Shareholder Wealth Enhancement Through Outsourcing Strategies that Increase the Total Cost but Leave Revenues Unchanged

14 Pages Posted: 29 Oct 2013 Last revised: 18 Nov 2013

See all articles by R. Srinivasan

R. Srinivasan

Indian Institute of Management (IIMB), Bangalore - Finance & Control

Date Written: September 30, 2013

Abstract

This article focuses on outsourcing contracts which, while shifting internal processes and activities to an external party, substitute a fixed cost by a variable cost. Given this, the standard Capital Asset Pricing Model of finance theory is used to show that some of these outsourcing contracts may enhance a firm’s value despite increasing the total cost, while leaving revenues unchanged. This is because the substitution of fixed by variable cost reduces risk, as captured by the CAPM beta, and hence lowers the cost of capital used in the valuation of the firm. The article first derives value elasticity (the percentage change in firm value to the percentage change in fixed cost) for an outsourcing contract that displaces fixed cost by variable cost on a one-on-one basis, and shows that such a total cost preserving substitution of fixed by variable cost will always increase the value of the firm. Subsequently, the article shows that for a given reduction in fixed cost, the variable cost can be increased by an iso-value factor α greater that unity (this implies that the total cost will increase) such that the firm value is unchanged. Any contractual arrangement by which the variable cost increase lies between unity and α will therefore, despite an increase in the total cost, always result in an increase in firm value. This has important implications for firms that outsource, and for vendors, while designing and negotiating an outsourcing contract.

Keywords: CAPM, Valuation, Outsourcing

Suggested Citation

Srinivasan, Raghavan, Shareholder Wealth Enhancement Through Outsourcing Strategies that Increase the Total Cost but Leave Revenues Unchanged (September 30, 2013). IIM Bangalore Research Paper No. 424, Available at SSRN: https://ssrn.com/abstract=2346087 or http://dx.doi.org/10.2139/ssrn.2346087

Raghavan Srinivasan (Contact Author)

Indian Institute of Management (IIMB), Bangalore - Finance & Control ( email )

Bannerghatta Road
Bangalore, 560 076
India

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