Prof.

Harnesh Makhija
Introduction
 VBM seeks to integrate finance theory
with strategic thinking.
 Various approach to VBM:
 Economic Value Added
 Alcar Approach
OK Beverage Company
Income Statement Amount ($)
Sales 125000
COGS 86000
SG&A 22000
Interest Expenses 3312
Pretax profit 13688
Taxes (40%) 5475
Net income 8213

Shares outstanding 6250

EPS $1.31
OK Beverage Company
Assets Amt. ($) Liabilities Amt. ($)
Cash 750 Accounts payable 10000
U.S. Govt. Securities 1250 Wages payable 2000
Accounts Rec. 17000 Tax accruals 200
Inventory 63000 Current liabilities 14000
Current Assets 82000 8% Long term debt 41400
Property (Land) 4000 Common stock at par 625
Net Plant 15000 Add’l. paid in capital 14375
Net equipment 51000 Retained earnings 81600
Net fixed assets 70000 Stockholders’ equity 96600
Liabilities and
Total Assets 152000 stockholders’ equity 152000

Risk Free Interest Rate = 6.5%

Beta = 1
Market Risk Premium = 6%
Analysis
 Looking at the above statements from
traditional accounting perspective, it
seems that the firm is a profitable
beverage producer.
 As net income is $6250, with EPS of
$1.31.
 ROE = (8213 / 96600) * 100 = 8.5%
Economic Value Added (EVA)
 It is essentially the surplus left after
making an appropriate charge for the
capital employed in the business.
Formula

WACC (c) : Weighted Average Cost of Capital

NOPAT = Net Operating Profit After Tax
r = Return on Capital (NOPAT / Capital)
Step 1: Calculation of NOPAT
Particulars Amount
Sales
Less: COGS
Less: Selling & Admin. Exp.
EBIT
Less: Tax
NOPAT
OK Beverage Company
Particulars Amount
Sales 125000
Less: COGS 86000
Less: Selling & Admin. Exp. 22000
EBIT 17000
Less: Tax 6800
NOPAT 10200
Step 2: Calculation of WACC
Sources Capital Proportion Cost WACC
Equity 96600 0.7 0.125 0.0875
Debt 41400 0.3 0.048 0.0144
Total 138000 1 10.19%

Cost of Equity (Ke) = 0.065 + (1 x 0.06) = 12.5%

Cost of Debt (Kd) = 0.08 x (1-0.40) = 0.048 = 4.8%
Step 3: Calculation of EVA
 EVA = NOPAT – (WACC x Capital Employed)
 EVA = 10200 – (0.1019 x 138000)
 EVA = 10200 – 14062
 EVA = -$3862.2
 So from accounting perspective OK-B looks like a
profitable beverage producer, the EVA insight
reveals that the firm is a wealth destroyer.
What Causes EVA to Increase
 Improvement in Operating Performance
 Profitable Investment
 Reduction in the cost of capital
Base Case
 Capital = 10000
 NOPAT = 2000
 Cost of Capital = 15%
 Required rate of Return = 20%

 EVA = Capital x (r – c)
 EVA = 10000 x (0.20-0.15)
 EVA = 500
Improvement in Operating
Performance
 NOPAT increase from 2000 to 2250, due
to greater operating efficiencies.
 EVA = 10000 x (0.225-0.15) = 750
Profitable Investment
 A new project requiring 10000 is
expected to earn a return of 18%.
 EVA = 20000 x (0.19 - 0.15) = 800
Reduction in Cost of Capital
 The capital structure of the firm is
altered and this change lowers the cost
of capital to 13%, without affecting
anything else.
 EVA = 10000 x (0.20 – 0.13)
 EVA = 700
EVA and NPV

Investment 100 Equity financing 100

Project Life 4 Years Depreciation SLM
Salvage Value Nil Tax rate 50%
Annual Revenue 200 Annual Costs 135
Cost of equity 15% (Excl. dep., int., tax)
EVA and Cash Flow Projections
Particulars 1 2 3 4
Revenues 200 200 200 200
Costs 135 135 135 135
PBDIT 65 65 65 65
Depreciation 25 25 25 25
PBIT 40 40 40 40
Tax @ 50% 20 20 20 20
NOPAT 20 20 20 20
Capital (Investment-Dep.) 100 75 50 25
WACC @15% of Capital 15 11.25 7.58 3.75
Employed
EVA (NOPAT-Capital Charge) 5 8.75 12.5 16.25
Calculation of NPV
EVA PV Factor @15% PVEVA
5 0.8695 4.347
8.75 0.7561 6.616
12.5 0.6575 8.219
16.25 0.5717 9.29
28.475
ALCAR Approach
According to Rppaport, the following seven
factors affect shareholders value:
 Rate of sales growth
 Operating profit margin
 Income tax rate
 Investment in working capital
 Fixed capital investment
 Cost of capital
 Value growth duration (The period over which
investments are expected to earn rate of
return in excess of the cost of capital).
Steps
 Forecast the operating cash flow
 Discount the forecasted operating cash flow
stream
 Estimate the residual value of business
 Determine the total shareholder value = PV of
operating cash flow + PV of residual value –
Market Value of Debt
 Establish the pre-strategy value = (Net Profit
Before New Investment / WACC) – MV of debt
 Infer the value created by the strategy = Total
shareholder value – Pre-strategy value