Economic Value Added Financial Accounting

1
Economic Value Added Financial Accounting
Corporate Finance

• Dr Clive Vlieland-Boddy

2
How Value is Created

• Management makes decisions, hopefully, with
  benefits exceeding costs
• Benefits may be near or distant future
• Costs should include direct investment costs
  cost of capital
• True source of value-enhancing projects
• Firms comparative or competitive advantage.

3
Competitive Advantage

• Advantage one firm has over another in terms of
• Cost of producing or
• Distributing goods/services
• Example Wal-Mart invested in regional warehouses
  and distribution system
• Reduces the need for retail inventory
• Replenish store inventory quickly.

4
Competitive Advantage

• Advantage one firm has over another because of
  structure of the markets in which they operate
• Barriers to entry
• Patents
• Capital requirements
• Regulation
• Influence over suppliers
• Influence over buyers

Must be sustainable to be a true competitive advan
tage
5
Traditional View of Finance
6
Traditional - Return on Investment

• Compare benefits (numerator) with resources
  (denominator) affecting that benefit
• Basic earning power ratio
• EBIT / Total assets
• Return on assets
• Net income / Total assets
• Return on equity
• Net income / Book value of equity

Measured relative to what? But the
public understand them
7
Pros Cons

• Benefits of these ratios
• Ease of calculation interpretation
• Decompose to reveal sources of changes
• Universally understood
• Downside of these ratios
• Sensitive to choice of accounting method
• Accumulation of monetary values from different
  periods
• Backward looking
• Fail to consider risk.

8
EPS and Management!

• EPS is such an unreliable measure of value that
  managers often make dumb decisions to increase
  it
• Prompts managers to misallocate capital
• Treats retained earnings as a free source of
  capital
• Promotes retaining capital and using it
  wastefully.

9
EPS

• Accounting rules discourage EPS-manic mangers
  from spending capital on value enhancing
  investments on intangibles like
• Brands
• marketing campaign or
• research and training
• Why?
• GAAP requires outlays to be written off
  immediately against earnings. (Prudence)

10
EPS

• EPS focus may cause management to refrain from
  issuing equity at times when the company really
  needs it
• Create EPS gains by using more debt than prudent
  (Encourages financial leverage )
• Both on and off the balance sheet
• Accept weak projects that happen to be financed
  with debt.

11
EPS

• Todays market perception
• Management that aims to boost earnings at the
  expense of quality will be more certainly
  penalised then ever before with a lower stock
  price and a sullied reputation.

12
Performance Vs. Valuation

• Performance measurement
• Relies on actual results
• Historical
• IFRS or GAAP
• Valuation
• Relies on forecasts
• Stock price relies on investors expectations,
  not historical performance.

13
Focused Finance EVA
14
Focused Finance
15
EVA Wealth Creation

• Warren Buffet
• We feel noble intentions should be checked
  periodically against results. We test the wisdom
  of retaining earnings by assessing whether
  retention, over time, delivers shareholders at
  least 1 of market value for each 1 retained.
• Translation
• Ultimate test of any companys success lies in
  increasing its market value by more than it
  increases its capital.

16
View of the Firm
Market Valued Balance Sheet
Assets Liabilities Equity

• Value of firm Value of Liabilities Value of
  Equity
• That is the amount of invested capital
• Market value of a company reflects
• Earning power of invested assets
• Present value of current operations
• Present value of expected improvement in
  operating performance.

17
What is Required to Focus?

• Tie performance methods to capital budgeting
  techniques
• Economic value added (EVA)
• Market value added (MVA)
• Want to gauge managements performance
• Focus on
• Decisions made in the past to help project the
  future.

Links to NPV
18
Market Value Added
Market value added
Premium
Total market value
Debt equity capital
Investment In Company
19
What is EVA?

• EVA Economic profit
• Not the same as accounting profit
• Difference between revenues and costs
• Costs include not only expenses but also cost of
  capital
• Economic profit adjusts for distortions caused by
  accounting methods
• Doesnt have to follow GAAP
• RD, advertising, restructuring costs, ...
• Cost of capital accounted for explicitly
• Rate of return required by suppliers of a firms
  debt and equity capital
• Represents minimum acceptable return.

20
What is Cost of Capital

• Evaluation of profitability should also consider
  the lost opportunity that the capital has.
• A company has Invested capital. This could make a
  return elsewhere.
• Before fully evaluating the profitability
  allowance for the cost of this capital should be
  considered.
• This represents an opportunity cost.

21
Also, Market Value Added
Expected improvement in EVA
MVA Present value of all future EVA
MVA
Total market value
Debt equity capital
Current level of EVA
22
Components of EVA

• NOPAT
• Net operating profit after tax
• Operating capital
• Net operating working capital, net PPE,
  goodwill, and other operating assets
• Cost of capital
• Weighted average cost of capital
• Capital charge
• Cost of capital operating capital
• Economic value added
• NOPLAT less the capital charge.

23
Explicit Vs Implicit Costs

• Explicit costs are direct attributable costs like
  materials or labour used in production.
• Implicit costs or otherwise known as opportunity
  costs are those costs that are the result of
  losing an alternative use.
• Example If I have 1m to invest in a company, I
  lose the opportunity to leave it in the bank
  earning interest of say 5.

24
What is NOPAT?

• Net sales 150,000
• Cost of sales 135,000
• Depreciation 2,000
• SGA 7,000
• Net Operating profit 6,000
• Taxes _at_ 40 2,400
• NOPAT 3,600
• Excludes financing charges

25
What is Operating Capital?

• Capital Net operating assets adjusted for
  certain accounting distortions
• Asset write-downs, restructuring charges,
• Net operating assets
• Cash, receivables, inventory, pre-paid expenses
• Trade payable, accruals, deferred taxes
• Net property, plant, and equipment
• Exclude non-operating assets
• Marketable securities, investments,...

26
What is Cost of Capital?

• The cost of capital is the total cost of debt
  and equity that finances the business.
• Weighted average cost of capital (WACC) consists
  of
• Cost of debt after taxes
• Market interest rate x (1 tax rate)
• Cost of equity
• Risk-free rate beta x (market risk premium)
• WACC
• Cost of debt after taxes x debt
  cost of equity x equity
• where debt equity 100.

27
What is the Capital Charge?

• Represents a rental charge for the use of the
  operating capital
• Minimum rate of return the operating capital
  should earn
• Calculated as the firms weighted average cost of
  capital x invested capital.
• It represents the opportunity cost of capital

28
Calculating EVA

• NOPAT/Average capital
• Return on invested operating capital (ROIC)
• - Weight average cost of capital (WACC)
• Spread ( ROIC - WACC)
• Operating capital
• Economic value added (EVA)
• Net operating profit after tax (NOPAT)
• - Capital charge ( WACC Capital)
• Economic value added (EVA)

29
Whats Affecting EVA?

• Sales
• - Operating expenses
• - Taxes
• NOPAT
• - Capital charge
• EVA

Market potential
COGS, SGA Other
Potential govt actions
30
Forward Looking Relationship for EVA MVA
EVA EVA EVA EVA Year 1
Year 2 Year 3 .... Year n
MVA
MVA
Market Value
Market value
EVA EVA EVA ... EVA 1 r
(1 r)2 (1 r)3 (1 r)n

Capital
Market value is based on establishing the
economic investment made in the company
(capital), making a best guess about what
economic profits (EVA) will happen in the future,
and discounting those EVAs to the present to get
market value added.
31
EVA Drives MVA

• Companies that consistently earn profits in
  excess of their required return ...

EVA
NOPAT
Charge
are typically valued at premiums to book value.
MVA
Market Value
Capital
32
Fundamental Strategies
Operate Improve the return on
existing operating capital
Decrease WACC
Build Invest as long as returns exceed the cost
of capital
Harvest Re-deploy capital when returns fail to
achieve the cost of capital.
33
Measure Earnings with EVA

• Simple to explain and understand
• EPS (and NI) ignore cost of equity capital
• EVA doesnt
• Retained earnings no longer considered free
• Benefits
• Highlights real areas of concern. Can enable-
• Reduce cost of capital
• Improve operational efficiency
• Better management of assets
• Profitable growth.

34
Improving EVA

• EVA adapts accounting profits and concentrates on
  the forward picture rather than the past. It
  suggests up to 160 accounting adjustments as it
  believes in minimising the prudence accounting
  concept.
• IT encourages capitalisation of R D,
  Advertising and training programmes. It
  highlights
• Changes in Manufacturing Processes
• Managing the labour force more efficiently
• R D to improve activities
• Marketing to maximise facilities and expand

35
Manufacturing EVA Drivers

• Reduce inventory
• Reduce cycle time
• Improve yields
• Reduce scrap/waste
• Maximize labor efficiencies
• Improve vendor efficiencies
• Process improvements

36
Staff EVA Drivers

• Work group/process simplification
• Consistency monitors audit
• Centralizing resources/synergies
• Best practices benchmarking
• Insourcing/outsourcing decisions
• Simplify EVA measurements/reporting
• Ensure compliance with legislation

37
Research Development EVA Drivers

• Improve to-market process
• Reduce RD expenses as of new product sales
• Strategic partners for RD
• Stronger links to product marketing
• New products via
• - Research
• - Formulation
• - Development
• Acquisition

38
Marketing EVA Drivers

• Increase market share / revenue
• New markets
• More focused channel programs
• Voice of customer / consumer
• Leverage advertising / promotion
• Build brand awareness

39
Main Criticisms

• Created by Stern Stuart
• As such it is commercially driven unlike say
  DuPont.
• Can be confusing to the public

40
Main Benefits

• Only real forward evaluation tool for
  profitability and efficiency.
• Can be proven against NPV of MVA.
• Does accept that there is a real opportunity cost
  of capital especially Retained Earnings.

41
Bye for now!
Im ready forsome leisure time.
41
42
The End