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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).

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The value of any stock bond or business today is determined by

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 value of any stock bond or business today is determined by

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.


The value of any stock bond or business today is determined by

  • Net working capital (CA-CL)

  • 2. Capital expenditures and long-term assets.

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


The value of any stock bond or business today is determined by

Free Cash Flow& Firm valuation

Value of

Non-operating assets

Firm

Value

Present value of

free cash flow

=

- Marketable securities

- Excess real state

- Over funded pension plan

Firm

Value

=

Future claim

Shareholder value

- Interest-bearing debt

- Capital lease obligations

- Under funded pension plan

- Contingent liabilities


The value of any stock bond or business today is determined by

Through value drivers, we can analyze how to improve to firm’s FCF.

Free Cash Flow Approach

Free cash flow and firm’s valuation

  • How long should we calculate?

    • CF during strategic planning period

    • After strategic planning period, “residual value”

    • How long is strategic planning period?

  • 2. How to forecast free cash flow? (Value drivers)

    • Assumption of “Value Drivers”

      • a) Sales growth

      • b) Operating profit margin

      • c) Cash tax rate

      • d) Net working capital / sales

      • e) Other long-term assets / sales

  • Determine the discount rate.

  • - Based on opportunity cost.


  • The value of any stock bond or business today is determined by

    Forecasting Free Cash Flow

    Case: Ashley Corporation

    Value driver assumptions

    Residual

    period

    begins


    The value of any stock bond or business today is determined by

    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 t-1) × Asset-to-sales 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


    The value of any stock bond or business today is determined by

    Determining the Discount Rate

    Weighted cost of capital

    【Cost of debt×(1-Tax rate) ×Debt/Firm Value】

    7.68%×(1-0.27)=5.61%

    +【Cost of equity × Equity/Firm value】

    risk free rate+ company beta × market premium

    6%+(1.35×8%)=16.8%

    Percentage

    of capital

    After-Tax

    Cost

    Weighted

    Cost

    Debt25% 5.61%1.40%

    Equity75% 16.80%12.60%

    WACC14.00%


    The value of any stock bond or business today is determined by

    Free Cash Flow Calculations

    Planning period present value

    Residual value in year T

    Residual value in year 10=$18,623/(0.14-0.026)=$163,36

    Present value of residual CF=$163,36/(1+0.14)10=$44.06


    The value of any stock bond or business today is determined by

    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 year1-10 $ 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


    The value of any stock bond or business today is determined by

    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)


    The value of any stock bond or business today is determined by

    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 !


    The value of any stock bond or business today is determined by

    Economic Value Road Map

    Operating

    Decision

    Investing

    Decision

    Financing

    Decision


    The value of any stock bond or business today is determined by

    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)


    The value of any stock bond or business today is determined by

    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


    The value of any stock bond or business today is determined by

    Free Cash flow & Residual Income Approach

    Firm

    Value

    Present value of

    future free cash flow

    =

    Invested

    Capital

    Present value of

    future residual Income

    =


    The value of any stock bond or business today is determined by

    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%


    The value of any stock bond or business today is determined by

    Free Cash flow & Residual Income Approach

    g=7.5%

    g=7.5%

    Residual Income: 1,250-10,000 × 10% = 250


    The value of any stock bond or business today is determined by

    Free cash flow or Residual Income?

    The weakness of free cash flow:

    • Doesn’t provide readily apparent measure of

    • Annual Operating performance

    • When Free cash flow < 0

    • Investment is high in profitable firm

    • Operating is poor in unprofitable firm

    • e.g.Wal-Mart FCF -13% of capital, R is +8 % above its cost of capital

    • Kmart FCF +7% of capital, R is -3 % below its cost of capital

    Residual Income provides better measure of period performance!


    The value of any stock bond or business today is determined by

    EVA Approach

    Cash flow from operations

    After-tax interest

    Capital charges

    Accounting adjustments

    EVA

    =

    +

    +

    -

    +

    Accruals

    Earnings

    Operation profits

    Economic profits

    Economic Value Added (EVA)


    Eva drivers

    EVA Drivers

    • EVA = NOPAT- (k*Capital) = (r- k)*capital

      • NOPAT = operating profits after taxes but before financing costs and noncash bookkeeping entries except depreciation

      • Return on capital (r) =

      • Return on capital =

      • NOPBT = firm’s net operating profits before taxes

    Capital Turnover

    Cash tax rate

    Profit Margin


    Eva drivers1

    EVA Drivers


    The value of any stock bond or business today is determined by

    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 market-building expenditures

    that have been expensed in the past (R&D)

    3.Remove cumulative unusual losses or gains

    after taxes


    Nopat

    NOPAT


    Capital

    CAPITAL


    Example hobbs meyer co

    Example :Hobbs-Meyer Co.


    Example hobbs meyer co1

    Example :Hobbs-Meyer Co.


    The value of any stock bond or business today is determined by

    Example: Hobbs-Meyer co

    Finance

    Equity Equivalents

    Tax

    Equity Equivalents


    The value of any stock bond or business today is determined by

    Example: Hobbs-Meyer co


    Example hobbs meyer co2

    Example :Hobbs-Meyer Co.

    • 法一

      EVA=NOPAT-Cost of capital* Capital

      =686000-10%*3984000=288000

    • 法二

      EVA=(Return on capital-Cost of capital)

      *Capital

      =(686000/3984000-10%)*3984000

      =288000


    Eva v s mva

    EVA V.S MVA

    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


    Eva v s mva1

    EVA V.S MVA

    Positive MVA

    Negative MVA


    The value of any stock bond or business today is determined by

    EVA VS Investment

    相 反

    Source: Stern Stewart Research “Special Report”,Apr,2002


    The value of any stock bond or business today is determined by

    Advantages of EVA

    • EVA is closely related to NPV.

    • It avoids the problems associates with approaches that focus on percentage spreads( rate of return- rate of cost)

    • It makes top managers responsible for a measure that they have more control over

    • It is influenced by all of the decisions that managers have to make within a firm


    The value of any stock bond or business today is determined by

    Side Effectsof EVA with minimize risk

    • increases in current EVA come at the expense of future EVA

    • higher EVA is accompanied by an increase in the cost of capital

    • increase in EVA is less than what the market expected it to be, leading to a drop in the market price


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