Economic Value Added Financial Accounting & Corporate Finance

1. Economic Value Added Financial Accounting & Corporate Finance Dr Clive Vlieland-Boddy

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.

3. Competitive 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.

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

5. Traditional View of Finance

6. Traditional - 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? But the public understand them

7. Pro’s & Con’s • Benefits of these ratios • Ease of calculation & interpretation • Decompose to reveal sources of changes • Universally understood • Downside of these ratios • Sensitive to choice of accounting method • Accumulation of monetary values from different periods • Backward looking • Fail to consider risk.

8. EPS and Management! • 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.

9. EPS… • Accounting rules discourage EPS-manic mangers from spending capital on value enhancing investments on intangibles like • Brands • marketing campaign or • research and training • Why? • GAAP requires outlays to be written off immediately against earnings. (Prudence)

10. EPS… • EPS focus may cause management to refrain from issuing equity at times when the company really needs it • Create EPS gains by using more debt than prudent (Encourages financial leverage ) • Both on and off the balance sheet • Accept weak projects that happen to be financed with debt.

11. EPS… • Today’s market perception: “Management that aims to boost earnings at the expense of quality will be more certainly penalised then ever before with a lower stock price and a sullied reputation.”

12. Performance Vs. Valuation • Performance measurement • Relies on actual results • Historical • IFRS or GAAP • Valuation • Relies on forecasts • Stock price relies on investors’ expectations, not historical performance.

13. Focused Finance & EVA

14. Focused Finance

15. 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 test of any company’s success lies in increasing its market value by more than it increases its capital.

16. View of the Firm • Value of firm = Value of Liabilities + Value of Equity • That is the amount of invested capital • 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 Liabilities Equity

17. 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

18. Market Value Added Market value added Premium Total market value Debt & equity capital Investment In Company

19. 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.

20. What is Cost of Capital • Evaluation of profitability should also consider the lost opportunity that the capital has. • A company has Invested capital. This could make a return elsewhere. • Before fully evaluating the profitability allowance for the cost of this capital should be considered. • This represents an opportunity cost.

21. 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

22. Components of EVA • NOPAT • 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.

23. Explicit Vs Implicit Costs • Explicit costs are direct attributable costs like materials or labour used in production. • Implicit costs or otherwise known as opportunity costs are those costs that are the result of losing an alternative use. • Example: If I have €1m to invest in a company, I lose the opportunity to leave it in the bank earning interest of say 5%.

24. 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

25. What is Operating Capital? • Capital: Net operating assets adjusted for certain accounting distortions • Asset write-downs, restructuring charges, … • Net operating assets: • Cash, receivables, inventory, pre-paid expenses • Trade payable, accruals, deferred taxes • Net property, plant, and equipment • Exclude non-operating assets: • Marketable securities, investments,...

26. What is Cost of Capital? • The cost of capital is the total % cost of debt and equity that finances the business. • Weighted average cost of capital (WACC) 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%.

27. 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. • It represents the opportunity cost of capital

28. 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)

29. What’s Affecting EVA? Sales - Operating expenses - Taxes = NOPAT - Capital charge = EVA Market potential COGS, SG&A + Other Potential gov’t actions

30. 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.

31. 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

32. 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.

33. Improving EVA EVA adapts accounting profits and concentrates on the forward picture rather than the past. It suggests up to 160 accounting adjustments as it believes in minimising the “prudence” accounting concept. IT encourages capitalisation of R & D, Advertising and training programmes. It highlights: • Changes in Manufacturing Processes • Managing the labour force more efficiently • R & D to improve activities • Marketing to maximise facilities and expand

34. Manufacturing EVA Drivers • Reduce inventory • Reduce cycle time • Improve yields • Reduce scrap/waste • Maximize labor efficiencies • Improve vendor efficiencies • Process improvements

35. Staff EVA Drivers • Work group/process simplification • Consistency “monitors” – audit • Centralizing resources/synergies • Best practices benchmarking • Insourcing/outsourcing decisions • Simplify EVA measurements/reporting • Ensure compliance with legislation

36. Research & Development EVA Drivers • Improve “to-market” process • Reduce R&D expenses as % of new product sales • Strategic partners for R&D • Stronger links to product marketing • New products via: • - Research • - Formulation • - Development • Acquisition

37. Marketing EVA Drivers • Increase market share / revenue • New markets • More focused channel programs • Voice of customer / consumer • Leverage advertising / promotion • Build brand awareness

38. Main Criticisms • Created by Stern Stuart • As such it is commercially driven unlike say DuPont. • Can be confusing to the public

39. Main Benefits • Only real forward evaluation tool for profitability and efficiency. • Can be proven against NPV of MVA. • Does accept that there is a real opportunity cost of capital especially Retained Earnings.

40. Bye for now! Please ensure you Prepare for next session I’m ready forsome leisure time. 41

41. The End