Economic Value Added
FIN 461: Financial Cases & Modeling
George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University
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

Firm’s comparative or competitive advantage.
W. P. Carey School of Business
Slide 2
Comparative 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.
W. P. Carey School of Business
Slide 3
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
Must be
sustainable
to be a true
competitive
advantage
Influence over suppliers
Influence over buyers
W. P. Carey School of Business
Slide 4
Traditional Measures
Fuzzy Finance
W. P. Carey School of Business
Slide 6
Return on Investment

Compare benefits (numerator) with
resources (denominator) affecting that
benefit

Basic earning power ratio


Return on assets


EBIT / Total assets
Net income / Total assets
Measured
relative
to what?
Return on equity

Net income / Book value of equity
W. P. Carey School of Business
Slide 7
Pro’s & Con’s

Benefits of these ratios



Ease of calculation & interpretation
Decompose to reveal sources of changes
Downside of these ratios




Sensitive to choice of accounting method
Accumulation of monetary values from different
periods
Backward looking
Fail to consider risk.
W. P. Carey School of Business
Slide 8
EPS: Opiate of the
Executive Suite


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.
W. P. Carey School of Business
Slide 9
EPS…


Accounting rules discourage EPS-manic
managers from spending capital on
value enhancing investments in
intangibles like brands, research and
training
Why?

GAAP requires outlays to be written off
immediately against earnings.
W. P. Carey School of Business
Slide 10
EPS…


EPS focus may cause management to
refrain from issuing equity at times
when the company really needs it
Fabricate EPS gains by using more debt
than prudent


Both on and off the balance sheet
Accept weak projects that happen to be
financed with debt.
W. P. Carey School of Business
Slide 11
EPS…

Earnings manipulation often used



Establish reserves
Invest pension funds in equities
Extreme cases, make up numbers as you
go

Worldcom and HealthSouth.
W. P. Carey School of Business
Slide 12
EPS…

Today’s market perception:
“Management that aims to boost earnings
at the expense of quality will be more
certainly penalized then ever before with
a lower stock price and a sullied
reputation.”
W. P. Carey School of Business
Slide 13
Performance vs. Valuation

Performance measurement

Relies on actual results



Historical
GAAP vs. GAP
Valuation


Relies on forecasts
Stock price relies on investors’
expectations, not historical performance.
W. P. Carey School of Business
Slide 14
Cash Flows
Statement of Cash Flows

SCF combines balance sheet and
income info
 Eliminates
the “sins of accrual
accounting”

SCF consists of:
 Operating
cash flows
 Investing cash flows
 Financing cash flows.
W. P. Carey School of Business
Free cash flow
Slide 16
Cash Flow Not the Answer

Cash flow has problems as a valid
performance measure

So long as investments in projects earn a
return higher than shareholders could
earn by investing on their own, then the
more investment a company makes and
the more negative its cash flow becomes,
the higher its share price will be.

Think Wal-Mart.
W. P. Carey School of Business
Slide 17
Better Than Some Alternatives


Accounting profits
versus cash operating
profits
Cash flow frequently
defined as:
Net income +
depreciation or as
EBITDA


Poor definition
3000
2500
2000
1500
NI + depr.
1000
NI
CFFO
500
0
-500
'97
'98
'99
'00
'01
'02
Quality of earnings ...
W. P. Carey School of Business
Slide 18
Free Cash Flows

Definition:


After-tax operating earnings + non-cash charges
- investments in operating working capital, PP&E
and other assets
It doesn’t incorporate financing related cash
flows


Represents cash flow available to service debt and
equity.
When used in capital budgeting proposals

Based on expectations.
W. P. Carey School of Business
Slide 19
FCF & Capital Budgeting


FCF is the method of choice of most
firms for evaluating capital budgets
Identify incremental




Investment in PP&E + working capital
Revenues
Costs (excluding financing)
Depreciation tax shields.
W. P. Carey School of Business
Slide 20
Common Techniques

Evaluation techniques:



Payback
Accounting rate of return
DCF analysis


Consists of NPV and IRR
DCF analysis is not a problem in theory

Only in practice.
W. P. Carey School of Business
Slide 21
NPV Methodology

Net present value (NPV)


Estimate of change in the value of equity if
the firm invests in the project
Forward looking

If NPV>0


If NPV<0


Investment is expected to add value
Investment is expected to erode value
Decision rule

Invest in projects expected to enhance value.
W. P. Carey School of Business
Slide 22
A Capital Budgeting Example
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
NOPAT
115
110
90
70
60
40
30
20
15
15
15
15
15
15
15
15
15
15
15
15
Deprec
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
NPV
IRR
WACC
W. P. Carey School of Business
FCF
-200
125
120
100
80
70
50
40
30
25
25
25
25
25
25
25
25
25
25
25
25
Excellent NPV
and IRR
Accept the
project!
$125.86
50.4%
25%
Slide 23
NPV(Using FCF) Profile
Free Cash Flow Profile
150
100
50
0
-50
-100
-150
0
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
NPV of FCF = $125.86
Significant info revealed?
-200
-250
W. P. Carey School of Business
Slide 24
Internal Rate of Return


Practice is to compare IRR with
weighted average cost of capital
Problem:


IRR fails to measure scale or growth
It sees no difference between earning a
20% return on a $1 million investment or a
$1 billion investment

These two projects are very different with
distinctly different NPVs.
W. P. Carey School of Business
Slide 25
IRR Profiles
(New Example)
$1,100
$900
$700
$500
IRRATL =36.53%
$300
$100
($100)
0%
16%
•
50%
($300)
($500)
IRRNE=19.63%
($700)
W. P. Carey School of Business
Slide 26
Conflicts: NPV & IRR
Which to Choose?
NPV
Marketing
Campaign
IRR = 16.35%
10% 10.7%
Discount
rate
Product
development
IRR =
13.24%
Select project with higher NPV (product development project)
W. P. Carey School of Business
Slide 27
Value Enhanced?

Once a project is applied, the investment
becomes buried in the balance sheet


How is its contribution measured?
No idea whether project generates value

Accounting measure relied upon



EBITDA and EPS generally increase
Means Bonuses probably will be paid
Motivation:

Get your hands on as much capital as possible.
W. P. Carey School of Business
Slide 28
Focused Finance & EVA
Focused Finance
W. P. Carey School of Business
Slide 30
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 litmus test of any company’s
success lies in increasing its market value
by more than it increases its capital.
W. P. Carey School of Business
Slide 31
View of the Firm
Market Valued Balance Sheet
Assets


Debt
Equity
Value of firm = Value of debt + value of stock
Market value of a company reflects:
 Earning power of invested assets
 Present
value of current operations
 Present value of expected improvement in
operating performance.
W. P. Carey School of Business
Slide 32
What is Required to Focus?

Tie performance methods to capital
budgeting techniques:



Economic value added (EVA)
Market value added (MVA)
Links to
NPV
Want to gauge management’s
performance

Focus on:

Decisions made in the past to help project the
future.
W. P. Carey School of Business
Slide 33
Market Value Added
Total
market
value
W. P. Carey School of Business
Premium
Market
value added
Book
value
debt +
equity
Investment
Slide 34
Also, Market Value Added
MVA = Present value of all future EVA
Total
market
value
W. P. Carey School of Business
Expected
improvement
in EVA
MVA
Book
value
debt +
equity
Current level
of EVA
Slide 35
What is EVA?

EVA = Economic profit

Not the same as accounting profit

Difference between revenues and costs


Economic profit adjusts for distortions caused by
accounting methods

Doesn’t have to follow GAAP


Costs include not only expenses but also cost of capital
R&D, advertising, restructuring costs, ...
Cost of capital accounted for explicitly


Rate of return required by suppliers of a firm’s debt and
equity capital
Represents minimum acceptable return.
W. P. Carey School of Business
Slide 36
Components of EVA

NOPLAT


Operating capital


Weighted average cost of capital %
Capital charge


Net operating working capital, net PP&E,
goodwill, and other operating assets
Cost of capital


Net operating profit after tax
Cost of capital % * operating capital
Economic value added

NOPLAT less the capital charge.
W. P. Carey School of Business
Slide 37
What is NOPAT?
Net sales
Cost of sales
Depreciation
SG&A
Net Operating profit
Taxes @ 40%
NOPAT
150,000
135,000
2,000
7,000
6,000
2,400
3,600
Excludes financing charges
W. P. Carey School of Business
Slide 38
What is Operating Capital?

Capital: Net operating assets adjusted for
certain accounting distortions


Net operating assets:




Asset write-downs, restructuring charges, …
Cash, receivables, inventory, prepaids
Trade payable, accruals, deferred taxes
Net property, plant, and equipment
Exclude non-operating assets:

Marketable securities, investments,...
W. P. Carey School of Business
Slide 39
What is Cost of Capital?

Weighted average cost of capital 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%.
W. P. Carey School of Business
Slide 40
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 firm’s weighted average
cost of capital % x invested capital.
W. P. Carey School of Business
Slide 41
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)
W. P. Carey School of Business
Slide 42
What’s Affecting EVA?
Sales
- Operating expenses
- Taxes
= NOPAT
- Capital charge
= EVA
Market potential
COGS, SG&A + other
Potential gov’t actions
Net working capital
PP&E
WACC
Evaluate the many assumptions!
W. P. Carey School of Business
Slide 43
Forward Looking Relationship
for EVA & MVA
EVA
Year 1
Market
Value
Market
value
EVA
Year 2
EVA
EVA
Year 3 .... Year n
MVA
=
Book
value
capital
W. P. Carey School of Business
EVA + EVA +
1+r
(1 + r)2
EVA + ... + EVA
(1 + r)3
(1 + r)n
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.
Slide 44
EVA Drives MVA
Companies that consistently earn profits
in excess of their required return ...
NOPAT
EVA
Charge
… are typically valued at premiums to book value.
MVA
Market
Value
Capital
W. P. Carey School of Business
Slide 45
Fundamental Strategies
 NOPAT

EVA  
 Cost of capital * Capital
 Capital

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.
W. P. Carey School of Business
Slide 46
An Example of Drivers
W. P. Carey School of Business
Slide 47
Focus on EVA Improvement

A positive change in EVA is better than
a positive yet unchanging base level of
EVA
 Why?


Positive changes in EVA are consistent with
“shareholder value added” -- whether from a
positive or negative base
Positive changes in EVA are consistent with
the managerial notion of continuous
improvement in performance.
W. P. Carey School of Business
Slide 48
Why Use EVA & Not NPV?




Present value of EVA
= Present value of NPV
Provides insight into each period
Is a direct link to performance
More useful for future project audits.
W. P. Carey School of Business
Slide 49
An Example Revisited
(See Slides 27 & 28)
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
NOPAT
115
110
90
70
60
40
30
20
15
15
15
15
15
15
15
15
15
15
15
15
Deprec
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
NPV
IRR
WACC
W. P. Carey School of Business
FCF
-200
125
120
100
80
70
50
40
30
25
25
25
25
25
25
25
25
25
25
25
25
$125.86
50.4%
25%
CapChg
50.0
47.5
45.0
42.5
40.0
37.5
35.0
32.5
30.0
27.5
25.0
22.5
20.0
17.5
15.0
12.5
10.0
7.5
5.0
2.5
Asset's
Balance
200
190
180
170
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
EVA
65.0
62.5
45.0
27.5
20.0
2.5
-5.0
-12.5
-15.0
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
12.5
EVA =
NOPAT
– WACC * Beginning Balance
= 110 – 25% * 190
= 110 = 47.5
= 62.5
$125.86
Slide 50
NPV
& EVA Profiles
(Using FCF)
FCF vs. EVA
150
100
50
0
-50
-100
-150
0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20
NPV of FCF = NPV of EVA = $125.86
Significant info revealed?
FCF
EVA
-200
-250
W. P. Carey School of Business
Slide 51
Real Life EVA

The Manitowoc Co. in Manitowoc, Wis., a diversified food service, crane
manufacturing and marine operations company, outsourced a reverse-auction
procurement system to a vendor instead of acquiring a software package itself. A
comparison using Economic Value Added of buying vs. renting would look like this
for the first year (hypothetical numbers):

In-house application
$180,000 in net benefits - ($1 million capital investment x 12% cost of capital) =
$60,000 EVA

Outsourced application
$180,000 in net benefits - ($0 capital investment x 12% cost of capital) - $80,000 in
rental fees = $100,000 EVA


Outsourced application requires no capital investment thus, no capital charge.
Suppose the operating costs to run the system in-house were $50,000 per year.

Most companies only look at the income statement side of the ledger; they wouldn't
outsource this application because it would be exchanging $50,000 of in-house expenses for
the $80,000 rental fee, another kind of expense on the income statement. Yet on an EVA basis,
the company would outsource the system, because doing so would produce more residual
income ($100,000 vs. $60,000) by virtue of the $0 capital charge.
"When you are exposed to the EVA philosophy, you recognize how to better manage
your capital," says Jim Pecquex, Manitowoc's CIO.
Source: Computerworld, February 17, 2003.
W. P. Carey School of Business
Slide 52
Real Life EVA …

Consider a recent EVA analysis that Robert Egan, vice president of IT at Boise
Cascade Corp., and his colleagues conducted for a storage investment. The
decision was whether to keep storage assets or replace them with new technology
that has lower maintenance charges.


The new storage technology costs $1 million, with maintenance costs of $100,000
per year. The maintenance expense on the old storage technology is $350,000.



For simplicity, we'll assume that the new storage equipment offers no benefits other than
the lower maintenance costs.
Boise's cost of capital is about 16%. Thus, the capital charge for investing in the
new storage is 16% x $1 million = $160,000, which EVA says must be added to the
$100,000 maintenance costs to get the true cost.
The result:



The example is illustrative. Egan declined to provide real cost figures.
The total cost of the new storage is $260,000, vs. $350,000 for the old storage.
"In this case, have you lowered the operating cost enough to make up for spending the
capital?" asks Egan. Yes -- $90,000 worth.
Boise is constantly reminded of the obvious point that technology isn't free. The
company is also aware of the less obvious fact: neither is the capital to finance it.
Source: Computerworld, February 17, 2003.
W. P. Carey School of Business
Slide 53
Real Life: Walgreen’s
Performance
W. P. Carey School of Business
Slide 54
Real Life: EVA & MVA
3-year changes in MVA explained by
regression analysis
W. P. Carey School of Business
Slide 55
Measure Earnings with EVA


Simple to explain and understand
EPS (and NI) ignore cost of equity capital

EVA doesn’t


Retained earnings no longer considered free
Benefits:




Reduce cost of capital
Improve operational efficiency
Better management of assets
Profitable growth.
W. P. Carey School of Business
Slide 56
Improvement in EVA
Sales
Operating Expenses
Capital Charge
Customer Satisfaction
New Products
Overhead
Compensation
Acquisitions & Divestitures
Working Capital Management
Volume
Marketing
Account Management
Training & Development
Alliances
Accounts Receivable
Product Pricing
Growth
Manufacturing Costs
R&D Decisions
Inventory Management
Manufacturing EVA Drivers
Research & Development EVA Drivers
Reduce inventory
Reduce cycle time
Improve yields
Reduce scrap/waste
Maximize labor efficiencies
Improve vendor efficiencies
Process improvements
Improve “to-market” process
Reduce R&D expenses as % of new product sales
Strategic partners for R&D
Stronger links to product marketing
New products via:
- Research
- Formulation
- Development
-Acquisition
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
W. P. Carey School of Business
Marketing EVA Drivers
Increase market share / revenue
New markets
More focused channel programs
Voice of customer / consumer
Leverage advertising / promotion
Build brand awareness
Slide 57
The End
W. P. Carey School of Business
Slide 58