Hen ce profit maxi mi za ti on translat es into maximizing t he value of the

Hen ce profit maxi mi za ti on translat es into

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Hen ce . profit maxi mi za ti on translat es into maximizing t he value of the firm. The va l ue of the fir m is calculated in the same way as any other asset: it is the nel JJresenl
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I 42 PART II THE TOOL.~ m- STRATEGY ANALYSIS uci lu e (NPV) of th e re turn s that the a sse t ge nerates. Th e rel ev ant re turn s are th e cas h n ows to the firm. Hen ce , firms are va lued using th e sa me di sco 11 n. ted cas bjl ow (DCF) m et h odo l ogy th at we a ppl y 10 th e valuatio n of in ves tm e nt p ro j ec ts. Thu s, th e va lu e of an <e nte rpri se (V) is th e sum of it s fr ee cas h fl ows (C) in eac h ye ar I, di sco unt ed at th e e nt erp ri se 's cos t of ca pital. 1·1 The relevant cos t o f capital is th e we ig ht ed av e ra ge c os t of ca pital (WACC) that averages the cos t of e quit y a nd th e co st of de bt : "' c, V = ~ (l+WA CCJ' w h ere C is m ea sur ed as : Net operating p ro fit + De pr eciation - T axes - In ves tm e nt in fixed a nd working ca pital Tlrns, to maximi ze it s valu e, a firm mu st maximi ze it 5 fuwre net c ash fl ows whil e managing it s ri sk to minimi ze it s cos t of capital. 11,is va lu e-maximizing a ppr oac h identifi es cas h flow rath er th an pro fi t as th e re leva nt performan ce measure fo r th e valu e- maximi z ing firm. In pra cti ce, va luin g co mp ani es by dis co unting eco nomic profit giv es th e s am e re sult as by dis co unt - ing net cash fl ows. The differen ce is in the tr ea tm e nt of th e ca pital co ns um ed by th e busin es s. The cash fl ow appr oac h de du c ts ca pital at th e time whe n the ca pital e xp enditure is made; th e eco n om ic p ro fit approa ch follows the a cc o unting co n ven- ti on of charging capital as it is co ns um ed ( through ch arging de pr ec iation ). Whil e th e DCF a ppro ac h is th e t ec hnica ll y co rr ec t a pproa ch to v aluin g c omp a ni es, in p rac t ice , it r eq uir es forecasting cash fl ows seve ral yea rs ah ea d. DCF va lu atio n is es pe cially problematic fo r young, growing co mp anies b eca u se th eir level of ca pit al inv es tm e nt ty pi ca ll y m ea ns th ey o ft e n have n ega ti ve fr ee cas h flo ws for man y yea rs. If financial for ecas ts ca n only be made for a f ew yea rs out , th e n profit (net of de pr ecia tion) m ay o ffer a be tter ba sis fo r va lua ti on than cas h fl ow d oe s. The difficulti es of for ecas ting cash fl ows or profi ts far into th e future h ave e n co ur - age d the se ar ch for ap pro ximations to DCF valua tion . McKin sey & Co mpan y argu es th at ente rp ri _ se value depe nd s u po n thr ee k ey variables: re turn on ca pit al e mpl oye d CHOCE), weight ed average cos t of capital ( WA CC), a nd grow th of ope ratin g p ro fit. Hence,_ cr ea ting e nt erp ri se va lu e req uires increasing ROCE, re du cing WA CC, a nd mc r eas mg th e rate ot growt h of pro fit s. 15 Ent e rprise Value and Shareholder Value H ow d oes ma ximizing the v alu e of the fi rm (e nt e rpri se valu e) relate to th e mu ch- bucl ed a nd wi de ly vilified goa l of m ax imiz in g s har eho lde r valu e' At th
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