4M BG

Although the defi nition of success given above may be at the heart of

a business, many companies prefer a softer approach to defi ning what

they are in business to achieve. For example, Microsoft (a software giant)

states that its mission is: “To enable people and businesses throughout

the world to realize their full potential. We work to achieve our mission

through technology that transforms the way people work, play, and

communicate.”

There is no mention of the investors here. Among the exceptions are:

_ ExxonMobil, an American oil company, which in its Securities and

Exchange Commission (sec) fi ling stated: “We are committed to

enhancing the long-term value of the investment dollars entrusted

to us by our shareholders.”

_ Scottish and Newcastle, a UK drinks company, states: “Our mission

is to be the best European beer-led drinks company with sustained

revenue growth and consistently improving returns on invested

capital.”

A business as a corporate citizen

An increasing preoccupation in business is corporate social responsibility

(csr), whereby a business’s pursuit of success should benefi t its

shareholders in a way that respects (and benefi ts) the other stakeholders

that make it possible: employees, suppliers, customers and the wider

community. Being a good corporate citizen is also about a business taking

responsibility for the impact it has on the world in areas such as the

environment, including the consumption of global resources, pollution,

carbon footprint and the generation of waste. For example, bp in a

billboard advertisement in 2005 had the line “it’s important to answer to

shareholders and to more than six billion other people”.

The csr argument is that only by working in harmony with all these

external infl uences can a business achieve true success and contribute to

an ethical goal of prosperity for all. A company to overtly embrace success

within this context is Ben and Jerry’s, an American ice-cream company

that is now part of Unilever. It has three interrelated parts to its mission:

_ Economic – To operate the company on a sustainable fi nancial

basis of profi table growth, increasing value for our stakeholders

and expanding opportunities for development and career growth

for our employees.

_ Product – To make, distribute and sell the fi nest quality all natural

ice cream and euphoric concoctions with a continued commitment

to incorporating wholesome, natural ingredients and promoting

business practices that respect the earth and the environment.

_ Social mission – To operate the company in a way that actively

recognises the central role that business plays in society by

initiating innovative ways to improve the quality of life locally,

nationally and internationally.

The third part is perhaps the most altruistic in recognising the role of

a business is to “improve the quality of life”. Cynics might say that this

is just good marketing: by giving the business strong ethical credentials it

attracts certain types of loyal customers and boosts sales. Whichever view

you take, there is growing momentum behind the desire for businesses to

balance their duty to shareholders with their responsibility to other stakeholders.

Paying insuffi cient attention to the latter, especially if that results

in adverse media coverage, will undermine the long-term sustainability of

the business and ultimately shareholder value.

Setting up a new business

At the outset of starting a business the founders need to raise money to

cover the costs of setting up and running the business until it is generating

suffi cient revenues to cover the business’s costs. To get this initial capital

the directors must convince potential investors and other providers of

fi nance of the soundness of the business proposition and the returns that

can realistically be expected. There are two options to raise the money to

set up in business:

_ Loan. The founders could put together a business plan showing

how they anticipate being successful, making enough money

to pay interest on a loan and ultimately repay the principal.

However, if the business has just started there will be nothing to

provide security for the loan should the venture fail. The risk to

the provider of the loan is therefore high and repayment depends

on the founders being able to carry out their business plan. The

loan provider would therefore want the founders to put some of

their own money into the business, not only sharing the risk but

also demonstrating their belief and commitment to the venture.

Alternatively, it would require some security from them – a charge

on their homes, for example, which could mean the founders

losing their homes if the business does not work out.

_ Equity (or share) capital. A company is owned by its

shareholders, so if the founders want to part own the business,

they need to invest some of their own money to buy shares

in addition to attracting outside investors. Any profi ts that the

business generates belong to the shareholders (the owners) and

any losses are borne by the shareholders (up to the amount

invested). The shareholders are therefore the ones that take the

highest risk in a business, but they also have the potential for

the highest reward. Should the business fail any assets it owns

will be sold to pay the creditors (in the fi rst instance secured

lenders and then unsecured creditors such as suppliers and other

payables). Only after all debts are satisfi ed will the shareholders

 

get any of their investment back.

With a signifi cant amount of share capital invested to take the primary

risk of the business, a bank will be much more willing to provide loans.

Weighted average cost of capital

In Figure 1.1 the business has a pool of money, the “capital invested”. To

invest this wisely, the fi rst stage is to determine what the average dollar

in the pool costs in terms of the return that the investors are seeking.

Knowing this value enables the directors to make choices about the activities

and projects they select to invest in.

For example, a business has raised $70,000 of equity capital and a

$30,000 loan. If the shareholders require 20% return on their money and

the bank wants 8%, the average dollar would cost the business 16.4%,

which is calculated as follows:

Sources of money to establish a business

Equity (or share) capital

_ Owners of the business

_ Higher risk

_ High potential reward

_ Responsible for losses up

to the amount invested

Loans

_ Lower risk

_ Reward in the form of an

agreed rate of interest

_ Often secured on the

assets of the business

CAPITAL

Annual cost ($)

Shareholders $70,000 @ 20% 14,000

Debt $30,000 @ 8% 2,400

Total $100,000 16,400

Therefore the average cost of a dollar _ 16,400/100,000 _ 16.4%

This is known as the weighted average cost of capital (wacc). For a

business to be successful and satisfy its investors it must earn at least this

rate on its operating activities.

A combination of the two sources of fi nance provides an optimal way

to raise funds and build a business. A business with debt usually has a

lower wacc than one without. A low wacc can therefore create more

value for the shareholders out of the projects it chooses to invest in.

This is a simplifi ed formula for the purposes of illustrating the concept.

To calculate the actual returns required for shareholders and banks, the

optimal proportions of each source and the effect of tax are explained in

more detail in Chapter 6.

Selecting successful activities

Any project that can earn a business a roi that is greater than the wacc

will help the business be successful.

It is rare that a business will publicly quote its wacc as it is the

determinant of investment selection and therefore valuable competitive

information when bidding against others for opportunities. However, back

in 2002 Coca-Cola, an American drinks company, said in its annual report:

“Our criteria for investment are simple: New investments should directly

enhance our existing operations and generally be expected to provide

cash returns that exceed our long-term, after-tax, weighted average cost of

capital, currently estimated at between 8% and 10%.”

An executive of British Airways, the UK’s largest airline, once described

the business as “a group of investment projects fl ying in close formation”.

This is an apt description of a business, illustrating that any organisation

is a collection of business decisions, all intended to generate returns that

exceed the cost of funding them.

As anyone who has worked in business will know, the returns anticipated

by business plans are not always achieved and it is the shortfalls

that cause businesses to fail. The wacc is a fairly constant and predictable

percentage compared with the volatility of a project’s performance in

which the investment is placed. For example, an ice-cream business excels

in a hot summer, but in a cold and wet summer sales volumes are much

lower. The wacc for both scenarios will be the same.

Once a project has been selected (see Figure 1.2 on the previous page)

the implementation needs to be managed well to achieve the expected

returns. Shareholder value is created by following the cycle in Figure

1.3. Starting at the top, select projects that are rigorously evaluated and

promise high returns. Manage these projects excellently to fulfi l their

promise. Combining the fi rst two items should enable premium returns

on investment to be achieved. The premium returns should generate

substantial cash fl ow which will provide the resource for future investment

opportunities.

Overall success

Success can therefore be achieved by understanding and satisfying

investors’ requirements which can be interpreted as “creating a sustainable

superior return on investment”. To do this directors need the vision,

business sense and confi dence to invest in ideas and opportunities that

they believe will produce a roi that is greater than the wacc.