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Open Access 2023 | Open Access | Book

Corporate Finance for Long-Term Value

Authors: Dirk Schoenmaker, Willem Schramade

Publisher: Springer International Publishing

Book Series : Springer Texts in Business and Economics

Part of: Springer Professional "Wirtschaft+Technik" , Springer Professional "Technik" , Springer Professional "Wirtschaft"

Table of Contents

About this book

This open access textbook offers a guide to corporate finance for modern companies that want to create long-term value. Drawing on recent literature on sustainable companies, it starts by analysing the Sustainable Development Goals as a strategy for the transition to a sustainable economy. Next, it translates the general concept of sustainability into core corporate finance methods, such as net present value, company valuation, cost of capital, capital structure and M&A.

Current corporate finance textbooks are primarily based on the shareholder model, designed to maximise financial value. This book instead adopts the integrated model, which argues that companies have to serve the interests of their current and future stakeholders. Accordingly, companies move from simply maximising financial value to optimising integrated value, which combines financial, social and environmental value. Applying this new paradigm of integrated value is the truly innovative feature of this textbook.

Written for undergraduate and graduate students of Finance, Economics, and Business Administration, this textbook provides a fresh analysis of corporate finance. Combining theory, empirical data and examples from actual companies, it reveals the sustainability challenges for corporate investment and shows how finance can be used to steer funds to sustainable companies and projects and thus accelerate the transition to a sustainable economy.

Frontmatter

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Why Corporate Finance for Long-Term Value?

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1. The Company within Social and Planetary Boundaries

Abstract

Society faces multiple sustainability challenges. The transition towards a sustainable and inclusive economy requires rethinking and reorganising many current practices. Companies play an important role in that transition because social and environmental impacts are generated primarily in the corporate sector. Some companies will survive the transition by providing valuable solutions; others will not, as their competitive positions are eroded. Sustainability is therefore also about corporate survival. Responsible companies are increasingly adopting the goal of integrated value creation, which unites financial, social, and environmental value.

This raises the fundamental question in corporate finance: what is the objective of the company? The traditional objective is maximising profit, which boils down to maximising financial value for shareholders. This does not incentivise companies to act in a sustainable manner. An alternative view is to broaden the objective of the company to optimising integrated value (IV) for all stakeholders, which combines financial value (FV), social value (SV), and environmental value (EV). Applying this new paradigm of integrated value is the real innovation of this corporate finance textbook.

Dirk Schoenmaker, Willem Schramade

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2. Integrated Value Creation

Abstract

Chapter 1 gave us a clear starting point: responsible companies create integrated value based on financial value (FV), social value (SV), and environmental value (EV). But what does that mean and imply? This chapter outlines what value creation is, and how the various types of value creation can be prioritised. For the alignment of all types of value, the prospect of internalisation is crucial. Internalisation means that the burdens of (social and environmental) externalities are increasingly shifted back from society to the companies and consumers who cause them. If companies’ FV depends on the exploitation of an external impact (i.e., FV at the expense of SV or EV), that FV will be affected if and when internalisation occurs.

As responsible companies aim to create value based on FV, SV, and EV, they should have a clear picture of their current value creation profile and of their capabilities to create integrated value. Based on their purpose and area(s) of value destruction, companies can accordingly adjust their strategy and business model. In the case of serious value destruction, they should be able to outline a credible transition pathway. Companies can invest in their capabilities to adapt to sustainable business models. In that way, they increase their transition preparedness.

Dirk Schoenmaker, Willem Schramade

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3. Corporate Governance

Abstract

Corporate governance is about controlling and directing the company. The starting point is the objective of the company. In the shareholder model, the ultimate control is with shareholders, who usually aim to maximise company profits and thus put financial value as the company objective. In contrast, the stakeholder model includes other stakeholders, notably employees and customers, alongside shareholders. The integrated model expands the company objective to integrated value, which combines financial, social, and environmental value. This includes not just current stakeholders and shareholders, but also future stakeholders, by representing the environment and people not yet born.

The conflict of interest between managers and shareholders has been at the heart of corporate governance research for decades. However, this debate changes if one broadens the objective of the firm to integrated value. How does one balance the interests of the various stakeholders? What information is used for this balancing? What ownership structures and governance mechanisms are most effective in balancing these interests? How can management be held accountable to stakeholders? The answers lie in the concept of integrated value as introduced in Chap. 1. It provides guidance on the required information; the alignment of interests; accountability; and decision-making, which involves dealing with trade-offs between the interests of various stakeholders.

Dirk Schoenmaker, Willem Schramade

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Discount Rates and Valuation Methods

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4. Discount Rates and Scarcity of Capital

Abstract

Dealing with the future and determining the present value of future cash flows are key parts of corporate finance. The first section of this chapter therefore addresses discount rates and the time value of money. Subsequently, the determinants of discount rates are discussed, starting with government bonds as a benchmark, and then adding the risk premia on corporate bonds and equity. This all applies to financial capital. Next, we introduce the social discount rate for social and environmental capital. The counterparty of companies’ social and environmental capital is the wider society, representing current and future generations. Leading economists argue for an equal treatment of current and future generations, which implies a low social discount rate. Finally, we show how the financial discount rate can be expanded to an integrated discount rate that can be applied to integrated value, which also includes social and environmental value. It is shown that larger environmental and social liabilities raise the integrated discount rate. Conversely, environmental and social assets lower the integrated discount rate.

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5. Calculating Social and Environmental Value

Abstract

The previous chapters described the importance of balancing the various types of value, but how to calculate those types of value? The core model in corporate finance is the discounted cash flow (DCF) model, used to determine the financial value (FV) of a project or a company. This chapter explains how social (S) and environmental (E) issues can be expressed in value terms to arrive at social value (SV) and environmental value (EV). Recent advances in impact measurement enable companies to measure social and environmental quantities (such as life years saved by medical treatment or carbon emissions from using fossil fuels) and then to multiply these quantities by their respective shadow price, derived from welfare theory.

The reason for monetary valuation of (non-market priced) social and environmental impact is to make them visible, and part of the decision-making process, by integrating SV and EV in the accounting system and business language. A common unit ($, € or any other currency) for financial, social, and environmental aspects of business impacts enables managers (and stakeholders) to compare different value components and to analyse the interactions between these value components. The mental challenge for many managers is to start thinking, analysing, and acting in this way, in spite of data gaps and other hurdles.

Dirk Schoenmaker, Willem Schramade

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6. Investment Decision Rules

Abstract

When making investment decisions, companies need to be able to compare various investment opportunities. Which ones offer the best value? The first sections of this chapter describe how companies can make such comparisons on a purely financial basis, using the basic investment decision rules of payback period; internal rate of return (IRR); discounted cash flow (DCF); or net present value (NPV) to calculate financial value (FV). We then dive deeper in the calculation of social value (SV) and environmental value (EV). Even with these values known, the big question remains: how to balance them? What decision rules should be followed? We present three approaches to combining NPV with social (S) and environmental (E) factors: (1) the constrained PV (with S & E as a budget); (2) the expanded PV (with SV & EV in monetary values); and (3) the integrated PV (with SV & EV explicitly balanced). In all three approaches F, S, and E all weigh in and can be prioritised—ideally informed by the company’s purpose and value creation profile.

Dirk Schoenmaker, Willem Schramade

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7. Capital Budgeting

Abstract

In this chapter, we dive deeper into the capital budgeting process, which is the process of making a list of investment projects to be done. We make these investment decisions more tangible by presenting detailed calculation examples—including the calculation and forecasting of (incremental) cash flows and their drivers. Subsequently, we identify behavioural challenges in the capital budgeting process, such as the tendency to continue poor projects for too long, to underestimate risk, and to overestimate cash flows. Next, we integrate social and environmental factors in the capital budgeting process—integrated capital budgeting. The constrained, expanded, and integrated PVs (introduced in Chap. 6) are now shown with cash flow projections. It is shown that FV, SV, and EV can have shared, reinforcing, or conflicting underlying value drivers—and that the way and extent to which they are taken into account affect decisions.

Dirk Schoenmaker, Willem Schramade

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Valuation of Companies

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8. Valuing Bonds

Abstract

This chapter introduces the basic types of bonds and considers their valuation. Bonds are an important source of funding for corporations. And even government bonds are relevant to companies, since the yield on government bonds serves as the risk-free rate discussed in Chap. 4. We explain the drivers of bond yields and the term structure of interest rates. Subsequently, we discuss the liquidity and credit risk of corporate bonds, including the role of ratings.

Social and environmental factors are increasingly being integrated in the valuation of corporate bonds. Studying the company’s business model is important for sustainability integration in the credit risk analysis of bonds. This chapter shows how to include a company’s adaptability to sustainability transitions into the credit risk analysis. Companies that can better adapt their business model face a lower credit risk and hence a lower cost of debt. In addition, there is innovation in the form of sustainability-linked bonds, green bonds, and social bonds to cater for sustainable investment projects.

Dirk Schoenmaker, Willem Schramade

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9. Valuing Public Equity

Abstract

This chapter examines methods to derive the equity value of publicly listed companies. These equity valuation methods come in two forms: absolute and relative methods. Absolute valuation models are fundamental methods to calculate value by discounting cash flows from business activities or discounting dividends which are paid from realised profits. Relative valuation models determine the value of one company in comparison with another company with similar characteristics, taking the latter’s market value as a given.

Fundamental valuation methods—through a deeper understanding of companies and their value drivers—are most suited to sustainability integration. This chapter shows how these methods can incorporate social and environmental factors, alongside financial factors, into equity valuation. Moreover, fundamental valuation methods are at the core of valuing social and environmental factors in their own right, as discussed in Chap. 5.

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10. Valuing Private Equity

Abstract

Private equity funds are set up to invest in private companies for a predefined multiyear period. Private equity companies, i.e. the companies that run private equity funds, come in several types, with different goals and methods. Private equity performs an important role in funding and fostering companies that are as yet too small for the stock market and/or too risky for bank loans.

By nature, private equity is very well suited to sustainable investing since it is a fundamental form of investing with active ownership, multiyear investment horizons, and close consideration of the company’s business model and circumstances. However, in the application of sustainability considerations, private equity falls behind the public equity space. The main difficulty lies in getting the right information for the investors in private equity funds, as many of these funds are still reluctant to systematically report on environmental and social factors—although this is improving. The integrated view on private equity is again similar to the one on public equity, but with the added challenge of data and comparability.

Dirk Schoenmaker, Willem Schramade

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11. Case Study Integrated Valuation: Inditex

Abstract

This chapter applies the tools of the previous chapters to a particular company, Inditex, the largest fast fashion company in the world. The fast fashion industry faces major social (S) and environmental (E) challenges. Moreover, since the industry is characterised by high levels of outsourcing, those challenges tend to be hidden down the supply chain. The case study answers questions such as: how to calculate the integrated value of a company? Which company-reported data to use? How to fill the gaps from missing data in company reporting? We connect the company’s business model and purpose to its external impacts and transition challenges. This allows us to value on environmental (E), social (S), and financial (F) factors. We compute the company’s integrated value (IV) by summing FV, SV, and EV in several ways. The company’s IV turns out to be positive overall, but both positive SV and negative SV and EV turn out to be much larger than FV, which shows the importance of not netting. The large negative values need to be addressed: to be reduced and ideally eliminated. We therefore explore integrated value creation over time; how it can be improved; and how to communicate it to investors.

Dirk Schoenmaker, Willem Schramade

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Risk, Return and Impact

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12. Risk-Return Analysis

Abstract

Risk-return analysis is central to financial decision-making. The basic idea is that risk-averse investors ask compensation for higher risk, in the form of a risk premium on risky assets. The key insight of portfolio theory is that a company’s risk, at least as measured by the distribution of its historical stock returns, can be split into systematic or market-wide risk and idiosyncratic risk. As idiosyncratic risk can be diversified away in a portfolio, investors are only rewarded with a risk premium for the market risk component. This is the beta of the Capital Asset Pricing Model. But historical risk-return analysis has limitations in accurately assessing current and future financial risk. We therefore explore forward-looking measures of financial risk and return. Moreover, we expand the single-factor market model to a multifactor model by adding social and environmental factors.

Yet, another step is to assess social and environmental risk in their own right, as well as their impact on integrated risk. This, in turn, allows us to estimate the cost of integrated capital, which should give corporate managers the tools to make that assessment in their investment decisions. Company examples show that integrated risk-return analysis leads to different, and more sustainable, decisions.

Dirk Schoenmaker, Willem Schramade

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13. Cost of Capital

Abstract

A company’s value is determined not just by its expected cash flows, but also by its cost of capital, which we explore in this chapter. We start with the cost of financial capital r^FV, which is the required minimum return on financial capital that is used in investment decisions. Subsequently, we consider the impact of S (social) and E (environmental) risks on the cost of financial capital. That is, to what extent do companies incur additional (or reduced) financial risk from their S and E exposures? We then address the cost of social capital r^SV and the cost of environmental capital r^EV in their own right. These tend to be much lower than a company’s cost of financial capital. The flip side is that the present value of assets and liabilities on E and S tends to be quite high, as discounting with a low discount rate reduces the present value of underlying value flows in a limited way. Finally, we put r^FV, r^SV, and r^EV together to obtain the cost of integrated capital, r^IV, which is the return on integrated assets that is demanded by the company’s stakeholders on aggregate. Interestingly, r^IV gives an indication of the overall risk of the company, which can differ substantially from the risk picture that emerges from a purely financial perspective, even if that financial perspective is taken on an ESG integrated basis.

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14. Capital Market Adaptability, Investor Behaviour, and Impact

Abstract

The efficient markets hypothesis states that stock prices incorporate all relevant information instantaneously. However, investor behaviour is not always fully in line with theoretical predictions. The mechanism behind efficient markets is that a sufficient number of analysts pay attention to newly arriving information, judge it value relevant, and trade on that information. In that way, the new information gets priced in. But there is evidence that learning takes time and that adaptive markets are a better description than efficient markets. In particular, it seems that analysts have been slow to pick up sustainability-related information.

Moreover, stock prices only reflect the effects of (sustainability-related) information on the financial value of companies. There is no ‘market’ (yet) for the diffusion of information on the social and environmental value (impact) of companies. New regulations, scientific research, non-governmental organisations (NGOs), and ratings agencies do produce information on companies’ social and environmental impact. They create implicit markets on impact information and price-setting that are continuously evolving. These markets can be used to determine the willingness to pay for impact (and thus derive prices for impact). At the same time, a new breed of impact investors is emerging. These investors look for financial return (profit) as well as impact and may be willing to sacrifice some part of their financial return for higher impact.

Dirk Schoenmaker, Willem Schramade

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Corporate Financial Policies

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15. Capital Structure

Abstract

Capital structure is about the funding side of the company’s balance sheet and enables a better understanding of a company’s risk profile and health. We start from financial capital structure, which concerns the proportions of debt and equity in proportion to each other and the company’s asset base. These can be expressed in ratios such as debt/assets. We then consider theories that explain financial capital structure, such as the Modigliani-Miller (MM) theorems. Subsequently, we consider the capital structures of environmental (E) and social (S) separately. Companies generate assets and liabilities on E and S, as they do on the financial side. The main difference is that it is typically much less clear how strong the claims against the company are, and to what extent they will materialise in financial terms. However, their presence and size give strong indications of additional risk. The analysis of the capital structures of E and S allows us to take the next step, namely the construction of an integrated capital structure, which is the capital structure of F, E, and S combined. As found in Chap. 13 on the cost of integrated capital, liabilities on S and E can make the integrated capital structure riskier than the financial capital structure and raise the cost of integrated capital.

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16. Issues and Payouts: Changes in Capital Structure

Abstract

Companies can change the composition of their capital structure by adding (issuing) or reducing (paying out) types of funding. In issues, cash is raised from providers of capital and their claim is increased accordingly. Conversely, payouts refer to those situations in which cash is paid to providers of capital and the value of their claim is reduced accordingly. Both issues and payouts compete with alternative uses of corporate cash, such as investments and building cash reserves.

The impact of environmental (E) and social (S) factors on financial issues and payouts is most obvious through their impact on business models and operations, which in turn affect risk, debt capacity, and cash flows, thereby affecting the degree to which companies can and want to payout cash or issue new capital. As for issues and payouts of E and S themselves, the question is if they exist at all. After all, issues and payouts concern changes in claims that involve cash transfers, but it is not clear what the equivalent of cash could be in E and S. Still, an integrated view on issues and payouts makes sense: given that E and S liabilities affect integrated leverage, they are likely to have implications for integrated payouts as well. The question then is: how to manage issues and payouts, financial in nature, when managing for long-term value? It calls for caution on payouts in the presence of significant liabilities on E or S.

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17. Reporting and Investor Relations

Abstract

Financial reporting and investor relations serve important roles as a means of communication between corporate management and the company’s stakeholders, including investors. This chapter outlines why reporting matters, and how it falls short. It also shows how integrated reporting (combining financial, social and environmental value) might be an improvement. Integrated reporting is about understanding how an organisation creates integrated value and how its activities affect the capitals (human, social and natural capitals, next to financial capital) it relies upon for this. Emerging international sustainability reporting standards will spur integrated reporting. Ultimately, integrated reporting is related to integrated thinking, which takes into account the connectivity and interdependencies between the financial, social, human and environmental capitals that affect an organisation’s ability to create integrated value over time. But investors are slow to ask questions about this new information, as their main focus is still on the financials.

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18. Mergers and Acquisitions

Abstract

Mergers and acquisitions (M&A) are very large investments in which a company absorbs another company, which can dramatically change the profile of a company’s assets. This chapter discuss various types of M&A and the motives behind them, along with calculation examples. Just as in any other investment decision, the financial sanity of M&A activity can be assessed with the NPV method. However, the numbers tend to be much bigger than in ordinary capex decisions, hence the stakes are bigger as well. This makes behavioural issues even more problematic, as they can result in very large overvaluation, overinvestment, and value destruction. Likewise, if not properly understood and considered, environmental (E) and social (S) issues can have similar effects as the abovementioned behavioural issues and reduce the company’s financial value. While the effects of E and S issues on M&A valuation are increasingly understood, scarce academic attention is given to the valuation of E and S in their own right in M&A deals. An M&A deal can be massively value destructive on E or S, which may justify blocking the deal.

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19. Options

Abstract

Financial options are contracts that give the owner the right to buy (in the case of a call option) or sell (in the case of a put option) a security at a pre-specified price (the exercise price). The flexibility is on the side of the buyer, but the seller is compensated with a premium paid by the buyer. Sophisticated models have been developed to determine the value of options. Options are interesting since they offer an alternative way of tying payoffs to (future) situations, also outside of contractual settings. In that case, they are called real options. Real options come in various types, such as the option to delay, the option to expand, and the option to abandon. One can analyse many situations as combinations of options, and one can visualise them with decision trees and payoff graphs for a better intuitive grasp of situations.

Real options on financial (F) factors can have environmental (E) or social (S) drivers: payoff in terms of F, but with E or S as the underlying values. There are also real options on E and S themselves, i.e. with the payoffs in terms of E and S, and possibly the underlying values as well. In fact, companies are short a lot of options against society, but awareness of it is low. The interactions between F, S, and E options call for an integrated view on options, which helps make these options and their trade-offs more explicit.

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Backmatter

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Title: Corporate Finance for Long-Term Value
Authors: Dirk Schoenmaker
Willem Schramade
Publisher: Springer International Publishing
Electronic ISBN: 978-3-031-35009-2
Print ISBN: 978-3-031-35008-5
DOI: https://doi.org/10.1007/978-3-031-35009-2