UVA-F-1164 VALUE CREATION, NET PRESENT VALUE, AND ECONOMIC PROFIT This note discusses two approaches that companies frequently use to gauge value creation. The first class includes the discounted cash flow techniques that are the mainstays of bottom up corporate evaluation of future investments. Each investment is evaluated over its entire use life based on the cash flows it is expected to generate. The result is a measure of whether the multiperiod investment creates value (a positive net present value, [NPV]). The second class includes estimates of economic profit. 1 Economic profit is calculated by subtracting a capital charge from net operating profit after taxes. Economic profit figures are often calculated over a particular calendar period (often a year) and used as top down measures of an entire firm s (or division s) performance. A positive economic profit is a signal of value creation. Four messages for corporate managers and financial analysts are stressed: Both NPV and economic profit are tied to shareholder value. Both methods tell us that value is created only if the company can earn returns in excess of investor required returns as measured by the cost of capital. The two approaches give identical estimates of value creation only if the analyst projects economic profit into the future. NPV is equal to the present value of future economic profit. Despite the first two similarities, annual economic profit numbers can sometimes be poor signals of value creation. Annual figures for economic profit (as for any single period financial metric) can be distorted by arbitrary decisions concerning asset values and depreciation or by current patterns that are not sustainable. Such distortions can be particularly large for new businesses and ventures that ramp up over time. The savvy analyst must look beyond the current year figure. A primary advantage of the economic profit framework is to communicate and manage key elements of value creation. Careful managers must make sure, however, that the focus on current economic profit figures does not overshadow the need to look at cash flows and future performance. From a managerial perspective, use of both economic profit and 1 Economic profit often goes by other names including economic value added (EVA), which has been trademarked by the major consulting firm, Stern Stewart. This case was prepared by Professor Robert S. Harris. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 1997 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation.
-2- UVA-F-1164 discounted cash flow approaches may be a powerful means to actually create (not just estimate) value for investors. Net present value and economic profit What tools should and do managers use to measure value creation? There is general agreement that those measures should try to capture investors interests. After all, a primary corporate goal is to increase shareholder value. Investors and analysts carefully scrutinize announcements about corporate performance and managers compensation is often tied to such performance. Expectations about future performance are even more critical to investors contemplating purchase or sale of a company s stock. Unless such expectations meet investors minimum requirements, share price will likely fall none too pleasant an event for all concerned. To complicate matters, investor expectations about the future are often shaped by what they observe in the present. It is often easier to believe that good current performance will persist than to project a major turnaround. Even when there is agreement on the goal of measuring value creation, crafting and implementing good performance measures is no easy task. Such measures must deal with the fundamentals that drive market values, including expectations of future performance, risks associated with those expectations and rates of return otherwise available to investors. Some recommend measuring performance by looking at the current market value of the firm compared to what investors have put into the company (market value added). 2 Such a financial market scorecard is extremely important, but it fails to make a direct connection to many of the specifics of corporate activity (e.g., asset levels, sales volumes, and cost figures) that a manager must decide upon. Moreover, proactive managers are paid to create value for investors not just to wait to see if value was added. The approach most frequently used by companies to evaluate individual projects is discounted cash flow, as illustrated by net present value analysis. 3 A project s NPV is a measure of the value the project creates for the firm s investors. Positive NPVs thus represent desirable investment opportunities. NPV is calculated by estimating the incremental cash flows due to the project, taking the present value of those flows at an appropriate hurdle rate and then subtracting any initial outlay. The hurdle rate is often estimated as the weighted-average cost of capital appropriate for the risk of the proposed investment. Such a hurdle rate thus captures investors return requirements. NPV analysis looks at the project over a multiyear horizon to capture all the project s effects. NPV analysis addresses the question: should we do this project? It assigns value to decisions not to particular time periods. 2 For instance, each year Fortune publishes a ranking of firms based on market value added figures. See for instance, Who Are the Real Wealth Creators? Fortune (9 December 1996). 3 Discounted cash flow techniques including net present value and internal rate of return have been used for decades and are discussed thoroughly by standard finance textbooks. See, for example, R. Brealey and S. Myers, Principles of Corporate Finance (5th edition), (New York: McGraw Hill), 1996.
-3- UVA-F-1164 An alternate approach to thinking about value creation is captured in the calculation of economic profit. 4 As often applied, economic profit is calculated for a specific year by subtracting a capital charge from a firm s net operating profit after taxes (NOPAT). This capital charge is the product of the firm s cost of capital and the level of capital employed. 5 As in the case of NPV analysis, the weighted-average cost of capital is used to capture investor requirements. A positive economic profit thus signals value creation since the operating profit is more than enough to cover investors financial requirements that are the capital charge. In practice, economic profit is often calculated for the entire firm rather than applied to individual projects. An annual figure for economic profit is directed at this question: did we create value this year? Economic profit calculations attempt to allocate value creation to a particular time period. Table 1 summarizes the two approaches. Table 1. Comparison of net present value and economic profit. NPV = Present value of future cash flows Initial outlay Where: Cash flow = NOPAT + Depreciation Increase in NWC Capital xpenditures, Hurdle rate = Cost of capital Economic profit = NOPAT Capital charge = NOPAT (Cost of capital)( Level of capital) NPV Economic Profit Typical application Project or decision Entire firm or division Time period Entire life of project A defined calendar period Base Cash flow NOPAT Investor benchmark Cost of capital Capital charge based on level of as hurdle rate capital cost of capital Capital expenditure Reduces cash flow Increases level of capital Depreciation Added to NOPAT Reduces level of capital Working capital Affects cash flow Affects level of capital Primary use Evaluation of future decisions Evaluation of current performance NOPAT = net operating profit after taxes NWC = net working capital 4 For a thorough discussion of the benefits of using economic profit and its calculation, see G.B. Stewart, Quest for Value, (Harper-Collins) 1991. 5 Capital is the money required to fund the assets of the company. In essence, capital is the assets of the business minus any noninterest bearing liabilities such as accounts payable. Appendix 1 discusses some of the issues in estimating capital.
-4- UVA-F-1164 Rate of return interpretations Both NPV and economic profit have rate of return interpretations that are often used and that provide important insights to managers. In the case of discounted cash flow, a key rate is the internal rate of return (IRR), which is the discount rate that makes the NPV equal to zero. If the IRR is higher than the cost of capital (hurdle rate), the NPV is positive. As a result, positive NPVs come from earning returns that are larger than the cost of capital. NPV approach Value creation if IRR > Cost of capital, (NPV > 0) In the case of economic profit, the calculations can be rearranged to focus on rates of return. If we define return on net assets (RONA) as NOPAT divided by the level of capital, economic profit is expressed as Economic profit = (RONA Cost of capital)(level of capital). Positive economic profit thus is the result of earning returns (RONA) that exceed the cost of capital. Economic profit approach Value creation if RONA > Cost of capital, (Economic profit > 0) Both approaches to measuring value creation thus provide the same key insight to managers. Value is created only by earning returns that are higher than the cost of capital. If such an excess return cannot be achieved, the firm will destroy, not build, value. Specific estimates of value creation While the two approaches both stem from a focus on investor requirements, do they yield the same estimates of value creation? Under certain circumstances, the answer is yes. It turns out the present value of expected future economic profit over the life of an investment is equal to NPV. Table 2 provides a simple example of this equivalence. 6 Appendix 2 provides a more complete treatment and discusses the underlying rationale. As Table 2 shows, the two methods take different paths but get to the same present value. 6 As is typical, the discounted cash flow (DCF) analysis assumes all cash flows occur at the end of the year. Given this assumption, the level of capital appropriate for economic profit calculations is beginning capital. If flows are assumed to occur throughout the year, an analysts could do economic profit calculations with an average level of capital.
-5- UVA-F-1164 Table 2. Net present value as the present value of future economic profit. Assumptions: An investment proposal requires an initial cash outlay of $1,000 to purchase an asset that will be depreciated over a two-year horizon ($500 per year). The investment will generate NOPAT of $210 in both years and the asset will then have no salvage value. The cost of capital is 10%. NPV estimate of value creation: Year Cash Flow 0 $1000 Cash flow = NOPAT + Depreciation 1 710 = 210 + 500 2 710 = 210 + 500 NPV = 1000 + 710/(1.10) + 710/(1.10) 2 = -1000 + 645 + 587 = 1000 + 1232 = $232 Economic Profit estimate of value creation Charge* Year Economic Profit 0 $0 Economic Profit = NOPAT Capital 1 110 = 210 0.10(1000) 2 160 = 210 10 (500) NPV of economic profit = 110/ (1.10) + 160/(1.10) 2 = 100 + 132 = $232 *Capital charge = Cost of capital Beginning capital. Assets at the beginning of year 2 are $500, calculated as the original asset level of $1000 minus depreciation of $500 One way to think of the different paths the approaches take is to focus on the entire value of the project, not just the NPV. For instance, suppose we wanted to value the project immediately after our initial outlay of $1,000 (i.e., the value of the project as if someone gave it to us without requiring the outlay). In Table 2, the cash flow approach attributes a present value of $645 to the year-one cash flow and a present value of $587 to the year-two flow. Those numbers are estimates of the prices the cash flows would command if sold in financial markets. Combined, the flows have a value of $1,232, which is the total value of the project. Since acquisition of the needed asset requires a cash outlay of $1,000, the firm s purchase of the asset creates value of $232. In contrast, the economic profit approach estimates the value of the project as the sum of the original book value ($1,000) and the present value of economic profits ($232). Just as we did in the
-6- UVA-F-1164 discounted cash flow analysis, we get a project value of $1,232. The present value of the economic profit is the NPV. When considering purchase of new assets, the value initially put on the books will often be the same as the cash outlay for the asset. In such a case, the calculated economic profits represent value created from acquiring and using the asset. Cash flow approach : Economic profit approach: Value = PV of future cash flows Value created = NPV = Value Initial cash outlay Value = Book value + PV of Economic profits Value created = PV of Economic profits Practical differences between NPV and economic profit approaches While discounted cash flow and economic profit approaches can provide the same present value signal for acquisition of new assets, there are many differences between the two approaches. Some of the differences are technical and lead many analysts to favor discounted cash flow techniques as approaches to guide long-term decisions. Potential pitfalls in using economic profit figures Allocating asset costs over time: Many companies look very closely at economic profit figures for a specific calendar year. There are numerous pitfalls in the calculation and interpretation of such annual numbers, many of the same pitfalls that affect any accrual accounting figures. Any year s economic profit number can be substantially affected by the choice of depreciation method and the sometimes arbitrary decisions about whether and how to expense or capitalize an expenditure (R&D for example). Those decisions about how to allocate asset costs over time can have a huge impact on a single year s economic profit calculation. 7 In the discounted cash flow approach, such allocations are irrelevant unless they affect cash flows (e.g., via taxes). Irrelevant book values: A related concern is the temptation to view economic profit figures as clear signals of value being created even if the book values of assets have little base in current economic reality. But this view can be seriously misleading. Remember that an economic profit calculation depends critically on the level of capital used to calculate the capital charge. And these levels depend on accounting decisions. 8 To illustrate, consider an alteration to the example in Table 2. Suppose that at time zero the company had to pay $1,800 for the asset but still only set up an asset account of $1,000. It immediately expensed the remaining $800 at time zero. The NPV approach would simply compare the value of the project $1,232 (based on year one and two cash flows) to the initial outlay of $1,800, 9 resulting in a NPV of $568. The project will destroy, not create, value. 7 Elaborate procedures may be introduced to take care of those decisions but the danger is that the focus on allocation distracts from the true underlying drivers of value. Moreover, it is the cash effects of depreciation for tax purposes (not economic) depreciation that affects corporate cash flow. 8 The following discussion abstracts from the tax effects of depreciation, which affect both economic profit and cash flow calculations. 9 For simplicity, it is assumed that the $800 expense is not tax deductible.
-7- UVA-F-1164 The economic profit approach could also yield the same conclusion about the desirability of the project by subtracting the $800 accounting loss at year zero from the present value of the subsequent calculated economic profits ($232 $800 = $568). On the other hand, the positive figures for economic profits in years one and two do not really signal value creation but rather the inappropriate capital charges imputed in those two years. The key point is that anytime the capital levels used to calculate capital charges are not based in economic reality, the resulting annual figure for economic profit is a distorted signal of value creation. Such instances frequently appear as market conditions change, assets age, and new technologies are introduced. Future trends versus current numbers: Another potential pitfall arises if decision makers use only a relatively short time span of economic profits, which may ignore future trends. A critical question for any manager or investor is whether the current trend in economic profit will be sustained into the future. If such stability is expected, then current economic profit figures may be reliable signals for decisions. If the future looks quite different from the present, then current figures tell only a small part of the story. Some would argue that relative stability is a much more reasonable assumption in the case of an entire firm (versus a project) that has a mix of projects in the initial, middle, and final stages. But even at the firm level, large expansions or temporary conditions can skew current economic profit figures. Short-term focus: An additional problem of using any short-term number is the danger of ignoring important tradeoffs between short- and long-run effects. Simply increasing this year s economic profit may not create value if the same decision reduces future economic profits. Investors must make these tradeoffs over time and so must managers. In the final analysis, one must also look to future performance before reaching final conclusions on value creation or destruction. Those difficulties with economic profit face all types of accrual accounting measures that attempt to allocate the costs of long-lived assets to shorter periods of calendar time. Proponents of economic profit offer a number of partial solutions to those difficulties. New procedures can be adopted to create a set of financial accounts that more nearly approximate the true value of assets. Those procedures may require capitalizing R&D or introducing other depreciation schedules. A leading consulting firm, Stern Stewart, lists over 100 items for possible adjustment. A complication is that this approach creates yet a third set of financial accounts for a company one for financial reporting purposes, one for tax purposes, and yet a third for economic profit purposes. Proponents of economic profit have developed additional ways to cope with some of its shortfalls. For instance, instead of focusing on the level of economic profit per se, managers may compare actual economic profit to some forecasted level of economic profit. By looking at such a difference, it is possible to control, at least partially, for some of the pitfalls listed above. For instance, in a start-up phase the forecasted economic profit may be negative for the early years. Needless to say, those adjustments to implement economic profit can be complicated and involve sometimes inherently arbitrary judgments. The inherent simplicity of the economic profit approach disappears quickly as one grapples with accrual accounting issues. On the other hand, cash flow analysis makes no pretense of making such allocations. It simply analyzes the flow of cash in and out of the company and explicitly deals with tradeoffs over time by discounting an entire stream of future cash flows. Moreover, discounted cash flow keeps track of the ultimate key to value cash.
-8- UVA-F-1164 Because of those strengths, NPV analysis (and its discounted cash flow cousins such as internal rate of return) is the business analysts preferred method to estimate value and to gauge the impact of projects. It is widely used in bottom up evaluation of new projects. Managerial benefits of economic profit concepts While it has potential shortcomings as an analytic tool for long-term decision making, economic profit has a number of attractive features. Economic framework for interpreting accounting data: Inevitably, many impressions of the future are shaped by measures of current performance. Moreover, investors typically focus on current performance of the whole company (not necessarily the details of each project). After all, they own stock in the entire company. Economic profit provides a framework for interpreting current accounting results in light of investor return requirements. While it shares some of the drawbacks common to accrual accounting data, economic profit offers better insights into value creation than do other metrics such as earnings per share. No method is perfect, and economic profit has the advantage of directly bringing in the investors perspective via the cost of capital. As a consequence, the economic profit framework can provide a very useful way for communication between managers, analysts, and investors. Managing inside the company: Many managers cite the advantages of using economic profit as a top down directive that enables new understanding and motivation across a wide array of participants inside a company. Employees see that economic profit is driven by key variables that their actions affect. Improvements in margins (increased NOPAT) or reductions in asset requirements (reduced capital charges) clearly flow through to increase economic profit. Savvy financing may lower a firm s cost of capital, again clearly visible in terms of increased economic profit. The implications of actions for economic profit can be understood in terms of day-to-day activities without reference to some specific multiperiod project. Moreover, economic profit can be measured at the firm or division level for the current year to give immediate feedback and to provide concrete goals. Citing those benefits, some view thinking in terms of economic profit as the critical mindset to instill in an organization. With economic profit as a guide, it is easier for top management to push value-creation thinking lower and wider in the company. Implications for managers From an analyst s perspective, the two approaches can be viewed as competing ways to serve the same end estimating value creation. From a manager s perspective, perhaps a more useful view is that the two approaches are complementary tools to achieve a more challenging objective actually creating value. Paired together, the two approaches may do more to motivate value creation (the goal of both approaches) than would use of either separately. Discounted cash flow takes a multiperiod perspective and focuses on the final currency of financial value-cash. It is critical to making sound decisions for the future and a powerful analytic technique for gauging value creation. Economic profit calculations on an annual basis may provide important focal points and goals for a wide array of employees and create a mindset of value creation. As some argue, a focus on economic
-9- UVA-F-1164 profit may help create the ideas and actions that lead to value creation. As is often true, success involves a blend of thinking carefully about the future and leading people to act today.
-10- UVA-F-1164 Appendix 1 VALUE CREATION, NET PRESENT VALUE, AND ECONOMIC PROFIT Elements in Calculating Economic Profit Calculating Economic Profit Any calculation of economic profit requires specifying three components: NOPAT, capital, and the cost of capital. 10 Cost of capital The cost of capital is estimated as the weighted-average cost of capital (WACC). This estimation is already done by many companies to establish hurdle rates for project analysis. WACC is a weighted average of after-tax debt and equity costs. Capital At a conceptual level, capital is simply the money needed to fund the asset investment in the business. But how do we measure such investment? For a start-up business, the concepts are straightforward. Suppose starting a business required current assets of $100 (e.g., inventories) and long-term assets of $150 (e.g., plant and equipment). At the same time, trade creditors were willing to extend accounts payable of $25. The total capital needed by the new business owners would be $100 + $150 $25 = $225. If they could borrow $80 from the bank, they could start the business with $145 of their own equity funds. A quick look at the opening balance sheet for the business is instructive. Assets Liabilities + Owners Equity Current assets $100 Accounts payable $25 Long-term assets $150 Debt (interest bearing) $80 $250 Equity $145 $250 There are two basic ways to estimate capital from this balance sheet: the asset approach and the source of financing approach. The two approaches will always lead to the same figure for capital. Asset approach: Capital is total assets minus any noninterest-bearing current liabilities. This means that capital is also equal to long-term assets plus net working capital. In essence, other parties put up the funding reflected in noninterest bearing current liabilities and hence not all of assets have to be funded by capital. Using data from the balance sheet: 10 For more details on calculations of each, see P. Peterson and D. Peterson, Company Performance and Measures of Value Added, The Research Foundation of the Institute of Chartered Financial Analysts, Charlottesville, VA (1996).
-11- UVA-F-1164 Capital = Total assets Noninterest bearing current liabilities = $250 $25 = $225 Source of financing approach: Capital is the book value of equity plus debt and debt equivalents. Using our example: Capital = Equity + Debt = $145 + $80 = $225 In actual applications, estimation of capital is complicated by a host of issues, many of which arise from the value of accrual accounting. 11 For instance, consider these issues if the asset approach is used to estimate capital. Should past R&D expenditures have been capitalized to create assets? Should we capitalize the present value of operating leases (e.g., for use of a truck)? Should we add back any amortization of goodwill? Generally, the answer is yes, but the details can be complicated and inherently some judgments are subjective. NOPAT Calculation of NOPAT is accomplished by subtracting operating taxes from operating profit. The operating taxes are the taxes the firm would have paid if all of operating profit were taxed and without taking advantage of the tax deductibility of interest payments on debt. The tax deductibility of interest shows up in the WACC since it uses an after tax cost of debt. To illustrate, suppose that our start-up company had an income statement as follows. 11 See Peterson and Peterson (1996) for a detailed example.
-12- UVA-F-1164 Income Statement Sales COGS SGA Deprec. Operating profit Interest* Profit before Tax Tax (40%) Profit after tax 100 35 5 10 50 8 42 16.80 25.20 *Assume 10% interest rate on borrowing of $80. Based on this data and assuming the firm is in a 40% tax bracket, NOPAT would be $50 0.4(50) = $30. Notice that operating tax is $20, the full 40% tax rate applied to $50 of operating profit. The difference between actual taxes ($16.80) and operating taxes ($20) is a $3.20 interest tax shield (0.40 $8 3.20). Since NOPAT focuses on the operational result, it does not incorporate this interest tax benefit. Just as with the estimation of capital, estimation of NOPAT requires addressing a host of accounting issues. For instance, should R&D have been capitalized rather than expensed? If so, we would need to adjust NOPAT. Should goodwill amortization be added back? Summary Suppose our business had a cost of capital of 11%. Based on the capital and NOPAT estimates above, economic profit would be as follows: Economic profit = NOPAT Capital charge = $30 (0.11)($225) = $30 $24.75 $5.25 The positive economic profit signals value creation.
-13- UVA-F-1164 Appendix 2 VALUE CREATION, NET PRESENT VALUE, AND ECONOMIC PROFIT Equivalence of NPV and Present Value of Future Economic Profit This appendix illustrates the link between economic profit and NPV for a multiperiod project. Consider an investment proposal, the essential features of which are as follows: 1. Initial investment of $850, of which $800 is depreciated straight line over 5 years. The remaining $50 of which is land. 2. Cost of goods sold = 60% of sales. 3. Operating expenses = $50 per year. 4. Tax rate = 40%. 5. Net working capital = 20% sales. 6. At the end of 5 years, the company can sell its facility (including land) for $320 (after taxes) and liquidate net working capital at book value. 7. Sales in the initial year are estimated to be $1,000 and are expected to grow at 3% per year. 8. A hurdle rate of 15% reflects the cost of capital given investors return requirements. Net Present Value Approach to Estimating Value Creation The NPV approach simply estimates the cash flows associated with the project and then matches the present value of the cash benefits against the initial outlay. Table A shows pro forma income statements and capital totals for the project. At the bottom of the table, the project s incremented cash flows are summarized. As the table shows, at a required return of 15% the proposal creates value, yielding a positive NPV of $193 and an internal rate of return of 21.74%. Table A. Estimation of value creation using net present value analysis. 1 2 3 4 5 Sales 1000 1030 1061 1093 1126 Grow at 3% Cost of goods 600 618 637 656 675 60% sales Operating expenses 50 50 50 50 50 Constant Depreciation 160 160 160 160 160 Straight Profit before tax 190 202 214 227 240 Taxes 76 81 86 91 96 40% Operating profit after tax (NOPAT) 114 121 129 136 144
-14- UVA-F-1164 0 1 2 3 4 5 Capital Net working capital 0 200 206 212 219 225 20% sales Build. and equipment 800 640 480 320 160 0 Depreciated Land 50 50 50 50 50 50 Total capital 850 890 736 582 429 275 Step 1. Estimation of cash flows NOPAT 114 121 129 136 144 + Depreciation 160 160 160 160 160 Increase NWC 200 6 6 7 6 = Operating cash flow 74 275 282 290 298 Cash flow summary Initial 850 Operating 74 275 282 290 298 Terminal 545 * Incremental cash flow 850 74 275 282 290 843 Step 2. Calculate NPV Net present value at 15% NPV (exclusive of terminal value) ($78) NPV of terminal value $271 Total NPV $193 Internal rate of return 21.74% * Terminal value is the after-tax value of assets left at the end of year 5. The facility (land, building, and equipment) can be sold for $320 (after taxes) and the net working capital will net its book value of $225. Economic Profit Approach to Estimating Value Creation We can reinterpret the figures in Table A in terms of economic profit, which is calculated as NOPAT minus a charge for the financial cost of capital. To calculate economic profit for each period we need both the annual NOPAT as well as an annual dollar charge for use of capital. To calculate this charge, we multiply the capital employed by the cost of capital (in our example 15%). It turns out that if we compute the annual economic profit and then take the present value of this stream of annual profits, we get a present value which is equal to the net present value that we calculated earlier using cash flows. See Table B. 12 Put simply, the present value of future economic profit is the 12 In practice, analysts often use average levels of capital over the year to calculate economic profit under the assumption that flows are received throughout the year not just at year-end. Since (as is typical), the DCF approach
-15- UVA-F-1164 net present value created by the project. If financial markets see this NPV, it will translate into higher market value for the company. The lesson is that value creation comes through earning returns that are expected to be higher than the market s required return. Table B. Estimation of value creation using the economic profit approach. Step 1. Calculate the annual charge for capital, which is based on the capital employed. Net working capital Build. and equipment Land Total capital 0 1 2 3 4 5 0 800 50 850 200 640 50 890 206 480 50 736 212 320 50 582 219 160 50 429 225 0 50 275 Beginning capital % cost of capital Dollar capital charge 850 0.15 $128 890 0.15 $134 736 0.15 $110 582 0.15 $87 429 0.15 $64 Step 2. Subtract the capital charge from NOPAT to get annual economic profit. NOPAT $114 $121 $129 $136 $144 Capital charge 128 134 110 87 64 Economic profit $14 $12 $18 $49 $80 Step 3. Calculate the additional terminal value profit when the assets are sold. Note that this is a profit not a cash flow. After tax proceeds from sale $545 Book value of assets 275 Profit (after tax) $270 assumes for simplicity that all flows are at year-end, to be consistent we use beginning levels of capital to calculate economic profit.
-16- UVA-F-1164 Step 4. Calculate the present value of the economic profit and add the present value of the terminal value profit. Note that there is no need to subtract the initial outlay. PV of economic profit from step 2 $59 PV of after-tax profit on sale 134 Total PV $193 This PV of $193 is exactly the same figure as the NPV based on cash flow analysis as shown in Table A. Equivalence of NPV and Present Value of Economic Profit It is not a coincidence that the two methods yield the same estimate of value creation. Except for treatment of asset investments (or disposals) and depreciation charges, they use the same flows. And in the case of assets and depreciation, they use different flows, which have the same present value costs but by different routes. The standard cash flow approach subtracts out the asset investments when they occur. It also adds back depreciation to NOPAT in calculating annual cash flow. In calculating terminal value, the cash flow approach gives credit for the entire cash value of the terminal value. The economic profit approach does not deduct the cash outlay for an investment in assets. Rather it deducts a depreciation expense (depreciation is subtracted as part of the profit calculation and is not added back) plus it deducts a capital charge for the as yet undepreciated assets. In addition, when calculating terminal values, the economic profit approach only gives credit to the excess of cash over the book (i.e. undepreciated) value of the assets disposed. Why do the two approaches lead to the same NPV? The answer is that in the economic profit approach the combined present value of the future depreciation expenses, capital charges on undepreciated assets and any remaining book value (subtracted in calculating terminal value profit) is exactly equal to the present value of the original cash outlay for the asset itself. Consider a simple two period example of a $1,000 initial purchase that has been depreciated to book value of $200 over two years. Assume a 15% hurdle rate. The depreciation schedule of $400 per year has been picked arbitrarily as an illustration. Table C carries out the calculations. Table C. Treatment of flows associated with asset investments. Comparison of cash flow and economic profit approaches Book value of asset Cash flow Approach 0 1 2 $1000 $600 $200 1000
-17- UVA-F-1164 Economic profit Approach PV at 15% 0 0.15(1000) 400 550 0.15(600) 400 200 690 Cash flow approach PV = $1000 capital charge depreciation book value at terminal period PV at 15% Economic profit approach PV = 550/1.15 690/(1.15) 2 PV = $1000 From the point of view of present value, any depreciation schedule will work to yield the present value of $1,000. This is because the lower the depreciation charge, the higher is the capital charge on the as yet undepreciated assets. The process is analogous to calculating an amortization schedule for a loan. This does not, however, mean that the depreciation schedule that is chosen will not have important effects in two ways. First, the timing of depreciation will affect the after-tax profits and cash flows through the timing of tax payments. Taking depreciation earlier rather than later will increase the overall NPV of the project. Both the cash flow approach and the economic profit approach will signal the same higher value if more tax savings are taken early. 13 Second, the timing of depreciation will influence the pattern of economic profit in specific years. To the extent that compensation and decisions are based on specific annual economic profit figures (not just on the present value of the whole future stream of economic profit) changes in this pattern may have substantial effects. A Caveat While this link between economic profit and net present value is useful, there are many pitfalls in simplistic interpretations of an annual economic profit number. Remember, it is the multiyear stream of expected economic profit that is the key to value not just this year s numbers. Table B is instructive. Note that while the NPV of the proposal is positive, the calculated economic profit in the early years is negative. As an alternate interpretation of this pattern in economic profits, consider the accounting rates of return implied in Table B if the operating results materialize as forecast. 14 RONA = Return on net assets = NOPAT/Capital 13 In both approaches, the depreciation in a given year is subtracted in calculating NOPAT and thus leads to a tax savings in that year. The flows in Table C have ignored those depreciation tax shields, which are the same under both methods. 14 The $270 gain on the sale of the project in year 5 could alternatively be allocated to year 5 or spread over each of the five years. Note that economic profit can be expressed as (RONA Cost of capital)(level of capital). For instance, in year one the economic profit of $14 can also be derived as (0.1341 0.15)(850)= 14.
-18- UVA-F-1164 Capital at beginning of year 1 2 3 4 5 Capital $850 $890 $736 $582 $429 NOPAT $114 $121 $129 $136 $144 RONA 13.41% 13.60% 17.53% 23.37% 33.57% The calculated operating returns on the project increase over time. Does this mean that the company is actually getting better at creating value as time marches on? No. The increases in operating rate of return simply reflect the way assets were depreciated over time. This is one reason to be careful in interpreting annual economic profit figures.