The value of any stock, bond or business today is determined by the cash inflows or outflows – discounted by an appropriate discount rate – that can be expected to occur during the remaining life of an asset. - Warren Buffett, Berkshire Hathaway Annual Report (1992)

The Evolution of Value Based Management Firm value = PV (future free cash flows). Firm value = Σ PV t (EVA t ) + Invested Capital. Firm value = Σ PV t (CVA t ) + Invested Capital. EVA Stern Stewart & Co. CVA BCG and HOLT Value Associates Basic Notion Firm value = PV (FCF of existing assets)+ PV (Growth opportunities) Strategic Value Analysis LEK / Alcar

Free Cash Flow Approach Firm’s FCF = Financing or Investors’ cash flow Firm’s perspective EBITDA – cash tax payments – incremental investment in operating assets Investor’s perspective FCF = The amount received by investors interest payment to creditors + repayment of debt principal - additional debt issued + dividends + share repurchases - additional stock issued Financing cash flow 1.Net working capital (CA-CL) 2. Capital expenditures and long-term assets.

Free Cash Flow& Firm valuation Firm Value Present value of free cash flow Value of Non-operating assets = ＋ - Marketable securities - Excess real state - Over funded pension plan Firm Value Shareholder valueFuture claim = ＋ - Interest-bearing debt - Capital lease obligations - Under funded pension plan - Contingent liabilities

Free Cash Flow Approach Free cash flow and firm’s valuation 1.How long should we calculate? 1.CF during strategic planning period 2.After strategic planning period, “residual value” How long is strategic planning period? 2. How to forecast free cash flow? (Value drivers) -Assumption of “Value Drivers” a) Sales growth b) Operating profit margin c) Cash tax rate d) Net working capital / sales e) Other long-term assets / sales 3.Determine the discount rate. - Based on opportunity cost. Through value drivers, we can analyze how to improve to firm’s FCF.

Forecasting Free Cash Flow Value driver assumptions Case ： Ashley Corporation Residual period begins

Free Cash Flow Calculations Sales of prior year= ＄ 240,000 Year 1 =(1+Sales growth rate) × Prior year sales = (1+0.08) × ＄ 240,000=259,200 Incremental asset investment in year t = ( Sales in year t – Sales in year t-1) × Asset-to-sales percent Year1 Net working capital=( ＄ 259,200- ＄ 240,000) ×5.5 ％ = ＄ 1,056 Fixed assets=( ＄ 259,200- ＄ 240,000) ×40 ％ = ＄ 7,680 Other long term assets= =( ＄ 259,200- ＄ 240,000) ×2 ％ = ＄ 384

Determining the Discount Rate 【 Cost of debt×(1-Tax rate) ×Debt/Firm Value 】 7.68 ％ ×(1-0.27)=5.61 ％ ＋【 Cost of equity × Equity/Firm value 】 risk free rate+ company beta × market premium 6 ％＋ (1.35×8 ％ )=16.8 ％ Weighted cost of capital Debt25 ％ 5.61 ％ 1.40 ％ Equity75 ％ ％ ％ WACC14.00 ％ Percentage of capital After-Tax Cost Weighted Cost

Free Cash Flow Calculations Planning period present value Residual value in year T Residual value in year 10= ＄ 18,623/( )=$163,36 Present value of residual CF=$163,36/(1+0.14) １０ =$44.06

Firm’s Economic value Economic value=present value of all cash flows = Present value of the planning period free cash flow +Present value of the residual period free cash flow Present value of the cash flows for year1-10 ＄ Present value of the cash flows for the residual value ＄ Firm’s economic value ＄ Excess real estate 7.5 Firm value ＄ Debt ＄ Shareholder value ＄ 48.08

Magic Value Drivers Threshold profit margin=7.2% Sales growth increase Firm value decrease Sales growth increase Firm value increase Myth of Growth & Firm Value In Case Table 4.2 PV of cash flow= ＄ 82.6 million If sales growth =0 PV of cash flow= ＄ 87.6 million Potential value = negative 5 million Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)

Further Dissuasion of Value Driver sensitivity Analysis of operating margin6.00%$27,369 - $20, %37,731-10, %48, %58,43610, %68,78920, %79,14131, %89,49441,410 Operating Profit Margin Equity Value Change in Base case of EV Base case Through sensitivity Analysis of different Value Divers We can find the one affects firm’s value most ！ Thousands of dollars

Economic Value Road Map Financing Decision Investing Decision Operating Decision

EVA is based on something we have know for a long time: what we call profit, the money left to service equity, is not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources…. Until then it does not create wealth; it destroys it. - Peter Drucker, The Information Executives Truly Need (1995)

EVA Approach Accounting profits v.s. Economic profits Accounting profits Sales Cost of goods sold Operating expenses Interest expense Taxes = Economic profits or Residual income Sales Cost of goods sold Operating expenses Taxes Charge for all capital used = NOPAT Net operating profits after taxes

Firm Value Present value of future free cash flow Invested Capital = ＋ = Present value of future residual Income Free Cash flow & Residual Income Approach

g=7.5% 1. Profit margin = 6.25% 2. Retention ratio = 60% 3. Investment (WC & real) = 0.5 per dollar of sales growth 4. Cost of capital = 10%

Free Cash flow & Residual Income Approach Residual Income: 1,250-10,000 × 10% = 250 g=7.5%

Free cash flow or Residual Income? Doesn’t provide readily apparent measure of Annual Operating performance When Free cash flow ＜ 0 a)Investment is high in profitable firm b)Operating is poor in unprofitable firm e.g.Wal-Mart FCF -13% of capital, R is +8 % above its cost of capital Kmart FCF +7% of capital, R is -3 % below its cost of capital The weakness of free cash flow ： Residual Income provides better measure of period performance ！

EVA Approach EVA Cash flow from operations Accruals After-tax interest Capital charges Accounting adjustments =++-+ Earnings Operation profits Economic profits Economic Value Added (EVA)

EVA Drivers EVA = NOPAT- (k*Capital) = (r- k)*capital EVA = NOPAT- (k*Capital) = (r- k)*capital NOPAT = operating profits after taxes but before financing costs and noncash bookkeeping entries except depreciation NOPAT = operating profits after taxes but before financing costs and noncash bookkeeping entries except depreciation Return on capital (r) = Return on capital (r) = Return on capital = Return on capital = NOPBT = firm’s net operating profits before taxes NOPBT = firm’s net operating profits before taxes Profit Margin Capital Turnover Cash tax rate

EVA Drivers

EVA Calculation 1.Convert from accrual to cash accounting (LIFO, Bad debt reserves) 2.Capitalize market-building expenditures that have been expensed in the past (R&D) 3.Remove cumulative unusual losses or gains after taxes Convert NOPAT and Capital form accounting book value to economic book value

NOPAT

CAPITAL

Example :Hobbs-Meyer Co.

Example: Hobbs-Meyer co Finance Equity Equivalents Tax Equity Equivalents

Example: Hobbs-Meyer co

Example :Hobbs-Meyer Co. 法一 法一 EVA=NOPAT-Cost of capital* Capital EVA=NOPAT-Cost of capital* Capital = %* = = %* = 法二 法二 EVA=(Return on capital-Cost of capital) EVA=(Return on capital-Cost of capital) *Capital *Capital =(686000/ %)* =(686000/ %)* = =288000

EVA V.S MVA Market Value Added Market Value Added = Market Value of Equity - Book Value of Equity = Market Value of Equity - Book Value of Equity = Present value of all future EVA = Present value of all future EVA Market Value of Equity Market Value of Equity = Book Value of Equity + Present value of all future EVA = Book Value of Equity + Present value of all future EVA

EVA V.S MVA Positive MVA Negative MVA

EVA VS Investment Source: Stern Stewart Research “Special Report”,Apr,2002

EVA is closely related to NPV. EVA is closely related to NPV. It avoids the problems associates with approaches that focus on percentage spreads( rate of return- rate of cost) It avoids the problems associates with approaches that focus on percentage spreads( rate of return- rate of cost) It makes top managers responsible for a measure that they have more control over It makes top managers responsible for a measure that they have more control over It is influenced by all of the decisions that managers have to make within a firm It is influenced by all of the decisions that managers have to make within a firm Advantages of EVA

increases in current EVA come at the expense of future EVA increases in current EVA come at the expense of future EVA higher EVA is accompanied by an increase in the cost of capital higher EVA is accompanied by an increase in the cost of capital increase in EVA is less than what the market expected it to be, leading to a drop in the market price increase in EVA is less than what the market expected it to be, leading to a drop in the market price Side Effects of EVA with minimize risk