A Shareholder Value and Agency Theory Based Compensation System

TABLE OF CONTENTS III

Table of Contents

TABLE OF CONTENTS................................................................................................. III

TABLE OF FIGURES....................................................................................................... V

LIST OF TABLES ............................................................................................................. V

  FREQUENTLY USED SYMBOLS  VI

1  INTRODUCTION 1  INTRODUCTION.......................................................................................................1

2  RATIONALE FOR THE SHAREHOLDER VALUE APPROACH 3  

2.1  VALUE-BASED MANAGEMENT 4  

2.1.1  Shareholder versus Management Interests 5  

2.1.2  The Relation to other Stakeholders 6  

2.2  SHORTCOMINGS OF ACCOUNTING NUMBERS 7  

2.2.1  Unreliable Performance Measurement Earnings 8  

2.2.1.1  LIFO versus FIFO 8  

2.2.1.2  The Amortization of Goodwill 9  

2.2.1.3  Time Value of Money 10  

2.2.2  Return on Investment (ROI) and Return on Equity (ROE) 12  

2.2.3  Long-term  View...........................................................................................14

2.2.4  Intellectual Capital 15  

3  SHAREHOLDER VALUE ANALYSIS METHODS 17  

3.1  RAPPAPORT S FRAMEWORK FOR VALUE CREATION 17  

3.1.1  The Estimation of the Cash Flow 18  

3.1.2  Cost of Capital 19  

3.1.2.1  Cost of Equity 20  

3.1.2.1.1  The Risk-Free Rate 21  

3.1.2.1.2  The Market-Risk Premium 22  

3.1.2.1.3  Estimating the Systematic Risk 24  

3.1.2.2  Cost of Debt 25  

3.1.3  Residual Value 26  

3.1.4  Rappaport s Shareholder Value Network 29  

3.2  COPELAND KOLLER AND MURRIN APPROACH (MCKINSEY) 31  

  ECONOMIC VALUE ADDED (EVA ) 34  

  3.3  

TABLE OF CONTENTS IV

4  ASSESSMENT OF THE SHAREHOLDER VALUE ANALYSIS METHODS  38

4.1  SIMILARITIES DISTINCTIONS 38  

4.2  PROBLEMATIC ISSUES 41  

4.2.1  Information Deficits 41  

4.2.2  Hockey-Stick Effect 43  

4.2.3  Compound Problem 45  

4.2.4  Manipulation Problem 45  

5  PERFORMANCE EVALUATION AND COMPENSATION SYSTEMS 47  

5.1  AGENCY THEORY OVERVIEW 48  

5.2  PRINCIPAL-AGENT CONFLICTS 50  

5.2.1  Adverse Selection 51  

5.2.2  Moral Hazard 52  

5.2.3  The Horizon Problem 54  

5.2.4  Risk Differential Behavior 55  

5.3  COMPENSATION SYSTEMS 57  

5.3.1  Recent Research 58  

5.3.2  Performance Measurement 59  

5.3.3  Stock Options 60  

5.3.3.1  Rewarding Outperformance 61  

5.3.3.2  Including Operating Units and Setting Targets 62  

5.4  E-BUSINESS: A PARADIGM FOR INNOVATIVE PERFORMANCE DRIVEN  

  COMPENSATION SYSTEMS 65  

6  PROSPECT AND DEVELOPMENT 67  

7  CONCLUSION 68  

  REFERENCES..................................................................................................................70  

  A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM  V

Table of Figures

  FIGURE 1: EPS GROWTH IS A POOR PREDICTOR FOR SHAREHOLDER VALUE 11  

  FIGURE 2: SECURITY MARKET LINE (SML) 25  

  FIGURE 3: THE WEIGHTED AVERAGE COST OF CAPITAL (WA)CC 26  

  FIGURE 4: THE SHAREHOLDER VALUE NETWORK 30  

  FIGURE 5: COMPARISON OF TOTAL VALUE DISTRIBUTION BASED ON DIFFERENT FORECAST  

  PERIODS  33

  FIGURE 6: HOCKEY-STICK EFFECT 44  

  FIGURE 7: AGENCY PROBLEMS 57  

  FIGURE 8: COMPENSATION SYSTEM IN COMBINATION WITH THE SHAREHOLDER  VALUE

  NETWORK  59

  FIGURE 9: HOLISTIC COMPENSATION SYSTEM 64  

List of Tables

TABLE 1:  ELEMENTS OF THE SHAREHOLDER VALUE METHODS 38  

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM VI

Frequently Used Symbols

APT Arbitrage pricing theory

b i Beta coefficient

CAPM Capital Asset Pricing Model

CF Cash flow, CF t is the cash flow in period t

DCF Discounted cash flow

Dividend, DIV t is Dividend in the t th period

DIV

EPS Earnings per share

ERP Enterprise resource planning

EVA ®

Economic value added

FCF Free cash flow

FIFO First in, first out

g expected growth rate in dividends as predicted by a marginal investor

IRR Internal rate of return

k Discount rate, rate of return, cost of capital, or required return

k E Cost of common equity

k D Cost of debt

k D(PT) Cost of debt (pretax)

k i Required rate of return on a stock

k ˆ

Expected rate of return on a stock

i

Risk-free rate of return

k RF

Required rate of return on a portfolio consisting of all stocks

k M

LIFO Last in, first out

M/B Market-to-book ratio

MVA Market value added

NOPAT Net operating profit after taxes

NOPLAT Net operating profit less adjusted taxes

NPV Net present value

ˆ

P Price of the stock in period 0

0

R&D Research and development

P/E Price/earnings ratio

ROI Return on investments

ROE Return on equity

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM VII

SHRM Strategic human resource management

SML Security market line

SVA Shareholder value added

T Tax rate

t time

VBM Value-based management

WACC Weighted average cost of capital

Percentage of common equity in the capital structure, at market value w E

Percentage of debt in the capital structure, at market value w D

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 1

1 Introduction

“The fundamental goal of all business is to maximize shareholder value.” 1 This statement

has become commonplace not only in corporate America, but it is also the imperative statement of business around the world. A failure to seek to maximize shareholder value results in pressure from the board of directors and activist shareholders. The takeover movement of the latter half of the 1980s provided another powerful incentive for managers to focus on creating value. This is grounded on the fact that the only compelling takeover defense is to deliver superior shareholder value.

Given the globalization of capital markets and their diminishing boundaries, economic systems will slowly run out of capital, if they are unable to create shareholder wealth and thereby attract investors. If economic systems are unable to provide superior or at least satisfying returns they will fall further and further behind in global competition and will lose employment opportunities. Thus, a value-based system grows in importance as capital becomes more mobile.

Although shareholder value metrics and value-based management are widely known they are far from being universally applied. Years of restructuring and employee layoffs frequently attributed to shareholder value considerations coupled with self-interested management and shortsighted focus on current stock price has promoted frustration and

uncertainty. 2 Thus, it is critical to fully understand the shareholder value approach and its

variants. Additionally, it is vital for the shareholder value approach that the objectives of the mangers and the company’s shareholders are aligned and focused on delivering superior shareholder value. The relationship between manager and stockholder can best be examined by the agency theory that studies the contract between agents (e.g. managers)

and principals (e.g. stockholders). 3 An overview of a holistic shareholder value and

agency based compensation system is the topic of this paper.

Based on the above discussion this paper first introduces the shortcomings of traditional accounting numbers and reveals the need for a more reliable measure: shareholder value. The third chapter then explains the shareholder value approach and three key methods are introduced: Rappaport’s shareholder value added (SVA), Copeland, Koller and Murrin’s

1 Copeland, T.E. (1994), p 97.

2 Wiseman, R. M./Gomez-Mejia, L. R. (1998), p. 133.

3 Rappaport, A. (1998), p. 3.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 2

total shareholder value, and Stern and Stewart’s economic value added (EVA). The following section reveals the major differences, respectively similarities of these methods in the areas of determination of the relevant cash flow and the cost of capital as well as the calculation of the residual value. Moreover, it indicates problems of which the manger should be aware of when applying shareholder value measurements. Chapter 5 introduces the agency theory with its central problems. These problems, which are responsible for the occurrence of agency costs, will be explained in detail. Based on those findings a compensation system grounded on the two established theories and a holistic compensation approach is introduced. Finally, E-business compensation packages, which seems to be the paradigm for innovative compensation systems, are touched upon briefly. The last two sections provide ideas for future research objectives and also summarize and conclude the paper.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 3

2 Rationale for the Shareholder Value Approach

The idea that management’s focus and responsibility is to increase value has gained

widespread acceptance. 4 The discussion of shareholder value and its creation first gained

prominence with the publication in 1986 of Creating Shareholder Value by the U.S.

academic Alfred Rappaport. 5 Although shareholder value orientation is commonplace in

most businesses it is still a high-decibel debate whether the manager’s sole focus should be to increase the firm’s value. A common criticism touching shareholder value is often the misunderstanding that a value-based strategy disregards the other stakeholder of the

company. 6 Another often articulated demur is that a strict shareholder value orientation might lead toward a short-term focus of business strategies. 7 Proponents of this “balanced

Stakeholders” approach point out the very high standards of living and rapid economic

growth in Europe and Japan to support their view. 8

However, the evidence against these arguments – and in favor of value-based shareholder

wealth maximization – is mounting. 9 Thus this chapter describes cornerstones of a value-

based management (VBM) and will provide evidence that it will lead to greater increases in shareholder wealth. In other words, even in an increasingly competitive world, shareholder value maximization will grant benefits for all stakeholders due to the fact that

there is no evidence of any conflict between shareholders and other interest groups. 10

These other groups also include the management of the company, which may have in some situations different objectives than the shareholders of the company. To prevent the company from such kinds of potential interest conflicts it is essential to put performance tied compensation systems in place, which will not only lead to better performance of the employees, but also will lower the need for performance and decision control mechanism installed by the stockholders of the company.

Furthermore this chapter discusses why the classical accounting numbers must fail to measure changes in the economic value of companies because alternative accounting

4 Rappaport, A. (1998), p. 1.

5 Black, A./Wright, P./Bachman, J. E./Davies, J. (1998), p. 22 and Kay, H. (1991), p 71.

6 Copeland, T. E./Koller, T. M./Murrin, J. (1995), p. 22.

7 Copeland, T.E. (1994), p 97.

8 Rappaport, A. (1998), p. 5. and Copeland, T.E. (1994), p 97.

9 Copeland, T.E. (1994), p 97.

10 Copeland, T. E./Koller, T. M./Murrin, J. (1995), p. 4.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 4

measures are employed, investments (e.g. R&D) are not fully incorporated, and the time value of money and risk are ignored. 11

2.1 Value-Based Management

Recent years have seen a plethora of “new” management approaches for increasing a

firm’s performance: kaizen (a Japanese continuous improvement management technique),

total quality management, flat organizations, business reengineering, empowerment and so on. Many of them have succeeded – but quite a few have failed. 12 In most cases, the

failures have been due to a lack of clear performance targets or the new management

approaches were not properly aligned with the ultimate goal of creating shareholder value. 13 VBM tackles this problem head on. It provides all members of the organization

with a precise and unambiguous metric – value – upon which an entire strategic management can be built. 14

VBM is very different from other management planning systems. It is not solely a staff-

driven exercise. It focuses on better decision and strategic planning at all levels in an organization and closes the gap between strategy and its implementation. 15 It recognizes

that top-down command-and-control style decision-making cannot work well, particularly in large transnational operating companies. 16 Accordingly, frontline managers must learn

to understand value-based performance metrics for making better decisions.

Nevertheless, value-based management is not without pitfalls. It can become a staff-

captured exercise which has no impact on the operating managers at the frontline or on the decisions they make. 17 Thus, VBM must be an integrative process designed to improve

strategic and operational decision-making throughout the entire organization by focusing on the key drivers of corporate value. 18 In essence, value-based management can best be

understood as a decision-guiding tool which should combine a value creation mindset with

the management processes and systems that are necessary to translate that mindset into a

value increasing actions.

11 Stewart, G. B. (1991), p 21ff and Ehrbar, A. (1998) p. 67ff.

12 Koller, T. M. (1994), p. 87.

13 Copeland, T. E./Koller, T. M./Murrin, J. (1995) , p. 96.

14 Koller, T. M. (1994), p. 87.

15 Black, A./Wright, P./Bachman, J. E./Davies, J. (1998), p. 100 16 Copeland, T. E./Koller, T. M./Murrin, J. (1995) , p. 93.

17 Koller, T. M. (1994), p. 87 18 Henry, J. (2000), p. 132.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 5

The key is the value creation mindset, which ensures that members of the firm’s board are clear among themselves that their ultimate goal is to maximize the firm’s value. Furthermore, they have to understand which performance variables drive the shareholder value of the company. 19 This understanding is essential for managers since they have to

develop and implement a strategy which focuses on these key performance variables. Value-based management analytical tools, such as DCF valuation and value driver analysis, provide the managers with the needed tools to make value-increasing decisions. 20

However, the understanding of this system alone is not enough to ensure that the shareholder value will increase. Moreover, it becomes crucial for the success of the value creation mindset that a management process and system is implemented likewise. This system should encourage managers and other employees to behave in a way that maximizes the value of the organization. An increasingly important factor to support the system is to implement a performance linked compensation system, which uses appropriate measures to evaluate the performance of the company and hence the performance of the employees. 21

2.1.1 Shareholder versus Management Interests

As previously mentioned, potential conflicts between shareholders and managers may arise due to different objectives of these groups. Managers, like other people, usually act in their own interest and are risk averse. 22 The theory of the market economy is based on

individuals promoting their self-interests reflected in market transactions to bring about an efficient allocation of resources. In a world in which principals (e.g. stockholders) have imperfect control over their agents (e.g. managers), these agents may not always engage in transactions solely in the best interests of the principals. Agents have their very own purposes and it may sometimes pay them to sacrifice the principals’ interests. 23 There are,

however, several factors that induce management to act more like a shareholder of the company. These factors derive from the fundamental premise that the greater the expected unfavorable consequences to the manager who destroys shareholder value, the less likely it is that the manager will act to the disadvantage of the stockholders. 24

19 Copeland, T. E./Koller, T. M./Murrin, J. (1995) , p. 98.

20 Francis, G./Minchington, C. (2000), p. 46.

21 Serven, L. (1999), p. 13.

22 Welbourne, T. M./Cyr, L. A. (1999), p. 438.

23 Wiseman, R. M./Gomez-Mejia, L. R. (1998), p. 133.

24 Barkema, H. G./Gomez-Mejia, L. R. (1998), p. 137.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 6

According to the above premise shareholders have to create an environment, which will induce value increasing behavior of the managers. To ensure that the management adopts a value increasing behavior a value creation mindset should be communicated to the executives. This value creation mindset consists of two key factors: compensation tied to

increasing shareholder value and a relatively large ownership position for the manager. 25

Along with these factors takeover threat by another organization and the fact that there is competition in the labor market should also induce corporate managers to adopt a shareholder value orientation. Further insight in these issues will be provided in section 5.

2.1.2 The Relation to other Stakeholders

A commonplace myth is that shareholder value orientation leads to conflicts with the

strategic interests of other stakeholders of the company. 26

Since the 1960s environmentalists, social activists, and consumer advocates argued that firms should be socially responsible, serving the public interest and not only the shareholders’ interests. In the 1990s corporate governance discussions focused more on balancing the interests of all

stakeholders. 27 While corporate social responsibility and stakeholder objectives may

sometimes embrace different issues, each calls for the corporation to fulfill purposes beyond the shareholder wealth maximization.

However, managers certainly have to be socially responsible, which may even lead to an

increase in shareholder wealth. 28 This value-based approach recognizes that the

requirements of the stakeholders can only be met if the company is competitive enough to survive. This view further recognizes that a firm’s long-term destiny heavily depends on a financial relationship with each stakeholder: employees seeking competitive wages, customers demanding high-quality products and competitive prices, and suppliers wanting payment of their financial claims. Management must generate enough cash flow by operating its business efficiently to setting such claims. Analyzing these requirements show the need for generating long-term cash inflows, which is again the heart of the shareholder value approach.

Consequently, a value-creating company benefits not only its stockholders but, the value of all stakeholders: while all stakeholders are vulnerable when management fails to create

25 Rappaport, A. (1998), p. 5.

26 Copeland, T. E./Koller, T. M./Murrin, J. (1995) , p. 22.

27 Mahoney, R. J. (2000), p. 1.

28 Rappaport, A. (1998), p. 7.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 7

value. Juergen E. Schrempp, currently COE of Daimler Chrysler, summed this view up

as: “Was den Aktionaeren nuetzt, traegt auch den Anspruechen anderer gesellschaftlicher Gruppen Rechnung.” 29 Thus, self-interest dictates every stakeholder to actively engage in

a partnership of value creation to serve each other’s overall goal of value maximization.

2.2 Shortcomings of Accounting Numbers

In both corporate reports and the financial press, there is an extreme focus on earnings per share (EPS) as the scorecard for corporate performance. 30 The traditional accounting

models of valuation are based on quarterly and annual earnings reported in leading financial publications such as “Wall Street Journal.” 31 Hence, financial analyst,

respectively the market, sets share prices by evaluating a firm’s growth opportunities equating its price/earnings ratio (P/E ratio) to the growth rate of earnings. 32 If, for

example, a company usually sells at 10 times earnings, and earnings per share (EPS) is

now $1, the accounting model would predict a $10 share price. However, if earnings fall to $0.80 per share, then the company’s shares are expected to fall to $8. 33 Thus, the price

of the firm’s stock is influenced by the broad dissemination of accounting earnings figures

and therefore strongly influenced, if not totally determined by the volatility of its earnings. 34 It is frequently assumed that if a company produces “satisfactory” growth in

EPS, then the market capitalization of its shares will increase. 35

Although EPS is useful for some situations, its simplicity and apparent precision allows managers to ignore other important factors that affect the value of a company. 36 EPS

growth does not necessarily lead to an increase in the market value of the shares. 37 It

might be that managers’ decisions’ destroy value in the long-term, often without increasing the short-term stock price. 38 This conclusion can be supported by simple

economic reasoning and can be convincingly demonstrated empirically as well. This

discussion of problems when using accounting numbers as performance measurement will

be followed by an enumeration of the shortcomings of the return on investment (ROI) and

29 Schrempp, J. E. quoted from Bea, F. X. (1997), p. 543.

30 Black, A./Wright, P./Bachman, J. E./Davies, J. (1998), p. 12. and McClenahen, J. S. (1998), p. 63. 31 Rappaprt, A. (1998), p. 13.

32 Christofi, A. C./Christofi, P. C./Lori, M./Moliver, D. M. (1999), p. 38.

33 Stewart, G. B. (1991), p. 22 34 Rappaport, A. (1998), p. 13 and Christofi, A. C./Christofi, P. C./Lori, M./Moliver, D. M. (1999), p. 38. 35 Copeland, T. E./Koller, T. M./Murrin, J. (1995) , p. 69.

36 Stewart, G. B. (1991), p. 22 37 Kay, H. (1991), p. 71.

38 Ehrbar, A. (1998) p. 41.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 8

return on equity (ROE) known as cornerstones for measuring business performance. Finally, problems to evaluate intellectual capital with accounting numbers will be introduced.

2.2.1 Unreliable Performance Measurement – Earnings

As previously established, providing the maximum return for shareholders is the fundamental goal of any business. Shareholder return is generated by dividends and

increases in share price. 39 The issue is whether accounting earnings assess strategic

options and measure performance consistent with the goal of the corporation. Stated more concretely, the issue is whether earnings can reliably measure the change in the present

value of the company. 40 In fact, there are several important reasons why earnings fail to measure changes in the market value of the firm: 41

• They are heavily dependent on accounting methods.

• The amortization of goodwill.

• Time value of the money is ignored.

2.2.1.1 LIFO versus FIFO

In times of rising prices the last in, first out (LIFO) inventory method results in lower earnings than the first in, first out (FIFO) method, because the costs of goods sold is based

on the more recent higher costs. 42 This is followed by lower tax payments and more cash

accumulation. A number of researchers have looked at how stock price is related to accounting methods. The accounting model implies that switching from FIFO to LIFO

should result in a lower share price due to decreased earnings. 43

Although the evidence is not entirely conclusive, Professor Shyam Sunder demonstrated that companies switching to LIFO experienced on average a 5% increase in market

capitalization on the date the change was announced. 44 Investors realized that LIFO

would be followed by lower earnings per share, but on the other hand they also knew that

39 Brigham, E.E./Gapenski, L. C./Ehrhardt, M. C. (1999), p. 13.

40 Stewart, G. B. (1991), p. 24.

41 Rappaport, A. (1998), p. 14 and Attaway, M. C. (2000), p. 78.

42 Stewart, G. B. (1991), p. 24.

43 Rappaport, A. (1998), p. 14.

44 Ehrbar, A. (1998), p. 71.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 9

the tax savings represent a real improvement in future cash flow for stockholders, and that is what the discounted cash flow model (DCF) predicts. 45 Analysis by a second group of

researchers revealed that the increase in the share price mirrored a direct proportion to the present value of the taxes saved by making the switch. These studies provide strong evidence that stock prices are significantly influenced by cash generation, not book earnings. 46

These findings also prove that a company adopting LIFO will sell for a higher multiple of its earnings than if it used FIFO. The increased multiple is consistent with the increased quality of LIFO earnings; inventory-holding gains are purged from income, and there are also tax savings. 47

However, as this research implies, a company’s share price depends on the quality as well as the quantity of its earnings, then the accounting model of value fails. The model fails because a company’s P/E multiple is not a primary cause of its stock price: it is a result of it. 48 It is therefore not possible for the accounting model to answer the question: What

determines a company’s stock price?

2.2.1.2 The Amortization of Goodwill

When the purchase method is utilized to account for an acquisition, any premium paid over the “fair value” of the seller’s assets is goodwill. Hence, goodwill can be defined as the difference between the price paid for an acquired company and the “fair value” of its assets in transactions using the purchase method of accounting. Acquirers are forced to write off the goodwill, and amortized against earnings over a period not to exceed 40 years. 49 Because goodwill is a non-cash, non-tax-deductible expense, the amortization per

se is of no impact in the economic model of valuation. However, in the accounting framework, amortization reduces reported earnings. 50

A survey on this subject by the faculty of Lehigh University revealed that the specter of

goodwill write-offs affect the behavior of some acquirers. This behavior usually reduces prices paid for businesses. Many companies apparently are willing to pay higher

45 Copeland, T. E./Koller, T. M./Murrin, J. (1995), p. 83.

46 Stewart, G. B. (1991), p. 24.

47 Ehrbar, A. (1998) p. 71.

48 Pratt, S. P. (1998), p. 182.

49 Ehrbar, A. (1998) p. 71.

50 Stewart, G. B. (1991), p. 25.

A SHAREHOLDER VALUE AND AGENCY THEORY BASED COMPENSATION SYSTEM 10

acquisition premiums to treat business purchases as poolings of interests, an accounting method that does not increase the goodwill. The result of this method is that the stocks of those companies underperform the stocks of those acquirers that utilize purchase accounting. 51

2.2.1.3 Time Value of Money

Another reason that leads to failures when using earnings to measure changes in economic value is that the earnings method ignores the time value of money. The economic value of an investment is the sum of anticipated future cash flows. The idea behind this financial calculation is merely that a dollar received today is worth more than a dollar received a year from now. One reason for that is potential inflation. Even more important is the fact that this dollar can be reinvested to earn money over the subsequent year. 52 The discount

utilized to estimate the net present value of an investment includes, therefore, compensation for bearing risk and for expected rates of inflation. The procedure for estimating the appropriate discount rate will be explained in chapter 3.

Taking these fundamental differences between the calculation of accounting earnings and economic value into account, the accounting earnings do not necessarily lead to the creation of economic value for shareholders. 53 Shareholder value will increase only if the

firm earns a greater rate of return on new investments than a potential investor can expect to earn by investing in alternative, equally risky, securities. 54 Earnings growth, on the

other hand, can be observed in a company not only when management is investing at or above the cost of capital, but also if the company is investing below the cost of capital and thereby decreasing the value of common stock. 55

In summary, an increase in earnings does not necessarily imply a rise to the corresponding shareholder value and vice versa. This is demonstrated by the fact that earnings do not reflect the firm’s level of business and financial risk, nor the change in working capital or fixed investment needed for anticipated growth. In addition, earnings are affected by a wide variety of accounting principles governing the allocation of costs to current as well

51 Ehrbar, A. (1998) p. 71.

52 Rappaport, A. (1998), p. 18.

53 Copeland, T. E./Koller, T. M./Murrin, J. (1995), p. 76.

54 Cooney, J. (1998), p. 69.

55 Bown, J. (1999), p. 44.