Misinformation About Capital Management

Topics: Stock market, Finance, Corporate finance Pages: 7 (2429 words) Published: November 28, 2014
Mercury Capital Analytics
Corporate Finance White Paper

Misinformation About Capital
Management and Value Creation

The quality of corporate financial
management has deteriorated generally
over the past few decades. Practitioners
have become so enamored of engineering
complex new investment instruments,
and legal structures, as well as with
accounting legerdemain, that attention
has been diverted from the theoretical
foundations which should help the
practitioner accomplish his most critical
function, viz. assist in maximizing the
Value of the Firm.
Part of the weakening of the practice of corporate financial management has to do with recent distortions in the data normally used in making such fundamental calculations as Weighted Average Cost of Capital. Another cause is the lack of uniformity in following the processes involved in such measurements. But another cause of concern is the


tendency to either ignore the fundamental tenets of the profession, or to demonstrate a puzzling ignorance of those tenets.
A Deloitte Global Services study, for instance, indicates that more than half of CFOs believe it will be easier for them to service debt in the near future. This suggests, perhaps, a lack of awareness of what is actually happening in the market for debt capital. The fact is that, globally, $11.5 trillion of debt will come due in the next five years, half of it in the U.S., and half of that in the financial services industry. This is one reason we see large stockpiles of cash, especially in the financial services industry. Over the same fiveyear period government debt is expected to increase annually by 9% to 11%. This means that the demand for debt capital will likely increase significantly, and, with it, interest rates. More of a concern than interest rates, however, will be capital availability itself. Many companies simply will not be able to find loans. It looks like many CFOs are going to be surprised.

More than half of CFOs believe it will be easier for them to service debt in the near future. This suggests, perhaps, a lack of awareness of what is actually happening in the market for debt capital.

This could make for a corporate “class war’ that will far outweigh anything politicians might stir up among voters. “Rich” companies, not facing much need for refinancing, will be able to take advantage of the desperation that many others will face as they place assets, and, in some cases, their entire business on the auction block. The statistics show that small companies are especially vulnerable in that most small company debt is noninvestment grade, and in the smaller companies tend to have lower credit ratings, size being a key variable in credit ratings.

Cost of Equity Capital will increase as well, as demand for it increases because of a dearth of debt capital, and, for those who find themselves desperate because of evidence to investors of less-than-prudent capital management in the past.

Smart capital management – it’s what Firm Value is all about. Ignorance and confusion regarding the nature of corporate growth and risk/return tradeoffs is not only common among those charged with growing Firm Value, or reviewing investment returns in view of related risks. Finance professionals and scholars also struggle to remain grounded in these principles. In an article in Bloomberg Businessweek, August 2010, a professor from the University of Virginia warned that growth strategies carry heavy risks. He writes, “The data show that consistent, aboveaverage growth is the exception, not the rule.” This is hardly a revelation worthy of the


academy. Above-average growth MUST be the exception. If it were the rule it couldn’t be ABOVE AVERAGE.
Forbes Magazine published an article in March 2011 about a “shocking” study by a team from Harvard, NYU, and a Boston asset management firm. The study showed that the performance of “most” high-risk stocks is worse than for low-risk stocks. The...
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