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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.

JNA/FEUNL 2

way of life: – Total commitment with the concept of shareholder value creation. – Implement profound change in systems and procedures. – Empower business units. • VBM . JNA/FEUNL 3 . … Intro (2). – Use training as an instrument to achieve total organizational involvement. – Use compensation policy to promote culture change.

You expect first-year sales of € 11. The project requires € 12 million in fixed assets. 45 percent of sales. Should you invest in this project? 2. straight-line. to be fully depreciated. The cost of sales represents. At the end of the sixth period you expect to fully recover working capital investment.1 million. The income tax rate is 35 percent. Capital budgeting exercise Take into account the following information: The new project is expected to last for six years. Compute the NPV of the project using this estimate of economic profit. Use Discounted cash flows to compute the NPV of the project. over the next six years with zero residual value. Assume a 13 percent cost of capital. Fixed assets are worthless. JNA/FEUNL 4 . Compute the NPV of the project using this estimate of economic profit (EVA). Use the Net income approach to estimate the economic profit. The growth rate in sales for the following 5 years is expected to be 4 percent. Other annual fixed expenditures are € 1.75 million and it should grow at the same annual rate as sales. Initial working capital is € 0.5 million. on average. Use the Operating cash flow approach to estimate the economic profit. 1.

Discounted cash flows JNA/FEUNL 5 .

. • CE = Net WC + Other net assets. • MVA = PV (EVA). Economic profit and EVA . • WACC = wL x kL + wB x kB x (1-t) JNA/FEUNL 6 .WACC) x CE • NP and EVA (applied to same project). • Equivalent definitions: – NP= NOPAT-Capital employed x WACC – NP = (NOPAT / CE ..

EVA JNA/FEUNL 7 . Economic profit .

NOPLAT JNA/FEUNL 8 . Economic profit .

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 JNA/FEUNL 9 .

. 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. JNA/FEUNL 10 .. 10% of the operating cash flow of the same year. Project Vega . 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%. each year. Consider the following information..

Please calculate: 1) Project NPV using discounted cash flows (use 200 periods).. 2) Project NPV using economic profit (use 200 periods).. Project Vega . What is the proportion of NPV generated from period 7 onwards? JNA/FEUNL 11 .. 4) Graph the project’s ability to generate value through time. 3) Project NPV using residual value formulas from period 7 onwards. ..

JNA/FEUNL 12 .

JNA/FEUNL 13 .

He has a background in engineering and was employed.00% 90.00% 67. two years ago.0% 10.0% 0. from the MBA program at NOVA.84 3.50% 70.00% 75.70 0. in a software company.5% Divestitures in FA (net of taxes) 0.0% 20. he is conducting a preliminary financial evaluation of the project.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) 87.81 4.0% 347 Divestitures = depreciation from period 7 onwards Depreciation rate 7.5% 7.5% 7.01 Growth rate in sales 100% 350% 25% 10% 5% 2% COGS as % sales 65.0% 20. the idea seems quite acceptable.5% 7.5% 7.0% 0.30 5.5% 7. Value and economic profit António Alves graduated.00% 65. As it stands.32% JNA/FEUNL 14 . 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. for a number of years.5% 7. Based his own technical analysis of the business opportunity and on expectations about sales potential provided by a local market research consultant.5% 7.5% 7.00% 80.00% 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. He is considering launching his own company.5% 7.16 6.15 3.

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 JNA/FEUNL 15 .

0000 0.5066 0.8929 0.1% JNA/FEUNL 16 .6355 0.7972 0.4523 PV of cash flows -3000 -1761 -620 1173 2152 2147 1560 2268 NPV 3920 MIRR 21.5674 0.7118 0. 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.

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 JNA/FEUNL 17 .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.

JNA/FEUNL 18 .

– Adjustments to non-operational items (Investment in progress. – Convert accrual accounting into cash flows (provisions. – Accrual of unusual events (corporate restructuring.). etc.). strategic investments. JNA/FEUNL 19 . tax payments. … Economic profit and EVA • Adjustments to NOPAT and CE (accounting information versus economic value): – Transform cash flows into economic flows (R&D. for instance). etc.). divestitures. etc.

etc. marketing.WACC) x CE = (NOPAT/Sales x Sales/TA . purchasing. JNA/FEUNL 20 . safety. sales mix.WACC) x CE= (ROI . etc. efficiency. EVA drivers • NP = (NOPAT / CE . innovation. • Costs: productivity. quality.WACC) x (WC+ONetAssets) • Revenues: price. • Cost of capital employed: asset efficiency and WACC.

Market value added EBITDA Innovation Discounted cash flows ROIC Efficiency Option valuation Net income Growth Diversification JNA/FEUNL 21 . IRR: Economic profit Market share. A sequence of metrics Price Intrinsic Financial ratios Value drivers behavior value Total Shareholder return NPV.

– Expected level of EVA. • Actual compensation depends on goals and bank balance. – Period by period performance evaluation. EVA and compensation system • Level of performance: – Involves whole organization. – EVA bank (bonus bank): • EVA adds to bonus bank. growth rate and maximum allowed shortfall. JNA/FEUNL 22 .