Antonio Majocchi

1
International Business and Management

• Antonio Majocchi
• antonio.majocchi_at_unipv.it
• Associate Professor in international business

2
Teaching Faculty

• Roger Strange, Professor of international
  business, Sussex University (18 hours)
• David Needle of Professor of management, King's
  College London (4 hours)
• A business case will be discuss under the
  supervision of an external business consultant
  (Dr. Ucci from Oliver Wyman)
• Attendance even if not compulsory is highly
  recommended

3
Assessment

• The course will be assessed by a final exam and
  assignments
• The final exam will cover mainly the theoretical
  arguments of the course and will count 50 of the
  final mark (this year the exam will be realised
  in 2 parts)
• The assignment is a group projects that count for
  40 of the final mark
• The class discussion of the business case
  (compulsory) will count for the remaining 10

4
Class assignment

• The goal of the class assignment is to present
  the international strategy of a MNCs
• Group should be formed by no more then 3 students
• A lecture (18 of March?) will be devoted to
  discuss and present the main criteria to be
  followed in the presentation (sources, aim of the
  presentation, methodology etc etc.)

5
Assignment

• The assignment should be completed for the end of
  the course and presented discussed in the last
  week of the lecturing period (exact dates to be
  defined)

6
Reading materials

• There is no single recommended text. Readings
  will be assigned to students at every group of
  thematic lectures
• The reference book for Professor Strange's
  seminars is
• Bartlett, C.A., Ghoshal, S. and Beamish, P.W.
  (2008). Transnational management text, cases,
  and readings in cross-border management. London
  McGraw-Hill (available in the faculty library)

7
Course brief Contents part I

• Market selection and Market Entry
• What is globalisation data and trends
• The Strategy and Structure of MNCs
• Control in MNCs
• The balance scorecard
• EVA principles and application

8
Course brief Contents part II

• Financial management in MNCs
• International pricing policy
• foreign exchange risk
• foreign exchange management
• Market forecast
• Methodology to forecast market potential
• Elasticity and pricing

9
To sum up
Antonio Majocchi Lectures Written exam (25). To be held in the planned exam dates
Group Assignments Group presentation (31st May, 1st June) (40)
Business case 15 March (tentative date) (10)
Roger Strange Written exam (25). 27th May
Final Mark

• if either the Business case or the Group
  assignment are missed then the student will have
  to sustain the full exam based on the Bartlett,
  Ghoshal, and Beamish (2008) book

10
Market selection and market entry

• Compulsory Readings
• Ghauri Cateora, International marketing, Mc
  Graw Hill (2 ed), Chapter 7 and Chapter 11 (530
  781)

11
Barriers to international business

1. Tariffs
2. Non Tariff Barriers
3. Specific limitations on trade (Quotas, local
   content requirements..)
4. Customs and administrative entry procedures
5. Standards
6. Government participation in trade
7. Risk (political and economic risk)
8. Knowledge (business, market, consumers,
   cultural.)

12
Political Risk

• The likelihood that a government or society will
  undergo political changes that negatively affect
  local business activity
• Political risk arises from a variety of sources
• Corrupt or poor political leadership
• An unstable political system
• Conflict between races, religions, or ethnic
  groups
• Economic problems

13
Examples of political risk

• Confiscation (take a piece of equipment )
• Expropriation (take the whole company )
• Nationalization (all the companies in a business
  sector)
• Political sanctions
• Violence
• Political reprisals
• Corruption

14
Economic Risk

• Any economic events that negatively affect local
  business activity
• As usual economic risk is measured with the
  volatility of economic variables
• Political and Economic risk define overall
  country risk

15
An assesment of country risk
The ICRG Rating System The ICRG Rating System The ICRG Rating System
Political
Economic expectations versus reality 6
Economic planning failures 6
Political leadership 6
External conflict 5
Corruption in government 3
Military in politics 3
Organized religion in politics 3
Law and order tradition 3
Racial and nationality tensions 3
Political terrorism 3
Civil war 3
Political party development 3
Quality of bureaucracy 3
Total Political Points 50
Financial
Loan default or unnfavourable loan restructuring 5
Delayed payment of suppliers credits 5
Repudiation of contracts by government 5
Losses from exchange controls 5
Expropriation of private investments 5
Total Financial Points 25
Economic
Inflation 5
Debt service as a of exports of goods and services 5
International liquidity ratios 3
Foreign trade collection experience 3
Current account balance as of goods and services 8
Parallel foreign exchange rate market indicators 3
Total Economic Points 25
16
Country risk agency

• http//www.prsgroup.com/

16
17
www.aon.com/
17
18
Factors Influencing Market Entry Strategy
19
Market selection

• The market selection process depends on the kind
  of investment
• resource seeking
• market seeking
• efficiency seeking
• strategic assets seeking

20
Market choice
20
21
Resources (example)
SCHOOL-LEAVING EXAMINATION GRADUATED
JOB FORCE
HUMAN CAPITAL
STRUCTURES FOR INSTRUCTION
PER CAPITAL INCOME
ROSOURCE ASSETS
GDP GROWTH
MARKET SIZE
TOTAL POPULATION
21
22
Resources (example)
PRODUCTION RESOURCES
Agglomeration of FF
BUSINESS COSTS
Industrial districts
22
23
Infrastructure
23
24
Alternative Market Entry Strategies
Alternative Market Entry Strategies

• Exporting
• Licensing
• Franchising
• Joint ventures
• Foreign Direct Investments

• Low risk...low control
• High risk...high control

24
25
Entry Mode
Financial Capital
0
100
Control/flexibility
Control
Minority holdings
JV
Licensing
Franchising
Flexibility
Export
Agreements
FDI
26
FDI

• There are 2 different kind of FDI
• Greenfield investments
• Mergers Acquisition (MA)

27
Data and trends

• FDI general trends

28
Regional trends
29
MA activity
Source www.unctad.org
30
Newcomers
Source www.unctad.org
31
Strategy and Structure

• Compulsory Readings
• Bartlett, Goshal and Beamish, (2008), (510
  2368),
• Chapter 1 (pp. 1- 13)
• Chapter 3 (pp. 197 209)
• Reading 3-2, G. S. Yip, Global strategyin a
  world of Nations? (pp. 291 304)
• Chapter 4 (p. 333- 349) and Case 4- 1 (p.350
  365)
• Chapter 7 (p. 648 660)

32
Organizational Designs

• Types of structures used by companies to manage
  foreign activities

Little/No Formal Organization
International Division
Global Organizations
33
No formal organisation

• Domestic operations assume responsibility for
  international activities in the early stages
• The organizational structure reflects the
  increased demands from the international
  marketplace
• The export department structure becomes obsolete
  as the firm becomes more involved in foreign
  markets

34
International division

• Centralizes in one entity all of the
  responsibility for international activities
• Best serve firms with few products that do not
  vary significantly

35
The Stopford Wells Model
Product Division
Improved cost efficiency is a major benefit
Follows the marketing concept most closely
Degree of product diversification
Area Divisions
Int division
Foreign sales/Total sales
36
The international division
37
International strategies
Local Adaptation
low
high
Standardization
Global
high
Transnational
Multi-domestic
low
37
38
Strategy implementation

• Multidomestic (Decentralized) systems have loose
  and simple controls. Subsidiary operates as a
  profit center
• Global (Centralized) systems have tight controls.
  Strategic decision making is at headquarters.
• Transnational (Coordinated decentralization)
  calls for overall strategy to come from
  headquarters
• Subsidiaries are free to implement within
  agreed upon range

39
A typical area division

• Telefónica has a regional structure
• The different operations of the Telefónica Group
  in 25 countries are organised into three
  geographical regions Spain, Latin America and
  Europe.
• The Corporate Centre is in charge of global
  strategy and corporate policies, management of
  common activities and coordination of the
  activity of business units.

40
A global company
41
Multidomestic

• Subsidiaries are managed as a portfolio of
  international assets
• Coordination is very limited
• Control is mainly financial
• Subsidiaries have an high level of autonomy and
  are focused on localisation issues

42
Global

• All value added activities are concentrated in
  the MNCs headquarter
• There is no adaptation and the world market is
  considered as an homogeneous market
• The role of subsidiaries is very very limited

43
The transnational model

• geographic dispersion
• economies of scale
• interdependence intense relationships among
  units characterised by an high of cooperation and
  competition (both horizontal and vertical)
• formal and informal methods of control
• diversified role for the subsidiaries

44
The complexity of the model
Source Bartlett Goshal, 1987
45
The new role of subisdiaries
Relevance of the local market
low
high
A competent national subsidiary that may be
serving as a partner in developing and
implementing strategy
Country organization with a distinctive
competence
Subsidiary Competences
STRATEGIC LEADER
CONTRIBUTOR
high
Most entities hold this role. It provides
critical mass
The international company has a low competence
country organization, or none at all
BLACK HOLE
EXECUTOR
low
45
46
The transnational model

• The model try to avoid problems of effort
  duplication and inefficiency
• Subsidiaries are able to make local business
  development decisions within the global framework
• Subsidiaries can take a leading role with regard
  to specific functions/business or areas

47
Control in transnationals

• Control evolves in transational corporation and
  became a very complex function
• i.e. RD not only has short-term objectives
  (product development) but also medium and long
  term ones (patents/research projects)
• Even aspects which cannot be expressed strictly
  in quantitative terms are considered

48
Strategic Control in MNCs

• Compulsory Readings
• The balanced scorecard. Measures that drive
  Performance, Kaplan R.S. Norton D.P. 1992
  Harvard Business Review, Jan/Feb, pp. 71-79
• Putting the balanced scorecard to work, Kaplan
  R.S. Norton D.P. 1993 Harvard Business Review,
  Sept/Oct, p. 71-79
• Balanced scorecard for multinationals, S.P.
  Landry, W. Y. Canri Chan, T. Jalbert, Journal of
  Corporate Accounting Finance, 2002, 13(6), p.
  31-40

49
Control

• Control refers to the general function of
  overseeing business unit performance
• Typically the corporate development function
  oversees strategy and the controllers (financial
  function) budget and measure short-term financial
  performance

50
Control

• Different categories of control

Personal/Cultural
Impersonal/Burocratic
Personal centralised control
Burocratic formalised control
Direct/ explicit
Control by Socialisation and Network
Output Control
Indirect/ implicit
51
Socialisation and Network

• It combines a lot of relatively diverse
  mechanisms.
• Socialisation instrument to ensure that
  employees share organisational values and goals
• Informal, lateral exchange of information
  mutual adjustment, informal communication
• Formalised cross-departmental relations
  temporarily formalised devices such as task
  forces, cross-functional teams

52
Performance measurement

• The organisations measurement system strongly
  affects the behaviours of managers and employees
• However, as the experience of Multidomestic firms
  showed, relying only on financial performance
  measurements is a too limited approach

53
The Balanced Scorecard (BSC)

• The BSC is a strategic planning and management
  system that is used to align business activities
  to the strategy of the organization, improve
  internal and external communications, and monitor
  organization performance against strategic
  goals
• The BSC includes financial measures but also
  operational measures on customer satisfaction,
  internal processes and the firms innovation
  activities

Kaplan Norton, 1996
54
BSC and strategy

• The BSC is not just a list of performance
  indicators but provides executives with a
  comprehensive framework that translate companys
  vision and strategy into a coherent set of
  performance measures
• Therefore, managers should first define the
  companys goal and then define the measurement
  and the goals

55
The Strategy process

• Given the firms strategy for each perspectives
  firm defines
• Goals
• Measures
• Targets
• Actions

56
BSC the implementation

• BSC Metrics allow the managers to know how well
  their business is running
• The financial perspective indicates whether or
  not the firms strategy and implementation is
  contributing to bottom-line improvement
• In the customer perspective managers define the
  segments in which the business units will compete
• In the internal perspective executives identify
  the internal process in which the firm must excel
• The learning and growth process identify the
  processes that the organisation must develop to
  create long-term growth and improvement

57
The Strategy process
Actions
Measures (KPI)
Goals
Goals
Actions
Measures
Mission
Strategy
4 perspectives
Goals
Actions
Measures
Goals
Actions
Measures
58
The Strategy process

• A scorecard makes sense primarily for business
  unites and divisions with a well defined
  strategy
• A corporate-level scorecard can be defined only
  after a BSC has been defined at a business level
• This explain the difficulties in implementing BSC
  for MNCs and multi-business firm

59
Goals measures examples

• The customer perspective goal time to market
• lead time (existing products)
• time to market (new products)
• on-time delivery
• The internal business perspective goal cost
  saving
• production time
• safety
• defect rate

60
Goals measures examples

• Innovation and learning perspective goal tech
  leadership
• Employee turnover
• Job satisfaction
• Training/Learning opportunities
• The financial perspective goal profitability
• ROE
• Shareholders value

61
How to choose the goals for each perspective

• Building a balanced scorecard should encourage
  managers to define the objectives according to
  corporate strategy
• By this point of view the objectives of the 4
  perspectives should be part of a coherent
  framework

62
Financial perspective

• Financial goals could differ considerably at each
  stage of a businesss life cycle
• Lets just consider three stages
• Growth
• Sustain
• Harvest

63
Financial perspective

• The growth stage is generally a cash burning
  phase
• Growth rate in sales
• Number of new market segments
• of sales from new products introduced within a
  specific period
• The sustain stage is the most common stage and
  typical profitability measure are used
• Operating income (Ebit)
• Return on capital employed

64
Financial perspective

• The harvest phase is the mature stage when firms
  try to harvest the investments made in the two
  previous phases
• The goal is typically to maximize cash flow back
  to the corporation
• Operating cash flow
• Reduction in working capital requirements
• Cash-to-cash cycle

65
Example Cash-to-cash cycle

• It is the sum of days cost-of-sales in inventory
  days sales in account receivables less days
  purchases in accounts payables

Days inventories
Days Receivables
Cash to cash cycle
Days payables
66
Cash-to-cash cycle

• The case of a construction company

• Cash-to-cash 89 days

67
The Customer perspective

• The customer perspective of the BSC is aimed at
  identifying the customer and the market segment
  in which they have to compete
• The core measurement group includes measures of
• Satisfaction
• Market share
• Retention
• Acquisition
• Profitability

68
The Customer perspective
Market share Is the proportion in a given market in terms of sales, customers, unit volume that a business sells
Acquisition Measures, in absolute and relative terms, the rate at which a business unit attracts or win new customers or business
Retention Tracks, in absolute and relative terms, the rate at which a business unit retains ongoing relationships with customers
Satisfaction Assesses the satisfaction level of customers along specific performance criteria
Profitability Measures the net profit of a customers after allowing for the unique expenses required to support the customers
69
Customer profitability

• In order to have measure of customer
  profitability firms should have implemented an
  activity-based cost system
• Not all clients demand can be satisfied in ways
  that are profitable to an organisation

70
The internal business perspective

• For the internal business perspective managers
  identify the process that are most critical for
  achieving customers and shareholders objectives
• Typically firms concentrate on things such as
  quality, time, productivity

71
The internal business perspective

• The BSC framework identify three main business
  processes
• Innovation
• Operations
• After-sales services

72
Innovation

• Measures for basic and applied research
• of sales from new products
• of sales from proprietary products
• New product introduction vs competitors or vs
  plan
• Time to develop next generation products
• Productivity measure

73
Operations

• Operations start with receipt of a customer order
  and finish with the delivery
• Typical measures are
• Standard costs
• Machine efficiency
• Operating processes quality
• Cycle time

74
Post sales

• Measures
• Cycle times from customers requests to
  resolutions of the problems
• Costs of after-sales services
• Dispute resolution time

75
Learning growth perspective

• This perspective develop objectives and measures
  to drive organisational learning and growth
• The previous three perspectives identify where
  the organisation must excel to achieve
  breakthrough performance
• Forward looking investments are generally treated
  as period expenses so that cutbacks in these
  investments are an easy way to produce
  incremental short-term earnings

76
Learning growth

• The BSC identify 3 main categories for this
  perspective
• Employee capabilities
• Information system capabilities
• Motivation, empowerment and alignment

77
Employee capabilities

• Core employee measurement group are
• Employee satisfaction (typically through survey)
• Employee retention (key staff turnover
  measurement)
• Employee productivity (ranging from simple
  measures such as revenue per employee to
  value-added per employee

78
Information system capabilities

• The information system is nowday a critical
  resource
• It not only interlink all the activities of the
  firm worldwide
• It supply also rapid, timely and accurate
  information and feedback on the product just made
  or the services just delivered

79
Motivation empowerment

• Measures of motivation
• Suggestions made and Suggestions implemented
• Implementing a reward structure for implemented
  suggestions
• Measures of improvements
• Late deliveries
• Number of defects
• Scraps
• absenteeism

80
Alignment

• Alignment focus on whether or not units and
  individuals have their objectives aligned with
  the company goals (as articulated in the BSC)

81
Alignment

• In the implementation process a typical initial
  measure is the percentage of top managers exposed
  to BSC then the same ratio considering all the
  staff employees
• At a later stage it is considered the degree of
  accomplishment of the BSC goals introducing
  incentives to achieving these targets
• Incentive can be referred to single employees
  (pay raise) or to subunit and division
  (resources, autonomy)

82
A tentative strategy map
Objective KPI Targets Actions
Financial share value EVA share increase larger benchmark positive EVA standardis. product program p discrimination
Customer premium p on competition complaints gt 10 vs comp price lt 5 of clients Loyalty program targeted sales force
Internal workforce retention av. Time lt 5 days after 1 contact gt 90 gt 90 Continuos learning program Contact centre
Learning workforce stockholders trained workforce stockholders Stock ownership plan training
Saherholder value
Retention Satisfaction
Premium price
Improve service contact time
Sales force empowerment
83
BSC web-service solutions

• The BSC is now implemented through web services
  applications
• At http//www.bscdesigner.com/download you can
  find a freeware version (BSC Designer Light) of
  one - among the thousands available applications

84
A practical example

• Tata Tea started building EVA as a key
  performance indicator in the balanced scorecards,
  so that the performance-management system centres
  around EVA

85
Economic value added (EVA)

• Compulsory Readings
• Journal of Applied Corporate Finance
• EVA Momentum The One Ratio That Tells the Whole
  Story G. Bennett Stewart III, 21(2), pp. 74-86,
  (Spring 2009)
• How To Fix Accountingmeasure And Report
  Economic Profit, G. Bennett Stewart III, 15 (3),
  pp. 63-82 (Spring 2003)
• The Eva Revolution, Al Ehrbar, G. Bennett
  Stewart III, 12 (2), pp 18 31, (Summer 1999)
• (SUGGESTED) Specific Knowledge and Divisional
  Performance Measurement, M. C. Jensen, W. H.
  Meckling, pp. 49-57, 21(2), (Spring 2009)

86
Shortcomings of accounting numbers

• The classical ratios considered for businesses
  control such as EPS, ROI or ROE have a series of
  limitation as standards for measuring business
  performance
• Standard earning numbers are sensitive to
  accounting methods, do not measure proper cash
  inflow and ignore the time value of money

87
Cash flow estimation

• Cash flow from operation (CFFO) may be calculated
  as follows
• CFFO sales-op expenses - tax Depreciation (
  other noncash items) incremental working
  capital investments Capital expenditures

88
Incremental Working Cap

• Any increments in Net working capital is a cash
  absorption activity
• NWC increase
• increase in receivables
• increase in inventories
• increase in payables
• increase in deferred taxes

89
EPS

• A Subsidiary is planning a new investments of
  15M which will generate a 10 increase of sales
• Consider that
• Subsidiary has no debt
• the cost of equity is 12
• The business is a mature business and the profit
  could be consider a perpetuity
• Remember that the present value of a perpetuity
  is

90
EPS

• Even if earnings increase the equity value of
  the investment does not change
• EPS fails to measure changes in economics value

Sub A with no debt Sub A 10
Sales 200 220
Op expenses 170 187
Earnings before tax 30 33
Income tax (0.4) 12 13.20
Earnings 18 19.80
Equity value (CF/CoE) 18/0.12150 19.8/0.12-15150
91
Roi

• Roi Roe are popular financial performance
  indicators. Roi is a frequently used measure of
  divisions performance
• Roi remains a good indicator of business
  profitability but still is an accrual accounting
  return and not a full economic measure
• This is true even when Roi is compared to an
  hurdle rate that generally equals the business
  unit cost of capital

92
ROI

• Roi is computed by a wide variety of methods
• This is one
• EBIT
• Net Book value of FA Net Working Capital
• In this case the tax shield effect is not
  considered

93
ROI

• Moreover, both the numerator and the denominator
  are affected by arbitrary accounting assumptions
• The recent drive towards fair value accounting
  has mitigated the problem
• Nonetheless, operating income (EBIT) is not the
  CF generated by the business

94
ROI

• Roi depends on capitalisation and depreciation
  policies that are strictly accounting decisions
• For example, RD expenses are customarily
  expensed in the current period and not considered
  as an investment (thus increasing the Roi rate)
• Thus, using Roi to compare RD intensive and not
  intensive business can be highly misleading

95
ROI

• Overall Roi has 3 main additional shortcomings
• It depends on the investments base of the
  business unit considered (the larger the
  investment base the lower the accounting return)
• Aggressive strategies (RD spending, new
  investments) typically lower Roi while
  harvesting strategies increase Roi
• Does not take in account the overall risk (i.e
  the cost of capital)

96
ROE

• Roe is the ratio of net profit on total
  shareholder capital
• Roe is seldom used at the divisional level where
  debt is rarely allocated but is more widely used
  at the corporate level
• Roe has all the shortcomings of Roi but in
  addition it is sensitive to leverage
• Roe increases as more then optimal debt is issued

97
Time value of money

• Earning calculations ignore the time value of
  money i.e. the risk free rate, the cost of risk
  compensation and the expected rate of inflation
• This is not the case with NPV calculation (CF
  cash flow rinterest rate)

98
The risk/return relationship
Expected return
Risk free rate (Rf)
Return
Risk
99
EVA

• EVA (Economic Value added) is a methodology aimed
  at measuring shareholder value creation
• EVA is increasingly becoming the global standard
  for measuring business performance
• Shareholder value is created only if a business
  earns a rate of return on investments greater
  than the rate investors can expect to earn by
  investing in alternative, equally risky,
  securities

100
EVA

• Eva take in account both the real cash flow
  generated by the business divisions and the
  overall risk of the business
• By this point of view Eva is an economic profit
  measure as opposed to the typical accounting
  measures
• Eva can be calculated for any entity including
  divisions departments, products lines

101
Eva balance sheet
Regular Balance Sheet
EVA Balance Sheet
Short term Debt
Short term Debt
Cash
Cash
NWC
Short term Not Interest-bearing liabilities
Long term Debt
Receivables Inventories Prepayments
Fixed Assets
SH Equity
Long term Debt
Net Assets
Invested Capital
Fixed Assets
SH Equity
Nopat
Wacc
102
The EVA approach

• Eva NOPAT (WACC?Invested Capital)

Weighted average cost of capital
Net operating profit after tax
Net Fixed asset net working capital
103
The EVA

• The return on net assets is defined as the ratio
  of Nopat on Net Assets (RONA)
• Eva will be positive if
• RONAgtWACC
• Eva can be also be expressed as
• Eva(RONA-WACC)?Invested Capital

104
NOPAT

• Nopat is the firms profit assuming that the firm
  has no debt
• The term net means that Nopat is net of
  amortization (which is a real economic cost)
• The idea is that Nopat captures the profit that
  accrue to all capital holders (both lenders and
  shareholders)

105
NOPAT adjustments

• The main adjustment is the reclassification of
  some expenses as investments (typically RD) and
  the subtraction of provision and extraordinary
  expenses i.e. all non-monetary costs such as
  provisions (except amortization!)

106
NOPAT

• Nopat is equal to
• Ebit (adjusted)-corporate taxes (without debt)
• or more precisely
• profit(adjusted)interest expenditures(1-t)

107
Nopat the formulas
Ebit () 100
Interest cost (-) 20
PTP () 80
Tax rate 50 40
Profit 40
Option 1 Option 1
Ebit () 100
Interest cost (-)
Tax rate 50 50
Nopat 50
Option 2 Profit IC(1-t) Option 2 Profit IC(1-t)
Profit () 40
Interest cost (1-t) () 10
Nopat 50
Option 3 Ebit (1-t) Option 3 Ebit (1-t)
Ebit () 100
(1-t) (-) 50
Nopat 50
108
Income statement (basic)
Sales () 100
Costs of Goods and Services (-) 20
Labour Costs (-) 10
Earnings before Interests, Taxes DA - EBITDA () 70
Depreciation Amortization - DA (-) 20
Interest costs (-) 10
Pre-tax profit (t40) PTP () 16
Profit 40
109
Adjusted Profit

• In order to estimate the adjusted profit
  exceptional costs (i.e. integration costs)
  should be deducted and RD costs should be
  amortised according to the amortisation period
  considered

Profit 40
Integration costs () 5
Research cost capitalised 50
n. of years of capitalisation of RD costs 10 years
Costs to be added and deducted 50 and 5
Adjusted Profit 90
110
Nopat

• Nopat is not affected by the firms capital
  structure choices

  Unlevered firm levered firm (1) levered firm (2)
Invested capital 10,000 10,000 10,000
Equity 10,000 5,000 2,000
Debt 0 5,000 8,000
Sales 16,667 16,667 16,667
Cogs 13,000 13,000 13,000
Depreciation 2,000 2,000 2,000
EBIT 1,667 1,667 1,667
Interests (i5) 0 250 400
Pre-tax Profit 1,667 1,417 1,267
Tax (0.4 tax rate) 667 567 507
Net Profit 1,000 850 760
NopatNPInt(1-t) 1,000 1,000 1,000
111
EVA BS at the divisional level

• When Eva is measured at the divisional levels,
  cash is typically excluded from invested capital
  (cash is typically managed centrally)

EVA BS at the Divisional Level
EVA Balance Sheet
Short term Debt
Cash
ST debt
NWC
NWC
Long term Debt
Long term Debt
Fixed Assets
SH Equity
Fixed Assets
SH Equity
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The Cost of capital

• The cost of capital is the rate of return a
  capital provider would expect to receive if the
  capital were invested in a project/division of
  comparable risk
• Therefore, the cost of capital is an opportunity
  cost
• Since risk is a crucial element investors require
  higher returns from equity capital than they do
  from debt

REgtRD
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WACC

• The WACC is calculated as follows
• Where the cost of debt is the pretax rate the
  company pays to its lenders (since interest
  payments are as a rule tax deductible)
• The cost of equity should be estimated and
  depends on the overall risk of the investment

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WACC

• If the market value of debt is 30M the
  market value of equity is 50M, the cost of
  debt 9 and the cost of equity is 15 then,
  geiven a tax rate of 40 the weighted cost of
  capital is equal to..

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CAPM

• The CAPM (Capital Asset Pricing Model) offers is
  one of the methodologies (among others!) to
  estimate the cost of equity
• The cost of equity is equal to the return on
  riskless assets plus a risk premium which reflect
  the price paid by the stock market to all equity
  investors, adjusted for beta which is a specific
  risk factor

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Beta

• Beta is the volatility of a company stock price
  with respect to the overall stock market
• Therefore Beta is the company-specific risk that
  the asset adds to a market portfolio
• Analytically Beta equals

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Riskless rate

• The only securities that have not default risk
  are government securities. Nonetheless they bear
  interest rate risk. The most common rates used
  are
• T-bill rate
• Treasury notes rate
• Inflation-indexed Treasury rate

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Equity risk premium

• Risk premium should measure what investors on
  average demand as extra return for investing in
  the market portfolio relative to a risk free
  assets
• RP is usually estimated looking at the historical
  premium earned by stocks over Treasury bills and
  bonds

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US Equity risk premium
Arithm. Av. Stock T bill T bond
1928-2003 11.82 3.90 5.28
1963-2003 12.10 6.01 7.40
1993-2003 12.63 4.20 7.76

Geom. Av. Stock T bill T bond
1928-2003 9.85 3.86 5.02
1963-2003 10.82 5.97 7.00
1993-2003 10.87 4.19 7.30
Source www.Damodaran.com
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Some Beta Examples
121
Some Beta Examples
122
Some Beta Examples
123
Some Beta Examples
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Beta for divisions

• The procedure for estimating betas for operating
  divisions within firms depends largely on whether
  the divisions are organized by product line or
  geography

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Geographical divisions

• In this case the cost of equity is set adding to
  the company cost of capital a risk premium
  equals to
• the rate of return on local bonds if the division
  is mainly funded in the home currency
• A measure of country risk if financing comes
  mainly from the parent company
• Typical measure of country risk are spread on
  local government bond denominated in foreign
  currency or DCS

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Product divisions

• When division are based on product line betas can
  be estimated from comparable firms in the same or
  similar industries
• This simple approach assumes that the capital
  structure of all the firms in the industry is
  similar (beta increases when the D/E ratio
  increases)

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The levered Beta

• If our capital structure is different from the
  industry average structure then we have to
  unlevered and then relevered the Beta
• Since we know that

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Estimating business Beta

• If the average industry beta is 1.27 and the
  average industry D/E ratio is 0.45, assuming
  t0.4, then the unlevered industry beta is
• This means that if the average industry beta is
  1.27, if all the firms had been all-equity firms,
  with no debt, their average beta would be 1.00

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Estimating business Beta

• Now to derive the beta for our division we just
  have to take the unlevered beta and then lever it
  back up again to out capital structure
• Lets assume that our D/E ratio is 0.25, then

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Eva guidelines

• Given that Eva is
• EvaNopat-(WACC)?Invested Capital
• The main indications of EVA methodology to
  managers is that they should implement action
  either to increase Nopat or the decrease the
  invested capital
• Wacc depends on overall risk and capital
  structure (a financial decision)

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EVA and time value of money

• EVA is much better than conventional measures in
  explaining the market value of a company
• The market value of a company depends directly on
  the future EVA-values
• The market value of a company
• Book value of equity present value of future
  EVA

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MV and EVA

• If the company produces a return that is equal to
  capital costs then the market value of the
  company will equal the book value of equity
• I.e. when EVA 0, then companys market value of
  equity equals its book value of equity

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The firm MV
Market value premium
Market value of the firm
Firms market value equity book value NPV of
future EVA Positive EVA builds up a premium to
the market value of equity, since investors pay
for excess return
Book value of equity
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Marginal EVA and pricing

• When EVA is computed at the division level, the
  computation requires estimation at the divisional
  level
• This will involve allocation mechanisms and
  allocation of fixed headquarters expenses becomes
  an issue
• The initial estimates of EVA are likely to
  reflect the allocation mechanisms used and the
  mistakes made in those allocations
• Changes in EVA over time are more useful measures
  than the initial EVA estimates themselves