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Economic Value Added FIN 502: Managerial Finance

Economic Value Added FIN 502: Managerial Finance. George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University. How Value is Created. Management makes decisions, hopefully, with benefits exceeding costs Benefits may be near or distant future

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Economic Value Added FIN 502: Managerial Finance

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  1. Economic Value AddedFIN 502: Managerial Finance George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University

  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 Executive MBA Program

  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 Executive MBA Program

  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 be sustainable to be a true competitive advantage W. P. Carey Executive MBA Program

  5. Traditional Measures

  6. Fuzzy Finance W. P. Carey Executive MBA Program

  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 Measured relative to what? W. P. Carey Executive MBA Program

  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 Executive MBA Program

  9. EPS: Opiate of the Executive 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 Executive MBA Program

  10. EPS… • Accounting rules discourage EPS-manic mangers 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 Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  15. Cash Flows

  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 Executive MBA Program

  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 Executive MBA Program

  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 ... W. P. Carey Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  23. A Capital Budgeting Example Excellent NPV and IRR Accept the project! W. P. Carey Executive MBA Program

  24. NPV(Using FCF) Profile NPV of FCF = $125.86 Significant info revealed? W. P. Carey Executive MBA Program

  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 Executive MBA Program

  26. IRR Profiles(New Example) IRRATL =36.53% • IRRNE=19.63% W. P. Carey Executive MBA Program

  27. Conflicts: NPV & IRRWhich to Choose? NPV Marketing Campaign IRR = 16.35% Discount rate 10% 10.7% Product development IRR = 13.24% Select project with higher NPV (product development project) W. P. Carey Executive MBA Program

  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 Executive MBA Program

  29. Focused Finance & EVA

  30. Focused Finance W. P. Carey Executive MBA Program

  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 Executive MBA Program

  32. View of the Firm Market Valued Balance Sheet • 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. Assets Debt Equity W. P. Carey Executive MBA Program

  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 Executive MBA Program

  34. Market Value Added Market value added Premium Total market value Debt & equity capital Investment W. P. Carey Executive MBA Program

  35. Also, Market Value Added Expected improvement in EVA MVA = Present value of all future EVA • MVA Total market value Debt & equity capital Current level of EVA W. P. Carey Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  38. What is NOPAT? Net sales 150,000 Cost of sales 135,000 Depreciation 2,000 SG&A 7,000 Net Operating profit 6,000 Taxes @ 40% 2,400 NOPAT 3,600 Excludes financing charges W. P. Carey Executive MBA Program

  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 Executive MBA Program

  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 % equity where % debt + % equity = 100%. W. P. Carey Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  43. What’s Affecting EVA? Sales - Operating expenses - Taxes = NOPAT - Capital charge = EVA Market potential COGS, SG&A + other Potential gov’t actions Net working capital PP&E WACC Evaluate the many assumptions! W. P. Carey Executive MBA Program

  44. Forward Looking Relationship for EVA & MVA EVA EVA EVA EVA Year 1 Year 2 Year 3 .... Year n MVA MVA Market Value Market value EVA + EVA + EVA + ... + EVA 1 + r (1 + r)2 (1 + r)3 (1 + r)n = Capital Market value is based on establishing the economic 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. W. P. Carey Executive MBA Program

  45. EVA Drives MVA Companies that consistently earn profits in excess of their required return ... EVA NOPAT Charge … are typically valued at premiums to book value. MVA Market Value Capital W. P. Carey Executive MBA Program

  46. Fundamental Strategies Operate: Improve the return on existing operating capital Decrease: WACC Build: Invest as long as returns exceed the cost of capital Harvest: Re-deploy capital when returns fail to achieve the cost of capital. W. P. Carey Executive MBA Program

  47. An Example of Drivers W. P. Carey Executive MBA Program

  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 Executive MBA Program

  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 Executive MBA Program

  50. An Example Revisited(See Slides 27 & 28) EVA = NOPAT – WACC * Beginning Balance = 110 – 25% * 190 = 110 = 47.5 = 62.5 W. P. Carey Executive MBA Program

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