The value of any stock, bond or business today is determined by the cash inflows or outflows – discounted by an appropriate discount rate – that can be expected to occur during the remaining life of an asset.  Warren Buffett, Berkshire Hathaway Annual Report (1992).
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The value of any stock, bond or business today is determined by
the cash inflows or outflows – discounted by an appropriate
discount rate – that can be expected to occur during the
remaining life of an asset.
 Warren Buffett, Berkshire Hathaway Annual Report (1992)
The Evolution of Value Based Management
Basic Notion
Firm value = PV (future free cash flows).
Strategic Value Analysis
LEK / Alcar
Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)
EVA
Stern Stewart & Co.
Firm value = ΣPV t (EVA t ) + Invested Capital.
CVA
BCG and HOLT Value Associates
Firm value = ΣPV t (CVA t ) + Invested Capital.
Free Cash Flow Approach
Firm’s FCF = Financing or Investors’ cash flow
Firm’s perspective
Investor’s perspective
EBITDA
– cash tax payments
– incremental investment
in operating assets
FCF = The amount received
by investors
interest payment to creditors
+ repayment of debt principal
 additional debt issued
+ dividends
+ share repurchases
 additional stock issued
Financing cash flow
Free Cash Flow& Firm valuation
Value of
Nonoperating assets
Firm
Value
Present value of
free cash flow
=
＋
 Marketable securities
 Excess real state
 Over funded pension plan
Firm
Value
=
Future claim
＋
Shareholder value
 Interestbearing debt
 Capital lease obligations
 Under funded pension plan
 Contingent liabilities
Through value drivers, we can analyze how to improve to firm’s FCF.
Free Cash Flow Approach
Free cash flow and firm’s valuation
Forecasting Free Cash Flow
Case： Ashley Corporation
Value driver assumptions
Residual
period
begins
Free Cash Flow Calculations
Sales of prior year=＄240,000
Year 1 =(1+Sales growth rate) × Prior year sales
= (1+0.08) ×＄240,000=259,200
Incremental asset investment in year t =
( Sales in year t – Sales in year t1) × Assettosales percent
Year1
Net working capital=(＄259,200＄240,000) ×5.5％=＄1,056
Fixed assets=(＄259,200＄240,000) ×40％=＄7,680
Other long term assets= =(＄259,200＄240,000) ×2％=＄384
Determining the Discount Rate
Weighted cost of capital
【Cost of debt×(1Tax rate) ×Debt/Firm Value】
7.68％×(10.27)=5.61％
＋【Cost of equity × Equity/Firm value】
risk free rate+ company beta × market premium
6％＋(1.35×8％)=16.8％
Percentage
of capital
AfterTax
Cost
Weighted
Cost
Debt25％ 5.61％1.40％
Equity75％ 16.80％12.60％
WACC14.00％
Free Cash Flow Calculations
Planning period present value
Residual value in year T
Residual value in year 10=＄18,623/(0.140.026)=$163,36
Present value of residual CF=$163,36/(1+0.14)１０=$44.06
Firm’s Economic value
Economic value=present value of all cash flows
= Present value of the planning period free cash flow
+Present value of the residual period free cash flow
Present value of the cash flows for year110 ＄ 38.52
Present value of the cash flows for the residual value ＄ 44.06
Firm’s economic value ＄82.58
Excess real estate 7.5
Firm value ＄ 90.08
Debt ＄ 42.00
Shareholder value ＄48.08
Magic Value Drivers
Sales growth increase
Firm value increase
Threshold profit margin=7.2%
Sales growth increase
Firm value decrease
Myth of Growth & Firm Value
In Case Table 4.2 PV of cash flow=＄82.6 million
If sales growth =0 PV of cash flow=＄87.6 million
Potential value = negative 5 million
Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)
Further Dissuasion of Value Driver
Operating Profit Margin
Equity
Value
Change in
Base case of EV
Base case
sensitivity Analysis of operating margin
Thousands of dollars
Through sensitivity Analysis of different Value Divers
We can find the one affects firm’s value most ！
Economic Value Road Map
Operating
Decision
Investing
Decision
Financing
Decision
EVA is based on something we have know for a long time: what
we call profit, the money left to service equity, is not profit at all.
Until a business returns a profit that is greater than its cost of
capital, it operates at a loss. Never mind that it pays taxes as if it
had a genuine profit. The enterprise still returns less to the
economy than it devours in resources…. Until then it does not
create wealth; it destroys it.
 Peter Drucker, The Information Executives Truly Need (1995)
Cost of goods sold
Accounting profits
Operating expenses
Interest expense
=




Sales
Taxes
Charge for all capital used
Cost of goods sold
Operating expenses
Economic profits
or
Residual income

=

Taxes

Sales

NOPAT
Net operating profits after taxes
EVA Approach
Accounting profits v.s. Economic profits
Free Cash flow & Residual Income Approach
Firm
Value
Present value of
future free cash flow
=
Invested
Capital
Present value of
future residual Income
=
＋
Free Cash flow & Residual Income Approach
g=7.5%
g=7.5%
1. Profit margin = 6.25%
2. Retention ratio = 60%
3. Investment (WC & real) = 0.5 per dollar of sales growth
4. Cost of capital = 10%
Free Cash flow & Residual Income Approach
g=7.5%
g=7.5%
Residual Income: 1,25010,000 × 10% = 250
Free cash flow or Residual Income?
The weakness of free cash flow：
Residual Income provides better measure of period performance！
EVA Approach
Cash flow from operations
Aftertax interest
Capital charges
Accounting adjustments
EVA
=
+
+

+
Accruals
Earnings
Operation profits
Economic profits
Economic Value Added (EVA)
Capital Turnover
Cash tax rate
Profit Margin
EVA Calculation
Convert NOPAT and Capital form accounting book value to economic book value
1.Convert from accrual to cash accounting
(LIFO, Bad debt reserves)
2.Capitalize marketbuilding expenditures
that have been expensed in the past (R&D)
3.Remove cumulative unusual losses or gains
after taxes
Example: HobbsMeyer co
Finance
Equity Equivalents
Tax
Equity Equivalents
Example: HobbsMeyer co
EVA=NOPATCost of capital* Capital
=68600010%*3984000=288000
EVA=(Return on capitalCost of capital)
*Capital
=(686000/398400010%)*3984000
=288000
Market Value Added
= Market Value of Equity  Book Value of Equity
= Present value of all future EVA
Market Value of Equity
=Book Value of Equity + Present value of all future EVA
Positive MVA
Negative MVA
EVA VS Investment
相 反
Source: Stern Stewart Research “Special Report”,Apr,2002
Advantages of EVA
Side Effectsof EVA with minimize risk