitalisation measure is more related to return on equity as compared to return on invested capital and thus there has been increase in market capitalisation despite fall in ROIC of the company.

Suppose the Chief Executive Officer (CEO) of a global mining company is contemplating a sustainability strategy that will result in substantial capital investments in the firm’s infrastructure. The CEO is concerned that despite this initiative, there may not be a positive reaction in terms of an increase in the share price of the firm.

Following consultation with sustainability practitioners, the CEO understands that there may not be short-term increases in revenue or reductions in costs associated with the initiatives, but there may be scope for changes in the firm’s cost of capital. This has grabbed the attention of the CEO.

Upon hearing that you have studied finance in your MBA, the CEO asks you to explain the various mechanisms by which the cost of capital for the firm is likely to change because of undertaking these initiatives. In what sense might these happen in the short-to-medium term, and in what ways might they impact on the value of the firm?

When the company invests in sustainable practices, funds are available at subsidised rate from the government as government promotes sustainability. Further, mining is one of the most polluting sector and reducing green measures helps to overcome these problem and thus subsidy is generally provided by the government and various agencies for sustainable mining. Further, weighted average cost of capital of the company comprise of debt and equity. As company procures funds for sustainable activities in the form of debt which shall be available at cheaper cost on account of government initiatives, the weighted average cost of capital shall reduce gradually and thus the cost of capital shall see a decline on account of lower borrowing cost.

Impact of Sustainability Initiatives on Cost of Capital and Shareholder Value

Further, in relation to reduction in cost and increase in revenue, those action generally takes in medium to long term as the impact of sustainable practices are seen over time and not in short frame of time. The results shall be decrease in cash on account of reuse of materials and the revenue might increase as customer generally pay higher price to sustainable companies.

Suppose you have been asked by a Board member of a company for advice on executive remuneration. The board member advises that the company typically provides bonuses based on EBITDA for the short-term components and total shareholder returns for the long-term component. The company is considering including the weighted average cost of capital (WACC) in determination of executive remuneration, but the Board member is not sure if this is appropriate. Please provide your response to the Board member.  

The weighted average cost of capital is a mixture of cost of debt and equity of the company, the lower the weighted average cost of capital the higher the valuation of the company. However, if the weighted average cost of capital is very low, it implies that equity shareholders of the company are not well paid off or there is excess leverage in the capital structure which is a warning signal for the default. Linking the weighted average cost of capital with the remuneration scheme shall not be a good action on the part of the management as the management may add additional debt yearly to reduce the weighted average cost of capital which may impact the long term financial solvency of the company. On the contrary, linking the performance with profitability measures like EBITDA is also not a viable option as the EBITDA of the company may be inflated on account of management practices. The ideal solution under such case shall be to link the performance with the Free cash flow from operations or free cash flow to the firm. As these measures are least subject to be tainted, they provide an ideal solution to the problem of management compensation.

Further, deciding the long terms returns based on shareholder return is a good option but considered ROE as the factor is not good. One should consider the market return and the dividend paid to shareholders over the period as the factor for computing the return.

Suppose over the period of one year the asset utilisation of a firm has declined  yet its return to shareholders has increased. What are some plausible commercial decisions that management may have taken that have led to result?

Asset utilisation ratio is measured using asset turnover ratio and is an activity ratio. The asset turnover ratio is computed by dividing sales by average asset of the company. The reason for such decline may be decrease in sales of the company or increase in assets not in proportion of increase in sales of the company. Both above causes results in decline in asset turnover ratio of the company. However, performance of the shareholders is determine by the bottom line of the company and revenue is the top line. The plausible commercial reason for increase in bottom line or shareholder returns are as under:

• Reduction in interest which has caused Earnings before tax to increase;
• Reduction in operating expenditure of the company;
• Reduction in depreciation on account of near end of the machinery;
• Reduction in equity of the company on account of buy back programme;
• Reduction in tax rate in the country;
• Reduction in cost of good sold on account of innovation in the company.

For the financial year ending 27 June 2021, Woolworths Limited (ASX:WOW) reported an amount of $1,009m in ‘cash and cash equivalents’ on its balance sheet. In the three-month period following this date, WOW undertook the following significant transactions:

1. Paid a final cash dividend for the 2021 financial year.
2. Demerged the Endeavour Group, owner and operator of its alcohol/beverages network and portfolio of hotels.
3. Acquired a 65% equity interest in PFD Food Services (PFD), one of Australia’s leading food service suppliers, resulting in WOW gaining control of PFD.
4. Raised $1500m in cash through a debt issue in the capital markets.
5. Completed a $2000m buyback of shares.

The combined impact of these transaction on the ‘Cash and cash equivalents’ account, as set out below, results in a balance $1,336m:

Assess and explain the potential impact of each of these transactions on a valuation of WOW, framing your discussion from the perspective of the valuation model we used in class and for your group assignment, treating each item separately. (Please note you do not need to use the class model to answer this question – the focus is on demonstrating your understanding of the mechanisms at work in determining a valuation).

The impact of each transaction on the valuation of the company as captured by Market Capitalisation has been presented as under:

Payment of Dividend gives a positive signal in the market and helps to increase the market capitalisation of the company in the long term. However, in the short term it reduces the valuation of the company by the amount of dividend on the ex date of such dividend as company is paying back the capitalisation to its shareholders. Accordingly, the said action shall reduce the valuation of the company by an amount of the amount of dividend paid or more on account of market reaction. However, in valuation we decrease the capitalisation by the amount of dividend paid;

Demerger of entity results in reduction in valuation of the company as the assets and liabilities of the company are reduced. In theoretical terms it results in split of valuation of the company and shall cause reduction in valuation of the company. However, under market conditions, the value of the company may increase on account of such demerger.

Acquiring controlling interest shall result in no change unless there is synergy from such acquisition and if there is synergy the valuation of the combined firm shall increase and thus the acquisition shall have positive impact. Further, in market such acquisition is seen positively.

Raising debt from the market results in decrease in market capitalisation of the company if viewed as negative. However, in theoretical computation, the said action has positive impact as it reduces the weighted average cost of capital of the company which causes enterprise valuation of the company to rise and thereby increase the valuation of the company.

Buyback of shares in theoretical computation has positive impact as it reduces the weighted average cost of capital of the company on account of change in debt and equity proportion which results in higher valuation of the company. However, in market the sentiment may be different and may result in fall/rise in the share price of the company to the extent of rate of buy back.

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