Accounting for Managers: Interpreting accounting information for decision-making

16 ACCOUNTING FOR MANAGERS

Rappaport (1998) coinedshareholder value added (SVA)to refer to the increase
in shareholder value over time. He defines shareholder value as the economic
value of an investment, which can be calculated by using the cost of capital to
discount forecast future cash flows (which he calledfree cash flows) into present
values (discounted cash flow techniques are described in detail in Chapter 12). The
business must generate profits in product markets that exceed the cost of capital
in the capital market for value to be created (if not, shareholder value is eroded).
Rappaport developed a shareholder value network (see Figure 2.2). Through
this diagram, he identified seven drivers ofshareholder value: sales growth rate,
operating profit margin, income tax rate, working capital investment, fixed capital
investment, cost of capital and forecast duration. Managers make three types of
decisions that influence these value drivers and lead to shareholder value:

žOperating decisions – product mix, pricing, promotion, customer service etc.,
which are then reflected in the sales growth rate, operating profit margin and
income tax rate.
žInvestment decisions – in both inventory and capacity, which are then reflected
in both working capital and fixed capital investment.
žFinancing decisions – the mix of debt and equity and the choice of financial
instrument determine the cost of capital, which is assessed by capital markets
in terms of business risk.

The value growth duration is the estimated number of years over which the return
from investments is expected to exceed the cost of capital.

CORPORATE

OBJECTIVE

Shareholder

Value Added

(SVA)

Shareholder Return

• Dividends


• Capital Gains

VALUATION

COMPONENTS

VALUE

DRIVERS

MANAGEMENT

DECISIONS

Cash Flow From

Operations

Discount

Rate Debt

Value

Growth

Duration

• Sales Growth


• Operating Profit
  Margin


• Income Tax Rate
  
  
  • Working Capital
    Investment
  
  
  • Fixed Capital
    Investment
  
  
  
  

Cost of

Capital

Operating Investment Financing

Figure 2.2 The shareholder value network
Reprinted from Rappaport, A. (1998).Creating Shareholder Value: A Guide for Managers and Investors.
(Revd. edn). New York, NY: Free Press.