Corporate Finance Theory and Practice, Third Edition

Chapter 27

VALUE AND CORPORATE FINANCE

No, Sire, it's a revolution!

Section 27.1

THE PURPOSE OF FINANCE IS TO CREATE VALUE

1/ Investment and value

The accounting rules we looked at in Chapter 4 showed us that an investment is a use of funds, but not a reduction in the value of assets. We will now go one step further and adopt the viewpoint of the financial manager for whom a profitable investment is one that increases the value of capital employed.

We shall see that a key element in the theory of markets in equilibrium is the market value of capital employed. This theory underscores the direct link between the return on a company's investments and that required by investors buying the financial securities issued by the company.

The true measure of an investment policy is the effect it has on the value of capital employed. This concept is sometimes called “enterprise value”, a term our reader should not confuse with the value of equity (capital employed less net debt). The two are far from the same!

Hence the importance of every investment decision, as it can lead to three different outcomes:

• Where the expected return on an investment is higher than that required by investors, the value of capital employed rises instantly. An investment of 100 that always yields 15% in a market requiring a 10% return is worth 150 (100 × 15%/10%). The value of capital employed thus immediately rises by 50.
• Where the expected return on the investment is equal to that required by investors, there ...