Economic Value AddedFIN 461: Financial Cases & Modeling
George W. GallingerAssociate Professor of FinanceW. P. Carey School of Business
Arizona State University
W. P. Carey School of Business Slide 2
How Value is Created
Management makes decisions, hopefully, with benefits exceeding costs Benefits may be near or distant future Costs should include direct investment
costs + cost of capital True source of value-enhancing projects
Firm’s comparative or competitive advantage.
W. P. Carey School of Business Slide 3
Comparative Advantage
Advantage one firm has over another in terms of Cost of producing or Distributing goods/services
Example: Wal-Mart invested in regional warehouses and
distribution system Reduces the need for retail inventory Replenish store inventory quickly.
W. P. Carey School of Business Slide 4
Competitive Advantage
Advantage one firm has over another because of structure of the markets in which they operate
Barriers to entry Patents Capital requirements Regulation
Influence over suppliers Influence over buyers
Must besustainable to be a truecompetitiveadvantage
W. P. Carey School of Business Slide 7
Return on Investment
Compare benefits (numerator) with resources (denominator) affecting that benefit Basic earning power ratio
EBIT / Total assets Return on assets
Net income / Total assets Return on equity
Net income / Book value of equity
Measuredrelativeto what?
W. P. Carey School of Business Slide 8
Pro’s & Con’s
Benefits of these ratios Ease of calculation & interpretation Decompose to reveal sources of changes
Downside of these ratios Sensitive to choice of accounting method Accumulation of monetary values from
different periods Backward looking Fail to consider risk.
W. P. Carey School of Business Slide 9
EPS: Opiate of theExecutive Suite
EPS is such an unreliable measure of value that managers often make “dumb” decisions to increase it
Prompts managers to misallocate capital Treats retained earnings as a free source
of capital Promotes retaining capital and using it
wastefully.
W. P. Carey School of Business Slide 10
EPS…
Accounting rules discourage EPS-manic managers from spending capital on value enhancing investments in intangibles like brands, research and training
Why? GAAP requires outlays to be written
off immediately against earnings.
W. P. Carey School of Business Slide 11
EPS…
EPS focus may cause management to refrain from issuing equity at times when the company really needs it
Fabricate EPS gains by using more debt than prudent Both on and off the balance sheet
Accept weak projects that happen to be financed with debt.
W. P. Carey School of Business Slide 12
EPS…
Earnings manipulation often used Establish reserves Invest pension funds in equities Extreme cases, make up numbers as
you go Worldcom and HealthSouth.
W. P. Carey School of Business Slide 13
EPS…
Today’s market perception:“Management that aims to boost earnings at the expense of quality will be more certainly penalized then ever before with a lower stock price and a sullied reputation.”
W. P. Carey School of Business Slide 14
Performance vs. Valuation
Performance measurement Relies on actual results
Historical GAAP vs. GAP
Valuation Relies on forecasts Stock price relies on investors’
expectations, not historical performance.
W. P. Carey School of Business Slide 16
Statement of Cash Flows
SCF combines balance sheet and income info Eliminates the “sins of accrual
accounting” SCF consists of:
Operating cash flows Investing cash flows Financing cash flows.
Free cash flow
W. P. Carey School of Business Slide 17
Cash Flow Not the Answer Cash flow has problems as a valid
performance measure So long as investments in projects earn
a return higher than shareholders could earn by investing on their own, then the more investment a company makes and the more negative its cash flow becomes, the higher its share price will be.
Think Wal-Mart.
W. P. Carey School of Business Slide 18
Better Than Some Alternatives
Accounting profits versus cash operating profits
Cash flow frequently defined as:
Net income + depreciation or as EBITDA
Poor definition
Quality of earnings ...
-500
0
500
1000
1500
2000
2500
3000
'97 '98 '99 '00 '01 '02
NI + depr.
NI
CFFO
W. P. Carey School of Business Slide 19
Free Cash Flows Definition:
After-tax operating earnings + non-cash charges - investments in operating working capital, PP&E and other assets
It doesn’t incorporate financing related cash flows
Represents cash flow available to service debt and equity.
When used in capital budgeting proposals Based on expectations.
W. P. Carey School of Business Slide 20
FCF & Capital Budgeting
FCF is the method of choice of most firms for evaluating capital budgets
Identify incremental Investment in PP&E + working capital Revenues Costs (excluding financing) Depreciation tax shields.
W. P. Carey School of Business Slide 21
Common Techniques
Evaluation techniques: Payback Accounting rate of return DCF analysis
Consists of NPV and IRR DCF analysis is not a problem in theory
Only in practice.
W. P. Carey School of Business Slide 22
NPV Methodology
Net present value (NPV) Estimate of change in the value of equity
if the firm invests in the project Forward looking
If NPV>0 Investment is expected to add value
If NPV<0 Investment is expected to erode value
Decision rule Invest in projects expected to enhance value.
W. P. Carey School of Business Slide 23
A Capital Budgeting ExamplePeriod NOPAT Deprec FCF
0 -2001 115 10 1252 110 10 1203 90 10 1004 70 10 805 60 10 706 40 10 507 30 10 408 20 10 309 15 10 2510 15 10 2511 15 10 2512 15 10 2513 15 10 2514 15 10 2515 15 10 2516 15 10 2517 15 10 2518 15 10 2519 15 10 2520 15 10 25
NPV $125.86IRR 50.4%
WACC 25%
Excellent NPV and IRRAccept the project!
W. P. Carey School of Business Slide 24
NPV(Using FCF) Profile
Free Cash Flow Profile
-250
-200
-150
-100
-50
0
50
100
150
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
NPV of FCF = $125.86
Significant info revealed?
W. P. Carey School of Business Slide 25
Internal Rate of Return
Practice is to compare IRR with weighted average cost of capital
Problem: IRR fails to measure scale or growth It sees no difference between earning
a 20% return on a $1 million investment or a $1 billion investment
These two projects are very different with distinctly different NPVs.
W. P. Carey School of Business Slide 26
IRR Profiles(New Example)
($700)
($500)
($300)
($100)
$100
$300
$500
$700
$900
$1,100
0% 16% 50%
IRRNE=19.63%
IRRATL =36.53%
•
W. P. Carey School of Business Slide 27
Conflicts: NPV & IRRWhich to Choose?
Discount rate
Marketing CampaignIRR = 16.35%
Product developmentIRR = 13.24%
10.7%10%
NPV
Select project with higher NPV (product development project)
W. P. Carey School of Business Slide 28
Value Enhanced?
Once a project is applied, the investment becomes buried in the balance sheet How is its contribution measured?
No idea whether project generates value Accounting measure relied upon
EBITDA and EPS generally increase Means Bonuses probably will be paid
Motivation: Get your hands on as much capital as
possible.
W. P. Carey School of Business Slide 31
EVA & Wealth Creation
Warren Buffet:We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.
Translation:Ultimate litmus test of any company’s success lies in increasing its market value by more than it increases its capital.
W. P. Carey School of Business Slide 32
View of the Firm
Value of firm = Value of debt + value of stock
Market value of a company reflects: Earning power of invested assets
Present value of current operations Present value of expected improvement in
operating performance.
Market Valued Balance Sheet
Assets DebtEquity
W. P. Carey School of Business Slide 33
What is Required to Focus? Tie performance methods to capital
budgeting techniques: Economic value added (EVA) Market value added (MVA)
Want to gauge management’s performance Focus on:
Decisions made in the past to help project the future.
Links to NPV
W. P. Carey School of Business Slide 34
Market Value Added
Total market value
Book valuedebt +equity
Marketvalue added
Investment
Premium
W. P. Carey School of Business Slide 35
Also, Market Value Added
Total market value
Bookvaluedebt +equity
Expectedimprovement in EVA
MVA
Current levelof EVA
MVA = Present value of all future EVA
W. P. Carey School of Business Slide 36
What is EVA?
EVA = Economic profit Not the same as accounting profit
Difference between revenues and costs Costs include not only expenses but also cost of capital
Economic profit adjusts for distortions caused by accounting methods
Doesn’t have to follow GAAP R&D, advertising, restructuring costs, ...
Cost of capital accounted for explicitly Rate of return required by suppliers of a firm’s debt
and equity capital Represents minimum acceptable return.
W. P. Carey School of Business Slide 37
Components of EVA
NOPLAT Net operating profit after tax
Operating capital Net operating working capital, net PP&E,
goodwill, and other operating assets Cost of capital
Weighted average cost of capital % Capital charge
Cost of capital % * operating capital Economic value added
NOPLAT less the capital charge.
W. P. Carey School of Business Slide 38
What is NOPAT?
Net sales 150,000Cost of sales 135,000Depreciation 2,000SG&A 7,000Net Operating profit 6,000Taxes @ 40% 2,400NOPAT 3,600
Excludes financing charges
W. P. Carey School of Business Slide 39
What is Operating Capital? Capital: Net operating assets adjusted
for certain accounting distortions Asset write-downs, restructuring charges, …
Net operating assets: Cash, receivables, inventory, prepaids Trade payable, accruals, deferred taxes Net property, plant, and equipment
Exclude non-operating assets: Marketable securities, investments,...
W. P. Carey School of Business Slide 40
What is Cost of Capital? Weighted average cost of capital consists of:
Cost of debt after taxes= Market interest rate x (1 – tax rate)
Cost of equity= Risk-free rate + beta x (market risk
premium)WACC
= Cost of debt after taxes x % debt + cost of equity x %
equitywhere % debt + % equity = 100%.
W. P. Carey School of Business Slide 41
What is the Capital Charge?
Represents a rental charge for the use of the operating capital
Minimum rate of return the operating capital should earn
Calculated as the firm’s weighted average cost of capital % x invested capital.
W. P. Carey School of Business Slide 42
Calculating EVA
NOPAT/Average capital
= Return on invested operating capital (ROIC)- Weight average cost of capital (WACC)
= Spread (= ROIC - WACC)* Operating capital
= Economic value added (EVA)
Net operating profit after tax (NOPAT)- Capital charge (= WACC * Capital)
= Economic value added (EVA)
W. P. Carey School of Business Slide 43
What’s Affecting EVA?
Sales- Operating expenses- Taxes
= NOPAT- Capital charge
= EVA
COGS, SG&A + other
Net working capitalPP&EWACC
Evaluate the many assumptions!
Potential gov’t actions
Market potential
W. P. Carey School of Business Slide 44
Forward Looking Relationship for EVA & MVA
EVA EVA EVA EVAYear 1 Year 2 Year 3 .... Year n
MarketValueMarketvalue
MVA
Bookvaluecapital
=EVA + EVA + EVA + ... + EVA1 + r (1 + r)2 (1 + r)3 (1 + r)n
Market value is based on establishing theeconomic investment made in the company(capital), making a best guess about what economic profits (EVA) will happen in the future, and discounting those EVAs to the present to get market value added.
MVA
W. P. Carey School of Business Slide 45
EVA Drives MVA
Companies that consistently earn profits in excess of their required
return ...NOPAT EVA
MarketValue
Capital
MVA
Charge
… are typically valued at premiums to book value.
W. P. Carey School of Business Slide 46
Fundamental Strategies
Capital * capital ofCost Capital
NOPATEVA
Operate: Improve thereturn on existingoperating capital Build: Invest as long as returns
exceed the cost of capital
Harvest: Re-deploy capital when returns fail to achieve the cost of capital.
Decrease: WACC
W. P. Carey School of Business Slide 48
Focus on EVA Improvement
A positive change in EVA is better than a positive yet unchanging base level of EVA Why?
Positive changes in EVA are consistent with “shareholder value added” -- whether from a positive or negative base
Positive changes in EVA are consistent with the managerial notion of continuous improvement in performance.
W. P. Carey School of Business Slide 49
Why Use EVA & Not NPV?
Present value of EVA = Present value of NPV
Provides insight into each period Is a direct link to performance More useful for future project
audits.
W. P. Carey School of Business Slide 50
An Example Revisited(See Slides 27 & 28)
Asset'sPeriod NOPAT Deprec FCF CapChg Balance EVA
0 -200 2001 115 10 125 50.0 190 65.02 110 10 120 47.5 180 62.53 90 10 100 45.0 170 45.04 70 10 80 42.5 160 27.55 60 10 70 40.0 150 20.06 40 10 50 37.5 140 2.57 30 10 40 35.0 130 -5.08 20 10 30 32.5 120 -12.59 15 10 25 30.0 110 -15.010 15 10 25 27.5 100 -12.511 15 10 25 25.0 90 -10.012 15 10 25 22.5 80 -7.513 15 10 25 20.0 70 -5.014 15 10 25 17.5 60 -2.515 15 10 25 15.0 50 0.016 15 10 25 12.5 40 2.517 15 10 25 10.0 30 5.018 15 10 25 7.5 20 7.519 15 10 25 5.0 10 10.020 15 10 25 2.5 0 12.5
NPV $125.86 $125.86IRR 50.4%
WACC 25%
EVA =NOPAT – WACC * Beginning Balance= 110 – 25% * 190= 110 = 47.5= 62.5
W. P. Carey School of Business Slide 51
NPV (Using FCF) & EVA Profiles
FCF vs. EVA
-250
-200
-150
-100
-50
0
50
100
150
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
FCF
EVA
NPV of FCF = NPV of EVA = $125.86
Significant info revealed?
W. P. Carey School of Business Slide 52
Real Life EVA The Manitowoc Co. in Manitowoc, Wis., a diversified food service, crane manufacturing
and marine operations company, outsourced a reverse-auction procurement system to a vendor instead of acquiring a software package itself. A comparison using Economic Value Added of buying vs. renting would look like this for the first year (hypothetical numbers):
In-house application $180,000 in net benefits - ($1 million capital investment x 12% cost of capital) = $60,000 EVA
Outsourced application $180,000 in net benefits - ($0 capital investment x 12% cost of capital) - $80,000 in rental fees = $100,000 EVA
Outsourced application requires no capital investment thus, no capital charge. Suppose the operating costs to run the system in-house were $50,000 per year.
Most companies only look at the income statement side of the ledger; they wouldn't outsource this application because it would be exchanging $50,000 of in-house expenses for the $80,000 rental fee, another kind of expense on the income statement. Yet on an EVA basis, the company would outsource the system, because doing so would produce more residual income ($100,000 vs. $60,000) by virtue of the $0 capital charge.
"When you are exposed to the EVA philosophy, you recognize how to better manage your capital," says Jim Pecquex, Manitowoc's CIO.
Source: Computerworld, February 17, 2003.
W. P. Carey School of Business Slide 53
Real Life EVA … Consider a recent EVA analysis that Robert Egan, vice president of IT at Boise
Cascade Corp., and his colleagues conducted for a storage investment. The decision was whether to keep storage assets or replace them with new technology that has lower maintenance charges.
The example is illustrative. Egan declined to provide real cost figures. The new storage technology costs $1 million, with maintenance costs of $100,000
per year. The maintenance expense on the old storage technology is $350,000. For simplicity, we'll assume that the new storage equipment offers no benefits other than
the lower maintenance costs. Boise's cost of capital is about 16%. Thus, the capital charge for investing in the
new storage is 16% x $1 million = $160,000, which EVA says must be added to the $100,000 maintenance costs to get the true cost.
The result: The total cost of the new storage is $260,000, vs. $350,000 for the old storage. "In this case, have you lowered the operating cost enough to make up for spending the
capital?" asks Egan. Yes -- $90,000 worth. Boise is constantly reminded of the obvious point that technology isn't free. The
company is also aware of the less obvious fact: neither is the capital to finance it. Source: Computerworld, February 17, 2003.
W. P. Carey School of Business Slide 55
Real Life: EVA & MVA
3-year changes in MVA explained byregression analysis
W. P. Carey School of Business Slide 56
Measure Earnings with EVA
Simple to explain and understand EPS (and NI) ignore cost of equity capital
EVA doesn’t Retained earnings no longer considered free
Benefits: Reduce cost of capital Improve operational efficiency Better management of assets Profitable growth.
W. P. Carey School of Business Slide 57
Custo m er Satis faction N ew P ro ducts
Vo lume M arketing
P roduct P ricing G row th
S a les
O verhead Co mpensation
Acco unt M anagem ent T ra ining & D evelo pm ent
M anufacturing Co sts
Operating E xpens es
Acqu isitions & D ivestitures W o rking Cap ita l M anagem ent
A lliances Acco unts R eceivab le
R & D D ecisio ns I nventory M anagem ent
C apita l C harge
Improvement in EVA
Manufacturing EVA DriversReduce inventoryReduce cycle time
Improve yieldsReduce scrap/waste
Maximize labor efficienciesImprove vendor efficiencies
Process improvements
Staff EVA DriversWork group/process simplification
Consistency “monitors” – auditCentralizing resources/synergies
Best practices benchmarkingInsourcing/outsourcing decisions
Simplify EVA measurements/reportingEnsure compliance with legislation
Manufacturing EVA DriversReduce inventoryReduce cycle time
Improve yieldsReduce scrap/waste
Maximize labor efficienciesImprove vendor efficiencies
Process improvements
Staff EVA DriversWork group/process simplification
Consistency “monitors” – auditCentralizing resources/synergies
Best practices benchmarkingInsourcing/outsourcing decisions
Simplify EVA measurements/reportingEnsure compliance with legislation
Research & Development EVA DriversImprove “to-market” process
Reduce R&D expenses as % of new product salesStrategic partners for R&D
Stronger links to product marketingNew products via:
- Research- Formulation
- Development-Acquisition
Marketing EVA DriversIncrease market share / revenue
New marketsMore focused channel programs
Voice of customer / consumerLeverage advertising / promotion
Build brand awareness
Research & Development EVA DriversImprove “to-market” process
Reduce R&D expenses as % of new product salesStrategic partners for R&D
Stronger links to product marketingNew products via:
- Research- Formulation
- Development-Acquisition
Marketing EVA DriversIncrease market share / revenue
New marketsMore focused channel programs
Voice of customer / consumerLeverage advertising / promotion
Build brand awareness