ECONOMIC VALUE ADDED

MANAGERIAL FINANCE 117/24/99

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

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)

ECONOMIC VALUE ADDEDECONOMIC 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

ECONOMIC VALUE ADDED =[Net Operating Profit After Tax - After Tax Dollar Cost of

Capital]

Net Operating Profit After Tax = Operating Profit - Income Tax

Cost of Capital = Weighted After Tax Cost of Capital

Capital = Total Capital Employed = Common and Preferred Stock + Long Term Debt

After Tax Dollar Cost of Capital= Cost of Capital (%) X Capital

ECONOMIC VALUE ADDED

NOPAT

Operating Profit - Income Tax = NOPAT; 4955 - 1260 = 3695

EVA

EVA = NOPAT - $ CC= $3695-3369 = $326

WACC

Debt 7890 @.12 Equity 16708 @.15

WACC = (7890/24598).12 +( 16708/24598).15 = .137

WACC = $24598(.137) = $3369

Economic Value Added ExampleNestle, 1997

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

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)

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.

BETA

MARKET

STOCK

450

10%

10%

B = 1.020%

B = 2.0

B = .50

5%

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.

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

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.

Economic Value Added ExampleEconomic Value Added ExampleBMS, 1998BMS, 1998

EVA= NOPAT - $ CC= 3941-1394 = 2547

NOPAT = Operating Profit - Income Tax = $5068 - $1127 =$ 3941

WACC = Wd (Kd1)(1-T) + We( (Ke)

= .2(.10)(1-.4) + .8(.17) =.148

Dollar Cost of Capital = $9422(.148) = $1394

EVA- JOHNSON & JOHNSON, 1998

(DOLLARS IN MILLIONS)

NB - Kd = .056 = Weighted average effective rate

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= NOPAT - $ CC= $3722-$2534=$1188

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

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

SUMMARYWe 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