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ECONOMIC VALUE ADDED

ECONOMIC VALUE ADDED. MANAGERIAL FINANCE 11 7/24/99. VALUE CONCEPTS. Traditional financial measures have limitations due to accounting distortions A variety of measures capture the economic performance of the firm

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ECONOMIC VALUE ADDED

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  1. ECONOMIC VALUE ADDED MANAGERIAL FINANCE 117/24/99

  2. VALUE CONCEPTS • Traditional financial measures have limitations due to accounting distortions • A variety of measures capture the economic performance of the firm • Economic Value Added (EVATM) measures increases in economic value and, hence , shareholder value • Economic Value Added ( EVATM) is a long term measure of value creation

  3. INCREASING FIRM VALUE A firm must earn returns in excess of its cost of capital • Produce more earnings on existing capital structure (operating) • Increase capital investment (investing) • Produce same earnings on less capital (operating) • Reduce the cost of capital (financing)

  4. ECONOMIC VALUE ADDED • Measures real profitably- on a cash basis • Measures the cost of equity- not shown on balance sheets • Cost of equity is its opportunity cost- what the investors could do in their next best alternative • Capital includes long term debt, preferred stock, and common stock • Cost of capital is its weighted average

  5. ECONOMIC VALUE ADDED = [Net Operating Profit After Tax - After Tax Dollar Cost of Capital] Net Operating Profit After Tax = Operating Profit - Income Tax ECONOMIC VALUE ADDED After Tax Dollar Cost of Capital= Cost of Capital (%) X Capital Cost of Capital = Weighted After Tax Cost of Capital Capital = Total Capital Employed = Common and Preferred Stock + Long Term Debt

  6. WACC Debt 7890 @.12 Equity 16708 @.15 WACC = (7890/24598).12 +( 16708/24598).15 = .137 WACC = $24598(.137) = $3369 Economic Value Added ExampleNestle, 1997 NOPAT Operating Profit - Income Tax = NOPAT; 4955 - 1260 = 3695 EVA EVA = NOPAT - $ CC= $3695-3369 = $326

  7. Weighted Average Cost of Capital WACC = Wd(Kd)(1-T) + We(Ke) where Wd = weight of debt in the capital structure Kd = cost of debt T = tax rate We = weight of equity in the capital structure Ke = cost of equity capital in the capital structure

  8. Cost of Equity Capital Ke = Rf + b( Rm-Rf) Ke = Cost of Common Equity Rf = Risk Free Rate ( One Year Treasury Bills) Rm = Returns to the market (typically the S & P average) b = Beta ( a Measure of the relative riskiness of the stock compared to the market)

  9. Cost Of Equity- An Example Rf = 5% Rm = 18% (Return to the S & P index for 1998) Ke = .05 + B ( .18-.05) If our firm is as risky as the market, then B=1. Therefore; Ke = .05 + 1.0(.18-.05) = .18 If the firm is as risky as the market, it should earn the market rate of return.

  10. BETA STOCK B = 2.0 20% B = 1.0 B = .50 10% 5% 45 10% MARKET

  11. REQUIRED RATE OF RETURN ON J&J Ke = .05 + .84 (.18-.05) = .05 + .84(.13) = .05 + .11 = .16 The Beta for J&J is .84 relative to the S&P 500 Index (Bloomberg) Ke = .05 + .59(.18-.05) = .05 + .59(.13) = .05 + .08 = .13 The Beta for J&J is .59 relative to the DAX (Bonn) for J&J ADR’s.

  12. Required Rate of Return- J&J Ke = .05 + .84 (.18-.05) = .05 + .84(.13) = .05 + .11 = .16 Note -If J&J earned a .34 rate of return in 1997 and the required rate of return is .16, then the stock is undervalued. If the health care industry earned .40, then the required rate of return for J&J is; Ke = .05 + .84 (.40-.05) = .05 + .84(.13) = .05 + .29 = .34

  13. Measuring Returns RETURNS TO A STOCK (ANY GIVEN YEAR) Rs = (Year Ending Price- Price at Beginning Year + Dividend / Price at Beginning Year Return to J & J (1997) = ( $65.87- $49.75 + .85)/ $49.75 = .34 Using a Weighted Average Stock Price for the Industry, The return to the Pharmaceutical Industry was .40 for 1997.

  14. WACC = Wd (Kd 1)(1-T) + We( (Ke) EVA= NOPAT - $ CC= 3941-1394 = 2547 Economic Value Added Example Economic Value Added Example BMS, 1998 BMS, 1998 NOPAT = Operating Profit - Income Tax = $5068 - $1127 =$ 3941 = .2(.10)(1-.4) + .8(.17) =.148 Dollar Cost of Capital = $9422(.148) = $1394

  15. NOPAT = Operating Profit - Income Tax = $4932 - $1210= $3722 WACC = Wd(Kd)(1-T) + We(Ke) = .46(..056)(1-.4) + .52(.16) =.10 Dollar Cost of Capital = $25337(.10) = $2534 EVA- JOHNSON & JOHNSON, 1998 (DOLLARS IN MILLIONS) EVA= NOPAT - $ CC= $3722-$2534=$1188 NB - Kd = .056 = Weighted average effective rate

  16. VALUE DRIVERS • FINANCING DRIVERS • Annual capital investment • Leverage ratio (debt to equity) • Share buyback initiatives • Debt equity swap • INVESTING DRIVERS • Asset acquisition • Capital budgeting • Working capital management • Asset disposition

  17. OPERATING VALUE DRIVERS • OPERATING DRIVERS • Purchase frequency and size • Cash management • Account receivable policy • Operating expense per cent • SG&A expense per cent • Distribution cost analysis • Accounts payable cycle • Inventory turns

  18. SUMMARY • We have described the value creation process • We have identified traditional measures of value creation • We have operationalized the concept of Economic Value Added (EVATM) • We have identified operating drivers that Andersen Consulting can affect and thereby increase value

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