usually requires the firm to increase internal investments or net new capital
expenditures beyond what it has historically done. Depending on the strate-
gic thrust, management may decide that buying is cheaper than building and
therefore decide to commit itself to an acquisition or series of acquisitions.
Such external investments might be accompanied by divestitures of business
units that no longer fit with the firm’s core business strategy.
MEASURING THE CONTRIBUTION
OF STRATEGY TO FIRM VALUE
Figure 2.1 shows that a firm’s value is the sum of the values created by var-
ious strategic initiatives. The aggregation of these values is equal to the
value of the firm, which is also equal to the sum of the market value of the
firm’s equity plus the market value of its debt. Moving counterclockwise,
the no-growth value is made up of the value of assets in place. This value is
equivalent to capitalizing the firm’s current cash flow by its equity cost of
capital. In this case, each year’s gross investment equals annual deprecia-
tion, so the assets in place are always sufficiently maintained to provide the
required cash flow. Thus, if a firm’s annual after-tax cash flow is $1 million
and the firm’s cost of equity capital is 10 percent, then the firm has an equity
market value of $10.0 million ($1 million ÷0.10). If the firm has 1 million
Creating and Measuring the Value of Private Firms 11
Continuing to operate at
historical growth rate =
business as usual or
going-concern value
Value to
a new
owner
market
value
Adjusted cash
cow value = no
growth with
optimal
capital
structure
Internal
investment in
excess of
historical growth
with optimal
capital
structure
Internal
and external
investment at
optimal capital
structure
Cash cow value
= no growth
value/all
equity
$1,500
$3,500
$1,000 $3,000
$1,250 $1,750
1 Control value
Control options gap:
Value not recognized
6 Internal + external
growth value
Value
created by
external
activities
More Active
Strategic
Management
5 Internal
growth value
Value created
by internal
4 Business as usual or growth
going-concern value
Value created
by business as
usual
3 Adjusted cash
cow value
Value
created by
financing
Less Active
Strategic
Management
2 Cash cow
value
FIGURE 2.1 The Value Circle Framework