ECONOMIC VALUE ADDED

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ECONOMIC VALUE ADDED
MANAGERIAL FINANCE 117/24/99
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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

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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)

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ECONOMIC 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

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ECONOMIC VALUE ADDED
After Tax Dollar Cost of Capital Cost of Capital
() X Capital
Cost of Capital Weighted After Tax Cost of
Capital
Capital Total Capital Employed Common and
Preferred
Stock Long Term Debt
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Economic Value Added ExampleNestle, 1997
NOPAT Operating Profit - Income Tax NOPAT
4955 - 1260 3695
EVA EVA NOPAT - CC 3695-3369 326

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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
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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)
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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 B1. 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.
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BETA
STOCK
B 2.0
20
B 1.0
B .50
10
5
45
MARKET
10
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REQUIRED RATE OF RETURN ON JJ
Ke .05 .84 (.18-.05) .05 .84(.13) .05
.11 .16 The Beta for JJ is .84 relative to the
SP 500 Index (Bloomberg) Ke .05 .59(.18-.05)
.05 .59(.13) .05 .08 .13 The Beta for
JJ is .59 relative to the DAX (Bonn) for JJ
ADRs.
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Required Rate of Return- JJ
Ke .05 .84 (.18-.05) .05 .84(.13) .05
.11 .16 Note -If JJ 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 JJ is Ke .05
.84 (.40-.05) .05 .84(.13) .05 .29 .34
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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.
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Economic Value Added Example
Economic Value Added Example
BMS, 1998
BMS, 1998
NOPAT Operating Profit - Income Tax
5068 - 1127 3941
.2(.10)(1-.4) .8(.17) .148
Dollar Cost of Capital 9422(.148) 1394
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EVA- JOHNSON JOHNSON, 1998
(DOLLARS IN MILLIONS)
EVA NOPAT - CC 3722-25341188
NB - Kd .056 Weighted average effective rate
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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

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OPERATING VALUE DRIVERS

• OPERATING DRIVERS
• Purchase frequency and size
• Cash management
• Account receivable policy
• Operating expense per cent
• SGA expense per cent
• Distribution cost analysis
• Accounts payable cycle
• Inventory turns

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SUMMARY

• We 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