Recognizing Macroeconomic Fluctuations in Value Based Management

Transcription

1 Recognizing Macroeconomic Flucuaions in Value Based Managemen Lars Oxelheim Insiue of Economic Research, Lund Universiy, P.O.Box 7080, Lund, Sweden, and IUI, P.O.Box 5501, SE Sockholm, Sweden, and Clas Wihlborg Deparmen of Finance, Copenhagen Business School, Solbjerg Plads 3, DK-2000 Fredriksberg, Denmark, e- mail: and Deparmen of Economics, School of Economics and Commercial Law, Göeborg Universiy, Box 640, Göeborg, Sweden December 2001 Absrac Value Based Managemen (VBM) has become a common ool for ex ane and ex pos evaluaion of corporae sraegies and projecs from he perspecive of shareholder wealh maximizaion (SWM). VBM-frameworks are designed o suppor invesmen and divesmen decisions, ex pos evaluaion of managemen and heir major sraegic decisions, and bonussysems. Tradiional VBM frameworks make no disincion beween sources of emporary changes in performance, and sources of performance reflecing he inrinsic compeiiveness of he firm. Temporary changes in performance are ofen caused by macroeconomic flucuaions. In his aricle we develop an approach for filering he impac of macroeconomic flucuaions from measures of performance in order for managemen o obain beer informaion for purposes of invesmen, divesmen, and exposure managemen decisions. We focus on filering for purposes of performance assessmen employed in compensaion schemes. A case sudy illusraes he approach, and shows he poenial magniude of effecs from macroeconomic evens. JEL classificaion: D81, G31, M22 Key words: Value Based Managemen (VBM), Shareholder Value Analysis (SVA), Economic Value Added (EVA), performance measuremen, macroeconomic flucuaions, bonus sysem

2 2 Recognizing Macroeconomic Flucuaions in Value Based Managemen Value Based Managemen (VBM) has become a common ool for ex ane and ex pos evaluaion of corporae sraegies and projecs from he perspecive of shareholder wealh maximizaion (SWM). VBM-mehods are designed o suppor, for example, invesmen and divesmen decisions, and ex pos evaluaion of major sraegic decisions. Measures of performance of managemen are anoher imporan componen of VBM. The performance measures are used in bonus sysems in order o align managerial incenives wih hose of shareholders. There are a number of VBM frameworks. Shareholder Value Analysis (SVA), developed in Rapapor (1986) and Economic Value Analysis (EVA) developed by Sern Sewar (1990) are he wo mos well-known ones. However, here exis many challengers as described in Black, Wrigh, and Backman (2001). Cash Value Analysis (CVA) developed by Ooson and Weissenrieder (1996), and Cash Flow Reurn on Invesmen (CFROI), (Madden, 1999) are wo offering serious alernaives o he differen versions of EVA. All he menioned VBM frameworks have in common ha hey do no make a disincion beween changes in cash flows ha reflec a firm s compeiive posiion, and changes caused by relaively shor erm influences from he firm s macroeconomic environmen. A firm s compeiive posiion may be aribued o is (and is managemen s) specific skills and knowledge relaive o he marke and compeiors. Shor-erm influences on he oher hand, are ofen caused by macroeconomic evens, and observed as changes in exchange raes, ineres raes and aggregae price levels domesically and abroad. Macroeconomic facors have in common ha hey are compleely beyond managemen s conrol alhough he cash flow effecs of such facors may be affeced by managerial acions. Thus, managemen may gain useful informaion abou curren and fuure prospecs of he firm by filering ou macroeconomic influences on curren performance measures. Such filering would allow managemen o esimae performance under neural macroeconomic condiions If cash flow forecass for a new projec are generaed wihou disinguishing beween susainable demand and cos condiions, and emporary demand and cos condiions generaed by macroeconomic evens, an esimaed posiive projec value may no be susainable under normal macroeconomic condiions. Alernaively, if forecass are generaed based on observaions under unfavorable macroeconomic condiions, hen projec values may be underesimaed and he projec abandoned premaurely. For insance, an undervalued currency can lead he managemen of an exporing firm o believe ha he company is

3 3 compeiive whereas is profis filered of he under-valuaion may be decreasing. An unsusainable good performance may lead o demand for wage and dividend increases ha are no moivaed by he firm s longer erm compeiiveness. Hence, he cos o shareholders of ignoring or remaining uninformed abou he emporary impac of macroeconomic flucuaions may be very high a he end of he day. In his paper we focus on correcing performance measures for influences of macroeconomic evens. From he poin of view of performance evaluaion macroeconomic effecs on cash flows and value could be considered noise o he exen hey are no predicable. I is well known in he incenive conrac lieraure ha if risk-averse managers remuneraion is linked o noise facors beyond heir conrol wihou srong linkage o shareholder value, hen heir incenive o exer effor on behalf of shareholders may be weakened. 1 Thus, from a SVM perspecive i could be desirable o cleanse performance measures of macroeconomic influences wih he aim of srenghening he incenives of managers. An addiional argumen for filering ou macroeconomic influences on measures of firms performance is ha hey represen a possible explanaion for large observed differences beween economic values as measured by EVA-analysis and marke values (O Byrne, 1997). Such differences could occur if marke paricipans were beer able o idenify macroeconomic influences han he EVA-analys. Oxelheim and Wihlborg (1997) discuss how managemen can develop a Macroeconomic Uncerainy Sraegy (MUST) - analysis o manage exposure caused by macroeconomic evens observed in, for example, exchange raes. A key componen of his analysis is he esimaion of exposure coefficiens for he impac of macroeconomic price variables on commercial (non-financial) cash flows, or on he value of he asses generaing such cash flows. Here we argue ha hese exposure coefficiens can be useful for purposes of performance assessmen as well. Changes in a firm s cash flows or value from one period o anoher can be cleansed from some or all macroeconomic influences once exposure coefficiens are known. Thereby susainable changes in cash flows or value ha should be aribuable o a firm s inheren compeiiveness would be idenified.. The basic framework for decomposing changes in cash flows and value using exposure coefficiens is laid ou in Secion 2. As an illusraion of he decomposiion procedure and he magniude of macroeconomic influences he case of Elecrolux is presened in Secion 3. In Secion 4 we urn o decomposiion for purposes of performance assessmen. The appropriae

4 4 decomposiion depends on flexibiliy in a firm s operaions, and on he exisence of real opions. Conclusions follow in Secion VBM and macroeconomic flucuaions A framework Value Based Managemen springs from he measure of firm value employed in convenional corporae finance. According o his measure he value of corporae asses (V A ) is he ne presen value of cash flows generaed by hose asses: j V A, = δ E [X +j ] + PVRO (1) j=0 where δ j is he discoun facor for j periods, X +j refers o cash flows in period +j, and PVRO represens he value of real opions ha canno be capured in convenional presen value analysis. The value of equiy, V S,, is he value of asses minus he value of deb V D,. Thus, V S, = V A, - V D, (2) In VBM he objecive of managemen is commonly o maximize he value of equiy, V S,. If markes for deb are well-funcioning, hen maximizaion of he value of asses, V A, leads o he maximizaion of he value of equiy, V S. In he following, we focus on he value of nonfinancial asses ha depends on expeced cash flows and he risk adjused cos of capial, δ. SVM implies a concern wih cash flows, as well as wih he minimizaion of he cos of capial. Invesmens in real opions also increase a firm s value by increasing he average level of cash flows. Cash flows in any period can be decomposed ino wo componens. One componen is cash flows ha would occur in he absence of macroeconomic flucuaions under hypoheical neural or normal macroeconomic condiions in counries of relevance for any paricular firm. These cash flows for any individual firm vary as a resul of changes in he firm s compeiiveness in he marke place and he growh rae of demand for he firm s oupu. Given a firm s echnology, knowledge among employees, managerial compeence, and demand, here is a any ime a level of cash flows ha may be called he susainable level of cash flows for he period. This susainable level, denoed X L, occurs under neural

5 5 macroeconomic condiions. I may no usually be observed, and i is no consan. I is independen of influences of macroeconomic evens, however, and reflecs he abiliy of managemen o employ resources producively. The fac ha he susainable level is no direcly observable does no mean ha i lacks pracical significance. On he conrary, we argue ha managemen should esimae i and use i as inpu in major business decisions. The cash flows during a period ha depend on macroeconomic condiions in counries where he firm has a presence are denoed X M. These cash flows may be posiive or negaive and more or less ransiory. They are by definiion never permanen. Thus: X +j = X L,+j + X M,+j (3) The paern of boh componens in (3) can be influenced by invesmens in real opions. We defer he discussion of his issue o Secion 4. Macroeconomic evens, causing flucuaions in a firm s cash flows and economic value, may be caused by a variey of policy and non-policy shocks originaing a home or abroad. Moneary and fiscal policy shocks are he policy shocks mos commonly referred o, while non-policy shocks may be caused by changes in privae secor aggregae demand and supply. The cash flows caused by macroeconomic shocks may have a subsanial effec on a firm s value in a period. Mos direcly and immediaely macroeconomic evens are observed as changes in macroeconomic price variables among which exchange raes, ineres raes, and price levels are mos prominen. Underlying macroeconomic evens are usually no direcly observed, however. In mos macroeconomic models differen shocks affec hese paricular price variables in differen combinaions. The price variables are essenially signals of macroeconomic condiions. Economic models differ abou he magniude and duraion of change in he price variables in response o differen macroeconomic shocks bu mos open economy models have in common he menioned price variables. The marke reurn on socks could be added in order o cover price responses o macroeconomic shocks more compleely bu his variable seems o be less sysemaically relaed o macroeconomic shocks. We need no link he discussion here o any specific macroeconomic model. The main poin is ha here is a se of price variables ha serve as indicaors of macroeconomic condiions. The correcion o commercial cash flows ha would be made o arrive a susainable cash flows under neural macroeconomic condiions in a paricular period can be expressed in

6 6 he following way when macroeconomic condiions are observed in exchange raes, ineres raes, and prices: δ X δx δx (4) δe δi δp M M M X M, = ( e e) + ( i i ) + ( p p) In (4) ( e e), i i ) (, and ( p p) represen deviaions from he exchange raes, ineres raes, price levels ha correspond o neural macroeconomic condiions in period. Each of hese variables can be seen as a vecor of domesic and foreign variables of relevance o a firm. The parial derivaives represen sensiiviy or exposure coefficiens. The coefficiens in (4) capure no only he direc impac of each variable on cash flows. Each coefficien depends on correlaions beween he variable and all oher macro-effecs of he even, as well as beween hese effecs and cash flows. In conras, exposure managemen in mos firms seems o presume ha changes in exchange raes, ineres raes, and price levels as shocks occurring independenly of each oher and oher variables affecing a firm s cash flows. We have discussed problems wih his view of macroeconomic exposure in Oxelheim and Wihlborg (1987, 1997), and recommended ha firms measure coefficiens as hose in (4) above for he hree menioned macroeconomic variables for relevan counries employing mulivariae regression or scenario analysis. The funcional specificaion of (4) describes a linear relaionship among he variables. Pracical and economeric consideraions dicae wheher he coefficiens should be esimaed for levels or changes in cash flows and price variables. Oher funcional forms are also possible bu he principles for decomposiion are he same in eiher case. Macroeconomic shocks may no be random bu serially correlaed o a subsanial exen. Each of he marke price variables in (4) may accordingly be expressed as a funcion of lagged and curren changes in i. For example, for he exchange rae he curren deviaion from is long run values could be wrien as: e e = ρ e) + s (5) e( e 1 where ρ e is a serial correlaion coefficien for he exchange rae and s is he unanicipaed change in period. The cash flow adjusmen o anicipaed changes may or may no be differen from adjusmen o unanicipaed changes. Furhermore, i is possible ha here are cash flow effecs in period of exchange rae changes in -1. Thus, he cash flows in period

7 7 explained by he exchange rae s and he oher variables deviaions from heir long run values can be wrien as in he following expression for he exchange rae s effec on cash flows: X δx δx e M M M, = ( e 1 e) + s (6) δ ( e 1 e) δs The firs erm in (6) includes boh he lagged curren period effecs of exchange raes in -1, and he curren period effecs of he anicipaed exchange raes deviaion from he long run level. The second erm incorporaes unanicipaed (in -1) cash flow effecs of unanicipaed exchange rae changes a period. Similar expression can be wrien for ineres rae and price levels for inclusion in a mulivariae formulaion of he impac of macroeconomic condiions on a firm s performance. I is in principle possible o decompose changes in value insead of cash flows along he lines described above. However, mos VBM-frameworks use cash flows as he major inpu o arrive a esimaes of projec and firm values, as well as o measure performance. We define he difference beween he value of asses in period and heir value under neural macroeconomic condiions as: j= 1 [ X ] j V = V V = δ E, A, A, AL, M, + j (7) where X M =X e M +X i M +X p M, (8) and δ M is he discoun facor for cash flows caused by macroeconomic condiions. 2 Superscrips indicae cash flow effecs of differen macroeconomic variables in (4). Each of hese variables can be expressed as in (6) in erms of an anicipaed componen and a noise componen. The formulaion for value effecs of cash flows caused by macroeconomic evens in (7) implies ha he value of real opions, PVRO, is par of he susainable value V AL. The raionale for viewing he value of real opions his way is ha hey are very much he resul of managerial aciviy. We reurn o his issue in Secion 4.

8 8 I is also possible o define he difference beween he value of equiy and he long run susainable value of equiy in he following way using (2): V S, = V S, V SL, = (V A, V AL, ) (V D, V DL, ) = V A, - V D, (9) In (9) V DL is he value of deb under neural macroeconomic condiions. Thus V D, is he value of deb caused by macroeconomic variables deviaions from values corresponding o neural condiions. These deviaions cause financial cash flows and capial gains or losses on financial posiions in a period. Corporae financial exposure managemen can be hough of as adjusing financial posiions including derivaives, V D, in order o creae an offse beween he sensiiviies of V D and VA--or he corresponding sensiiviies for cash flows-- o macroeconomic price variables. (See Oxelheim and Wihlborg, 1997) Cash flow decomposiion and valuaion ;The case of Elecrolux Elecrolux AB is one of he world s larges manufacurers of whie goods equipmen. Through acquisiions he company has become a ruly global player. Is headquarer is locaed in Sweden, and i is conrolled by he so-called Wallenberg group hrough a holding company called Invesor. In spie of widespread Swedish and inernaional ownership of equiy, conrol is held by Invesor and he Wallenberg group hrough a dual-class share sysem. The changes in quarerly real operaing cash flows for he Elecrolux group from 1986 hrough 1994 were obained from he firm. The purpose was o decompose he changes ino he componens described in he previous secion. 3 The changes in real operaing cash flows were regressed on changes in exchange raes beween Sweden and a number of major currencies, ineres raes in he same currencies, inflaion raes in he same currencies, and oal European housing sars o conrol for changes in he indusry s condiions. The cash flows were also seasonally adjused. Since he number of observaions is limied many differen combinaions of he currencies were used. Exchange raes and ineres raes are highly correlaed across currencies. Therefore, observaions from a few counries capure he combined exchange rae, ineres rae and inflaion effecs. Regressions were run for he whole period , as well as for , and The laer regressions made i possible o use coefficiens for ou of sample analysis. Wihou

9 9 going ino economeric mehodology and problems we presen resuls of he analysis as an illusraion of he decomposiion. The following ses of coefficiens were obained using conemporaneous dependen and independen variables: 4 Table 1 here. Table 1 shows ha he macroeconomic price variables explain abou 50% of he flucuaions in seasonally adjused changes in quarerly operaing cash flows. The coefficiens were employed ou of sample in such a way ha he coefficiens were used o esimae he impac of macroeconomic evens in 1993, and he coefficiens were used o esimae he impac in Table 2 shows he daa and he resuls of he ou of sample analysis. Column (1) shows acual quarerly cash flow changes in 1993 and Columns (2), (5), (6) and (7) lis he changes in he price variables, which are muliplied by he coefficiens in Table 1 o obain he changes in cash flows caused by changes in he macro economy ( X M ) in column (8). Changes in susainable cash flows ( X L ) are regisered in column (9). A second decomposiion in Table 2 is obained by removing only changes in cash flows caused by unanicipaed macroeconomic evens. The ineres rae differenial in he previous quarer is a proxy for he anicipaed exchange rae changes in column (3). Unanicipaed exchange rae changes follow in column (4). I is assumed ha all changes in ineres raes are unanicipaed in columns (5), (6), and (7). Afer muliplying unanicipaed changes wih he coefficiens in Table 1, unanicipaed cash flow changes caused by macroeconomic evens ( X U M ) are regisered in column (10). Finally column (11) shows susainable cash flow changes plus cash flow changes caused by anicipaed macroeconomic evens ( X L + X A M ). The disincion beween he wo decomposiions is paricularly imporan for performance assessmens. We urn o his issue in he nex secion. However, he disincion can also be imporan for he esimaion of changes in he ne presen value of he firm s asses wihin a VBM framework. For example wihin EVA analysis he economic value added for a period is esimaed based on he difference beween a period s acual cash flows and he cash flows required o cover he cos of capial for he same period.

10 10 Assume as an example ha Elecrolux a he end of 1994 employed a 15 percen cos of capial, and ha he expeced growh rae of cash flows was 9.33 percen. This figure is he average growh rae during 1993 and 1994 as shown in Table 2. Using he consan growh formula for esimaing he presen value of a dividend of 1 in 1994 would lead o a presen value of /( )= If insead he rue long run growh rae is he average of he growh of susainable cash flow in (8), hen he correced presen value is /( )=14.60, if he same cos of capial is used. Thus, disregarding he emporary naure of some cash flows, he value of he firm would be exaggeraed by 32% in his example. The exaggeraion presumes ha managemen has inerpreed emporary growh caused by macroeconomic effecs in 1993 and 1994 as susainable growh. A second source of error in he economic value esimaion wihin a VBM-framework is ha he discoun rae is assumed o be he same for all cash flows. Mos likely he riskadjusmen on he cos of capial for cash flows caused by macroeconomic evens should be lower han he risk-adjusmen for he susainable cash flows generaed by he business iself. If so, he difference beween he presen values including and excluding he macroeconomic componens of cash flows would be even larger. 4. Performance assessmen and real opions in VBM An imporan aspec of VBM is o link bonus for managemen o changes in shareholder value or value-enhancing cash flows. In he following i is assumed ha eiher cash flows during a period or changes in he esimaed presen value of cash flows provide he basis for a bonus for he period. Thus, sock marke values do no exis for he eniy or are considered excessively noisy o be used as a basis for compensaion. In his case he key elemen of performance is he operaing (or commercial) cash flows. These cash flows would provide he informaion based on which an economic value would be esimaed. One issue here is which componen or componens of operaing cash flows should be he major inpu in performance assessmen for he purpose of deermining managerial compensaion. The choices we have from Secion 2 and Table 2 are he oal operaing cash flows (X, column (1)), he susainable cash flows (X L, column (9)), or he oal cash flows minus hose caused by unanicipaed macroeconomic evens (X L + X A M, column (11)). A second issue is wheher he coefficiens esimaed as above in a linear model are appropriae when decomposing cash flows. Real opions in paricular imply a non-linear relaion beween shocks and cash flows.

11 11 Unanicipaed and anicipaed cash flow effecs from macroeconomic evens If managemen has no or negligable influence on cash flows caused by macroeconomic evens, an efficien compensaion scheme should be linked o susainable cash flows alone, or he presen value of expeced such cash flows. In his case he compensaion based on susainable cash flows creaes he sronges incenives for managemen o devoe effor owards enhancemen of he firm s long run compeiiveness, while cash flows beyond is conrol do no affec compensaion. To he exen a bonus sysem is linked o cash flows and value changes over which managemen has no conrol, effor may be divered owards speculaion abou macroeconomic developmens or owards obfuscaion of informaion abou hem. Furhermore, he incenives of risk-averse managers o exer effor are weakened, if he variable o which bonus is linked conains noise relaive o he variable ha is of concern o shareholders as noed above. The link beween effor and oucome is weakened. I could be argued ha managemen should be induced o ake advanage of anicipaed changes in he macroeconomic environmen. Naurally, if he firm s operaions in various ways can be adjused o changes in expecaions abou macroeconomic evens, hen managemen should have he incenive o implemen such adjusmen in sales effor, producion paern, or where adjusmen can be made in ime o ake advanage of he expecaions. In his case he adjusmen o oal cash flows would be limied o hose caused by unanicipaed changes such as s in (6) and column (10) in Table 2. The compensaion would be linked o cash flows in column (11) of Table 2. Evan if cash flows can be adjused a reason for no linking he bonus o anicipaed flows is ha hese can be affeced by managerial decisions o a lesser degree relaive o effor, han susainable flow. In he laer case, scarce managerial ime is mos producively used o enhance he firm s compeiiveness. The abiliy of managemen o ake advanage of anicipaed macroeconomic condiions may vary among indusries. Differences in compensaion schemes may herefore be observed wihou any implicaion ha one sysem is superior o anoher. The daa presened in Table 2 indicae ha a very large proporion of he variabiliy of operaing cash flows is caused by macroeconomic flucuaions. Comparing columns (8) for all macro-effecs and (10) for unanicipaed macro-effecs i can be seen ha he unanicipaed componen dominaes very srongly over he anicipaed componen in he paricular case presened.

12 12 Cash flows and value creaed by invesmens in real opions In eq.(1) he presen value of real opions is one componen of he value of a firm. Real opions are creaed by invesmens in flexibiliy. Such invesmens reduce irreversible coss associaed wih changes in operaions, and enhance a firm s abiliy o ake advanage of posiive changes in cos and demand condiions and o reduce he impac of negaive changes. By invesing in flexibiliy he firm can narrow he range of condiions wihin which i canno adjus is operaions o changes in he environmen. This range is defined by rigger levels for demand and cos condiions beyond which adjusmen of operaions is profiable (See, for example, Dixi and Pindyck, 1994). Invesmens in real opions--or flexibiliy --can be moivaed by uncerainy abou facors affecing susainable cash flows, as well as abou macroeconomic condiions. Here we are concerned wih he effecs of invesmens in flexibiliy in response o uncerainy abou macroeconomic condiions. For example, invesmens reducing irreversible coss of swiching suppliers, locaion of producion, or markeing effors beween counries enable a firm o reduce he cash flow impac of negaive changes in real exchange raes, and increase he cash flow impac of posiive changes (see Capel, 1997). Anoher example is ha invesmens in cusomer relaions may enable a firm o pass hrough large exchange rae or ineres rae changes ino prices by reducing coss associaed wih changes in prices. This flexibiliy could exend even o unanicipaed changes.. The opions o change prices, swich suppliers, ec. in response o price incenives of cerain magniudes imply ha he cash flow sensiiviy coefficiens end o become smaller for large deviaions from neural macroeconomic condiions. A linear relaion beween cash flows caused by macroeconomic facors, and heir deviaions from levels corresponding o neural condiions exiss only when here are no real opions ha managemen can exercise in response o relaively large price incenives. Figure 1 illusraes he cash flow effecs of unanicipaed macroeconomic shocks. The size of he shock is measured along he x-axis. The sraigh line shows he cash flow effecs of he disurbance if here are no real opions, i.e. if here is no flexibiliy in pricing, sourcing, locaion of producion ec. no maer how large he shock is. The broken line shows he cash flow effecs of he same shock, when an increasing number of real opions are riggered as he magniude of he shock increases. When he opion is riggered, cash flows denoed X R, arise. They add increasingly o he cash flows as he magniude of a posiive even increases. When

13 13 he even is increasingly negaive, he cash flows creaed by he opion reduce he impac on cash flow increasingly. I INSERT FIGURE 1 The framework developed in Secion 2 should be expanded o include cash flows, X R, ha occur in a period as a resul of previous invesmens in real opions. Toal cash flows in period can be decomposed as in e.q. (3) above ino susainable and macroeconomic componens. The laer componen, X M, described above in he linear expressions (4) and (6) mus now be exended o include he cash flows from real opions. Using M o denoe he level of a vecor of macroeconomic variables describing macroeconomic condiions in period, he cash flow effecs caused by macroeconomic evens can be wrien in he following way: δx δx M M X M, = ±, δ 1 ( ) ( M ) 1 M + m X R M M δm, (4A) where he firs erm represens anicipaed effecs of lagged changes in M, he second erm capures unanicipaed effecs, and X R, as described in Figure 1 represens cash flow effecs of real opions riggered by M in period. As in expression 6 above = M 1 ( M M ) m M ρ +, (6A) where ρ M is a serial correlaion coefficien and m is he unanicipaed change in macroeconomic condiions. The parial derivaives in he firs wo erms on he righ hand side are assumed o be linear coefficiens independen of he magniude of change in M. Esimaed coefficiens for changes in cash flows were esimaed and used in Table 2 o decompose cash flows ino susainable cash flows, X L, and cash flows caused by macroeconomic evens, X M. The nonlinear cash flows creaed by invesmens in real opions were no accouned for, however. The issue now is how he las erm in (10), X R,, should be reaed when esimaing he performance of managemen wih he objecive of providing incenives for managemen o maximize shareholder value. Clearly, shareholder wealh maximizaion includes maximizing he value of real opions (PVRO in (1)) wheher he opions refer o flexibiliy in responses o

14 14 compeiive condiions or macroeconomic evens. Thus, i is clearly desirable o include he cash flows rigged by real opions on macroeconomic condiions, X R, or he value of real opions, PVRO, in measures of managers performance. An economeric problem remains. The presence of real opions implies ha i is no longer appropriae o ake a linear relaion beween cash flows and macroeconomic pricevariables for graned, alhough he linear sensiiviy coefficiens in expressions like (4) and (6) are he appropriae ones o use for he decomposiion of cash flows. If he relaionship beween cash flows and macroeconomic variables are described by he non-linear broken line in Figure 1, he analys esimaing he linear sensiiviy coefficiens for macroeconomic effecs on cash flows may have o limi he regression o observaions of macroeconomic changes wihin he range bounded by he rigger levels for which he relaion can be assumed o be linear. The linear coefficiens measured his way apply neverheless ouside his range when cash flows ha canno be affeced by managemen are esimaed Concluding remarks Value Based Managemen is a ool ha should help managemen maximize shareholder value in large and small invesmen and divesmen decisions. I should also help shareholders designing bonus-sysems based on performance in order o induce managers o have shareholder value as heir prime objecive. As menioned in he Inroducion here is a number of compeing Value Based Managemen frameworks. One difference among hem is how hey arrive a cash flow esimaes. For example, EVA sars from accouning daa for income and makes a large number of adjusmens o arrive a a proxy for cash flows. On he oher hand, CVA and CFROI ake acual cash flows as saring poin for analysis. These frameworks are herefore more easily adjused o ake ino accoun and filer performance measures of macroeconomic influences. Macroeconomic flucuaions affec firms cash flows as well as marke values. Such flucuaions are beyond managemen conrol. Cash flow effecs of such flucuaions can someimes be influenced by managemen o he exen macroeconomic developmens can be forecas, or if firms can inves in flexibiliy wih respec o sourcing, pricing, locaion of producion, or locaion of sales in response o anicipaed and/or unanicipaed macroeconomic developmen. We have argued ha for purposes of exposure managemen, projec evaluaion, ex pos analysis of projecs, and performance assessmen i is valuable o decompose cash flows of

15 15 firms ino susainable cash flows under neural macroeconomic condiions, and cash flows caused by macroeconomic flucuaions around hese condiions. The laer flows can be decomposed furher ino anicipaed and unanicipaed cash flows. We have here suggesed ha sensiiviy- (exposure) coefficiens describing he impac of key macroeconomic price variables on cash flows should be esimaed and used as inpu o filer ou he cash flow effecs of macroeconomic flucuaions. The daa used as inpu in invesmen decisions, ex pos analysis of projecs and sraegies, and performance measures for compensaion-sysems could be subsanially improved if cash flows were decomposed each period as suggesed above. Inclusion of his ype of analysis as a key componen of Value Based Managemen would improve condiions for shareholder wealh maximizaion. In paricular, i would be possible o base compensaion sysems on measures of performance under he acual conrol of managemen. References Black, A., P. Wrigh and J.E. Bechman, 2001, In Search of Shareholder Value - Managing he Drivers of Performance, Price Waerhouse, FT Prenice Hall, London. Capel, J.,1997, A real opion approach o economic exposure managemen, Journal of Inernaional Financial Managemen and Accouning 8, Dixi, A. and R. S. Pindyck,1995, The opion approach o capial invesmen, Harvard Business Review 64, May/June, Froo, K., Scharfsein, D. and J. Sein,1994, A framework for risk managemen, Harvard Business Review 72, Sep-Oc., Froo, K. and J.C. Sein,1993, Risk managemen: Coordinaing corporae invesmen and financing policies, Journal of Finance 48, Nadden, B.J., 1999, A oal sysem approach o valuing he firm, Buerworh-Heinemann. Milgrom, R. and J. Robers,1992, Economics, Organizaion and Managemen, Prenice-Hall, New York. O Byrne, F., 1997, EVA and Shareholder Reurn, Conference paper, Financial Managemen Associaion Annual Conference, Honolulu. Oosson, E. and F. Weissenrieder,1996, Cash Value Added (CVA) A New Mehod for Measuring Financial Performance, Gohenburg Sudies in Financial Economics, 1996:1, Deparmen of Economics, Gohenburg universiy Oxelheim, L. and C. Wihlborg, 1987, Macroeconomic Uncerainy Inernaional Risks and Opporuniies for he Corporaion, John Wiley and Sons, Chicheser and New York. Oxelheim, L. and C. Wihlborg, 1995, Measuring Macroeconomic Exposure he Case of Volvo Cars, European Financial Managemen 1, Oxelheim, L. and C. Wihlborg, 1997, Managing in he Turbulen World Economy Corporae Performance and Risk Exposure, John Wiley and Sons, Chicheser and New York. Rapapor, A., 1986, Creaing Shareholder Value. The New Sandard for Business Performance, Free press, London.

16 16 Smih, C. and R. Sulz, 1985, The deerminans of firms hedging policies, Journal of Financial and Quaniaive Analysis 20, Sewar, G. 1990, The Ques for Value: The EVA-TM Managemen Guide, Harper Business, New York. Tufano, P. 1998, The deerminans of sock price exposure: Financial engineering and he gold mining indusry, Journal of Finance 53,

17 17 Table 1: Coefficiens for percen changes in seasonally adjused real operaing cash flow, Elecrolux Group SEK/GBP* Long DEM ineres rae* Shor GBP ineres rae* Shor Swedish ineres rae* R D.W * All variables are measured in percen rae of change.

18 18 Table 2. Decomposing Elecrolux cash flows ou of sample Year (1) (2) (3) (4) (5) (6) (7) Real Acual Anicipaed Unanicipae 10 Year Three monh Three mo nh Group SEK/GBP SEK/GBP d SEK/GBP German Ineres Grea Briain Swedish operaing cash flow % Change (ineres rae differenial) % Change rae % Change Ineres Rae % Change Ineres % Change % Change from previous quarer X % Change % 11.47% 0.79% 10.68% -7.78% % % % 1.96% 0.71% 1.25% -2.09% -6.59% -7.82% % 5.92% 0.56% 5.37% -5.07% -1.01% -7.84% % 1.89% 0.40% 1.49% -8.55% -6.33% % % -4.27% 0.42% -4.69% 5.72% -4.83% -2.62% % -0.48% 0.47% -0.96% 13.54% -2.73% 1.10% % 1.06% 0.50% 0.56% 5.64% 8.80% 8.40% % -0.88% 0.47% -1.35% 3.92% 11.56% 6.61% Mean 9.33% Sd.dev 9.37% Mean/S d.de 99.56% Year (8) (9) (10) (11) Operaing cash flow effec of all macro variables % change X M Operaing cash flow ne of all macro variable effecs % Change X L Operaing cash flow effec of unanicipaed changes in macro variables U % Change; X M Cash flow change afer hedging unanicipaed changes in macro variables A % Change; X L + X M % 12.60% 14.57% % 2.29% 3.09% % 7.28% 2.09% % 6.86% 2.87% % -5.66% 5.69% % -7.85% 10.63% % -2.63% 4.05% % -1.69% 20.43% Mean 7.63% 7.93% Sd.de 6.66% 6.66% v Mean/ Sd.de % %

19 19 Figure 1.Cash flows caused by macroeconomic facors when real opions are presen. Cash flows caused by macroeconomic facors X R Trigger level Trigger Level Macroeconomic deviaion from neural condiions X R

20 20 Endnoes 1 See for example, Milgrom and Robers (1992), Ch.5 2 The risk premium for cash flows caused by macroeconomic flucuaions may differ from he risk premium for cash flows a neural condiions. See below. 3 The procedures and resuls were presened in a Masers degree hesis by Henrik Dahl and Ulrika Linden (1996) in he deparmen of economics, Universiy of Gohenburg. The hesis implemens procedures described in Oxelheim and Wihlborg (1995). 4 Lagged variables were inroduced bu wihou subsanial changes in resuls 5 The regressions resuling in he coefficiens presened in Tables 1 and 2 did no reveal errors ha could be inerpreed as non-lineariies of he ype discussed here.