Why managers – now more than ever – need to understand corporate finance

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A solid business strategy is not about shareholders versus stakeholders, but about holistic value creation versus narrow value creation.

With the recent re-intensification of shareholder versus stakeholder debate, the concept of value creation has become more ambiguous. On whose behalf should organizations generate value? For owners, employees, upstream and downstream partners or local communities immediately affected by organizational activities?

Shareholders and stakeholders have strong demands. Financial managers are understandably obsessed with stock price as an index of market value. A stubbornly crashing stock price means the loss of real wealth for the owners of the business and a reduced ability to attract capital to fund the business’s operations. Without some form of social capital, a business cannot survive.

At the same time, the increasingly urgent global war for talent is raising the stakes for companies that pursue narrow financial goals at the expense of employees. Additionally, customers and civil society groups have a stronger voice than in the past, thanks to social media and other online tools allowing the remote masses to mobilize quickly and effectively.

Yet pleasing external stakeholders is no guarantee of success. Consider Saturn Corporation, a subsidiary of General Motors founded in 1985 with the goal of creating “a different kind of car” that could keep pace with nimble foreign competitors. Throughout the 1990s, Saturn was consistently rated highest for customer satisfaction. Employees were so happy with their working conditions that they rejected their international union’s standard contract. To crown it all, Saturns flew out of the lot; in 1995, there were only 400 unsold from the previous year. But all that endorsement couldn’t make up for the US$6 billion spent by GM to develop, manufacture and market the Saturn. The brand never really had a chance, due to poor financial management from day one.

It is therefore ironic that so much ink has been spilled on a putative shareholder/stakeholder divide at a time when this divide has never been so tenuous. Indeed, evidence shows that businesses that delight customers and employees also generate value for their owners. In all sectors, companies at the top FortuneRanking of the most admired companies of 2019 – criteria include innovation, quality of management, social responsibility and ability to attract talent – ​​have significantly exceeded S&P 500 averages over the past ten years. The least admired companies on Fortune‘s list has produced negative returns for their owners over the same ten-year period.

What does all this mean? Sound financial management goes beyond short-term stock price increases and cost control. This implies a holistic approach encompassing all relevant stakeholders. And given today’s enormous business challenges – environmental issues, equality and diversity concerns, and growing dissatisfaction with capitalism are just a few – I would say that the leaders of companies need to understand corporate finance more than ever.

Basics of corporate finance

Giving managers the basics of corporate finance is the purpose of the manual that I co-wrote with the late Claude Viallet, Finance for leaders: managing to create value, now in its sixth edition. As we describe in the book, making optimal financial decisions for your business can be a complicated art, but the basic premise is as simple as it gets. Ultimately, it’s only about two numbers: the cost of capital (i.e., how much it costs to finance your company’s investments) and the return on those investments. The extent to which this latter number outrun the first is the key to value creation in the form of increased business value. If, however, the return on investment is consistently inferior than the cost of capital (as happened with Saturn), value is destroyed and the value of the business drops. The concept is quite simple, but you’d be surprised how many smart, experienced managers take it for granted when it’s explained to them.

Where the complexity comes in, of course, is that the cost of capital is not always easy to calculate. It is made up of the average of two components: the cost of debt capital (borrowed money) and the cost of equity capital (money invested by the owners in the business). The first is usually not difficult to estimate. If your business has gone into debt, the interest rate on the loan(s) is essentially the cost of your business’s debt. Determining the cost of equity is the hard part. It is the return – either dividends or a rise in the share price – that shareholders demand in return for the investments they have made in the company. This is a risk-based calculation because the more risk investors are exposed to, the higher the return on investment they expect. As such, any change in business conditions (inside or outside the business) that increases or decreases risk will also affect the cost of equity, requiring this cost to be continually reviewed.

Managers who are familiar with the different business finance models will be better able to not only dialogue with the CFO to determine the cost of capital, but also work with them to create a system that follows its fluctuations in the future. For the CFO, the main challenge becomes to structure the finances of the company in order to minimize the cost of capital. From a value creation perspective, this can be as impactful as the usual managerial concern with minimizing the cost of operations – e.g., supply chain, labor costs, etc.

When managers master the principles of corporate finance, they are plugged into the primary source of value creation, rather than its secondary, often distorted reports, such as quarterly sales figures and short-term earnings. They can then make smart decisions with confidence about the likely outcomes for all stakeholders as well as the company’s financial outlook. This capability gives managers the strategic flexibility they need to respond effectively to our increasingly unpredictable world.

The original version of this post can be found at Cengage Unstoppable minds Blog.

Gabriel Hawawini is Professor of Finance at INSEAD and former Dean of INSEAD from 2000 to 2006. Professor Hawawini led the school’s expansion from Europe to Asia with the opening of the INSEAD Asia campus in Singapore in 2000. He is the author of The internationalization of higher education and business schools: a critical assessment.

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