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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.

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… 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.
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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.
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Discounted cash flows

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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 = wL x kL + wB x kB x (1-t)
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Economic profit - EVA

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Economic profit - NOPLAT

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Estimating residual value
• Discounted cash flows:
FH
OCFt +1 × 1 − g ROIC IK
NI
Residual value =
WACC − g

b g
g = ROICNI × 1 − P O ⇒ P O = 1 − g ROIC
NI

• Economic profit: g
EPt +1 OCFt +1 × ROICNI FG
ROICNI − WACC IJ
Residual value =
WACC
+
WACC − g
×
H
WACC K
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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 3a6 7 onwards

Investment from 0 to 5 5% 15% 25% 13%


Investment from 6 onwards 11%

3) Cost of capital is 10%.

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... 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?

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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%

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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

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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%

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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

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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).

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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.
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A sequence of metrics
Price Intrinsic Financial ratios Value drivers
behavior value

Total Shareholder return NPV, IRR: Economic profit Market share.


Market value added EBITDA Innovation
Discounted cash flows ROIC Efficiency
Option valuation Net income Growth
Diversification

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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.

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