Chapter Three: Performance

1
Chapter Three Performance

• Review from chapter two
• The market process results in resources being
  used where resources have the highest value.
• Firm exist as an alternative to market exchange
  because internal production if more efficient
  than purchasing products on the open market.
• Efficiency is then the key to evaluating a firm.
• How do we know if a firm is efficient?

2
What is the objective of the firm?

• Profit maximization The problem with this
  objective is that it is vague. A firm can
  maximize profit yet still not be adding value.
• Added Value Excess of revenues over the cost of
  all resources.
• If a firm fails to add value it cannot exist in
  the long-run.
• Economic Profit Total Revenue Explicit Cost
  Implicit Cost
• Accounting Profit Total Revenue Explicit Cost

3
Economic Profit

• Positive Economic Profit Total revenue exceeds
  the value of both implicit and explicit costs.
• a firm who is creating more value from its
  resources than those resource could generate in
  an alternative employment.
• Negative Economic Profit Total revenue is less
  than the value of both implicit and explicit
  costs.
• a firm who is creating less value from its
  resources than those resource could generate in
  an alternative employment.
• Zero Economic Profit Total revenue equals the
  value of implicit and explicit costs.
• Zero economic profit Normal accounting profit
• If a market is competitive we expect all firms to
  earn normal economic profits.

4
CAPM

• Capital Asset Pricing Model (CAPM)
• Calculates how risky a company is and devises a
  risk premium that must be added to the average
  cost of equity capital.
• In general, investors require 4 to 7 more per
  year to invest in company stocks than U.S.
  government securities. If U.S. securities return
  5.5, then the average firm needs to return
  between 9.5 and 12.5.

5
Economic Value Added

• Problem - Capital financed with equity is
  frequently regarded as free. It may be free to
  the firm but it is not to the shareholders.
• Terms
• NOPAT Net Operating Profit After Tax
• WACC Weighted Average Cost of Capital
• Economic Value Added Economic Profit
• EVA NOPAT WACCCapital
• http//www.eva.com/

6
EVA Example

• After-tax Profit 8 million (ignoring the cost
  of debt or interest payments)
• Capital 100 million
• 50 is financed through equity - _at_ 15
• 50 is financed through debt - _at_ 5
• 15 return on equity is determined by stockholder
  (owner) expectation which in turn is determined
  by the risk of the firm.
• Weighted average cost of capital .5015 .505
  10
• Cost of capital 100 million 10 10
  million
• EVA -2 million
• Debt is paid 2.5 million (50 million 5)
• Stockholders demand 7.5 million (50 million
  15) but only receive 5.5 million.

7
EVA Lessons

• If EVA is negative, stockholders might sell the
  stock, hence driving down its price. This will
  signal the firm that its performance is below
  expectations. Furthermore, future stock issues
  may be difficult, hindering firm growth.
• Stockholder opportunity cost (the return they
  could receive for their financial resources) is
  going to drive their response to the companies
  performance.
• If the company does not consider the opportunity
  cost of their capital (the return the capital
  could generate in alternative uses) they will not
  maximize the return the firm could be receiving.

8
Stock Prices and EVA

• What determines the value of a firms stock?
• Current measures of EVA are only important if it
  tells us about the future.
• Stock Price Present Value of Expected Future
  Economic Profit
• P S(Economic Profit)/(1r)i
• P stock price
• r cost of capital (WACC)
• Why do stock prices rise and fall? Investors
  revise expectations

9
Calculating Cost of Capital

• Cost of Capital Risk-free rate betarisk
  premium
• Beta measures the volatility of a companys
  stock relative to the entire market.
• If Beta 1, then a firms stock is as volatile
  as the market.
• If Beta 1, then a firms stock tends to rise
  farther than the market, but also fall further.
• If Beta as far nor fall as far.