Value Based Management

Value Based Management

Intro (1)... Requirement for value creation: ROI>k. Measuring business profitability: Economic profit = NI Cost of invested capital. VBM financial perspective: EP is key measure of business performance; Compensation should be indexed to negociated EP improvement. JNA/FEUNL 2

Intro (2). VBM -way of life: Total commitment with the concept of shareholder value creation; Use training as an instrument to achieve total organizational involvement; Use compensation policy to promote culture change; Empower business units; Implement profound change in systems and procedures. JNA/FEUNL 3

Capital budgeting exercise Take into account the following information: The new project is expected to last for six years. You expect first-year sales of 11,5 million. The growth rate in sales for the following 5 years is expected to be 4 percent. The cost of sales represents, on average, 45 percent of sales. Other annual fixed expenditures are 1,1 million. The income tax rate is 35 percent. The project requires 12 million in fixed assets, to be fully depreciated, straight-line, over the next six years with zero residual value. Initial working capital is 0,75 million and it should grow at the same annual rate as sales. At the end of the sixth period you expect to fully recover working capital investment. Fixed assets are worthless. Assume a 13 percent cost of capital. 1. Use Discounted cash flows to compute the NPV of the project. Should you invest in this project? 2. Use the Net income approach to estimate the economic profit. Compute the NPV of the project using this estimate of economic profit (EVA). Use the Operating cash flow approach to estimate the economic profit. Compute the NPV of the project using this estimate of economic profit. JNA/FEUNL 4

Discounted cash flows JNA/FEUNL 5

Economic profit and EVA... Equivalent definitions: NP= NOPAT-Capital employed x WACC NP = (NOPAT / CE - WACC) x CE NP and EVA (applied to same project); MVA = PV (EVA); CE = Net WC + Other net assets; WACC = w L x k L + w B x k B x (1-t) JNA/FEUNL 6

Economic profit - EVA JNA/FEUNL 7

Economic profit - NOPLAT JNA/FEUNL 8

Discounted cash flows: Residual value = g Estimating residual value OCF g ROIC WACC g = ROIC = NI t F H + 1 1 b g 1 1 g ROIC NI P O P O NI I K Economic profit: Residual value = EPt + 1 + WACC OCF t + 1 g ROIC WACC g NI F HG ROICNI WACC WACC I K J JNA/FEUNL 9

Project Vega... Consider the following information, related to project VEGA: 1) Expected total investment is as follows (IC invested capital): 0 1 2 3 4 5000 4000 3000 2000 1000 From period 5 onwards, the company expects to invest, each year, 10% of the operating cash flow of the same year.. 2) ROIC assumptions are the following: Period 1 2 3 a 6 7 onwards Investment from 0 to 5 5% 15% 25% 13% Investment from 6 onwards 11% 3) Cost of capital is 10%. JNA/FEUNL 10

... Project Vega... Please calculate: 1) Project NPV using discounted cash flows (use 200 periods); 2) Project NPV using economic profit (use 200 periods); 3) Project NPV using residual value formulas from period 7 onwards. 4) Graph the project s ability to generate value through time. What is the proportion of NPV generated from period 7 onwards? JNA/FEUNL 11

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Value and economic profit António Alves graduated, two years ago, from the MBA program at NOVA. He has a background in engineering and was employed, for a number of years, in a software company. He is considering launching his own company. Based his own technical analysis of the business opportunity and on expectations about sales potential provided by a local market research consultant, he is conducting a preliminary financial evaluation of the project. As it stands, the idea seems quite acceptable. Comment the potential of this new project using the information provided by the promoter: Table 1 1 Assumptions 0 1 2 3 4 5 6 7 Sales / fixed assets (period 1) 0.70 0.84 3.15 3.81 4.30 5.16 6.01 Growth rate in sales 100% 350% 25% 10% 5% 2% COGS as % sales 65.00% 65.00% 67.50% 70.00% 75.00% 80.00% 90.00% Other expenditures 500 1000 1000 1250 1400 1500 2000 Income tax rate 40% 40% 40% 40% 40% 40% 40% A/c receivable 45 A/c payable 15 Invest in FA / (% of FA n-1) 3000 2000 1000 200 7.5% 7.5% 7.5% 7.5% Divestitures in FA (net of taxes) 0.0% 0.0% 0.0% 10.0% 20.0% 20.0% 347 Divestitures = depreciation from period 7 onwards Depreciation rate 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% k 12% 12% 12% 12% 12% 12% 12% 12% k (period 8 onwards) 12% g (period 8 onwards) 1% P/O (priod 8 onwards) 87.32% JNA/FEUNL 14

Table 2 Income statement, working capital, capital employed and free cash flow 0 1 2 3 4 5 6 7 Sales 2100 4200 18900 23625 25988 27287 27833 Cost of sales 1365 2730 12758 16538 19491 21830 25049 Gross margin 735 1470 6143 7088 6497 5457 2783 Other expenditures 500 1000 1000 1250 1400 1500 2000 Depreciation 225 358 406 391 350 267 197 Earnings before taxes 10 112 4736 5447 4747 3690 586 Income taxes 4 45 1894 2179 1899 1476 234 Net income 6 67 2842 3268 2848 2214 352 A/c receivable 259 518 2330 2913 3204 3364 3431 A/c payable 56 112 524 680 801 897 1029 Working capital 203 406 1806 2233 2403 2467 2402 Changes in working capital 203 203 1400 427 170 64-65 Investment in fixed assets 3000 2000 1000 200 465 453 397 347 Divestitures 0 0 0 0 620 1209 1058 347 Ending fixed assets 3000 5000 6000 6200 6045 5289 4628 4628 Depreciation 0 225 358 406 391 350 267 197 Net book value of fixed assets 3000 4775 5417 5211 4665 3559 2631 2434 Net income 6 67 2842 3268 2848 2214 352 Depreciation 225 358 406 391 350 267 197 Operating cash flow 231 425 3248 3659 3198 2481 549 Changes in working capital 203 203 1400 427 170 64-65 Investment in fixed assets 3000 2000 1000 200-155 -756-661 0 Free cash flow -3000-1972 -778 1648 3387 3784 3078 5015 JNA/FEUNL 15

Table 3 Components of continuing value (period 8 onwards) Operating CF (period 8) 554 Free cash flow (period 8) 484 Value of constant growth in 7 4401 Table 4 Valuation 0 1 2 3 4 5 6 7 Free cash flow -3000-1972 -778 1648 3387 3784 3078 5015 Discount factor 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 PV of cash flows -3000-1761 -620 1173 2152 2147 1560 2268 NPV 3920 MIRR 21.1% JNA/FEUNL 16

Concerned with the potential for future growth (given his business experience during the colapse of the high-tech buble) he decided to add to the previous analysis a more detailed estimate of the ability of the project to generate value over time. Does this alternative approach add anything to your previous understanding of the project? Table 5 EVA estimate 0 1 2 3 4 5 6 7 NOPLAT = Operating CF 0 231 425 3248 3659 3198 2481 549 Employed capital 3000 5203 6406 8006 8278 7692 7095 7030 Employed capital x k 360 624 769 961 993 923 851 EVA -129-199 2479 2698 2205 1558-2932 Table 6 Components of continuing value Estimate of CV NOPLAT (period 8) 554 Employed capital x k (period 8) 844 EVA (period 8) -289 PV of constant growth in 7-2629 Table 7 Valuation 0 1 2 3 4 5 6 7 PV of EVA -115-159 1765 1715 1251 789-1326 NPV 3920 JNA/FEUNL 17

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Economic profit and EVA Adjustments to NOPAT and CE (accounting information versus economic value): Transform cash flows into economic flows (R&D, strategic investments, etc.); Convert accrual accounting into cash flows (provisions, tax payments, etc.); Accrual of unusual events (corporate restructuring, divestitures, etc.); Adjustments to non-operational items (Investment in progress, for instance). JNA/FEUNL 19

EVA drivers NP = (NOPAT / CE - WACC) x CE= (ROI - WACC) x CE = (NOPAT/Sales x Sales/TA - WACC) x (WC+ONetAssets) Revenues: price, sales mix, marketing, quality, innovation, etc. Costs: productivity, purchasing, efficiency, safety, etc. Cost of capital employed: asset efficiency and WACC. JNA/FEUNL 20

A sequence of metrics Price behavior Intrinsic value Financial ratios Value drivers Total Shareholder return Market value added NPV, IRR: Discounted cash flows Option valuation Economic profit EBITDA ROIC Net income Market share. Innovation Efficiency Growth Diversification JNA/FEUNL 21

EVA and compensation system Level of performance: Involves whole organization; Expected level of EVA, growth rate and maximum allowed shortfall; Period by period performance evaluation; EVA bank (bonus bank): EVA adds to bonus bank; Actual compensation depends on goals and bank balance. JNA/FEUNL 22