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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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slide1
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)

slide2
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.

slide3
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

slide4
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

slide5
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.
slide6
Forecasting Free Cash Flow

Case: Ashley Corporation

Value driver assumptions

Residual

period

begins

slide7
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

slide8
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

Debt 25% 5.61% 1.40%

Equity 75% 16.80% 12.60%

WACC 14.00%

slide9
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

slide10
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

slide11
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)

slide12
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 !

slide13
Economic Value Road Map

Operating

Decision

Investing

Decision

Financing

Decision

slide14
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)

slide15
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

slide16
Free Cash flow & Residual Income Approach

Firm

Value

Present value of

future free cash flow

=

Invested

Capital

Present value of

future residual Income

=

slide17
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%

slide18
Free Cash flow & Residual Income Approach

g=7.5%

g=7.5%

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

slide19
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!

slide20
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

slide23
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

slide28
Example: Hobbs-Meyer co

Finance

Equity Equivalents

Tax

Equity Equivalents

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

slide33
EVA VS Investment

相 反

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

slide34
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
slide35
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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