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8/7/2019 A question of values _ ACCA Qualification _ Students _ ACCA

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A QUESTION OF VALUES

by Steve Jay

01 Oct 2001

It is generally accepted that the objective of corporate financial management is to maximiseshareholder wealth in the form of rising share prices and dividends. Whilst this is obviously inthe interest of shareholders it should also benefit society as a whole. This is because it shouldlead to the most efficient companies finding it easiest to raise new share capital and thusensure that societys scarce resources are allocated and managed most efficiently.Unfortunately history shows us that accounting profit measures often appear to have littlecorrelation with share price performance. This is particularly true in new-economy companies,many of which have poor profit records but who have demonstrated large increases in wealthfor their investors during the 1990s.

Market Value AddedBefore proceeding with a look at economic value added it is important that we clarify ourmeasure of shareholder wealth. Imagine two quoted companies A plc and B plc. Both firms areentirely equity financed. Both have a start of year stock market equity capitalisation of 400million. A raises 20 million via a rights issue and invests it in a project that adds 100m to thepresent value of its future earnings. B raises 150 million via a rights issue and invests in aproject that adds 120m to the present value of its future earnings. Table 1 demonstrates thechanges to equity market capitalisation and shareholder wealth.

Table 1 Changes in Stock market value

A B

Opening Total Value (equity market capitalisation) 400m 400mAddition to Present value of earnings stream 100m 120m

Closing Total Value (equity market capitalisation) 500m 520m

Changes In shareholder wealth

Increase in Total Value (equity market capitalisation) 100m 120m

Funds subscribed by shareholders (20m) (150m)

Market value added for the period 80m (30m)

It is clear that although company B has the greater increase in market capitalisation it hasdecreased the wealth of its shareholders as the present value of the future income generated

by its new project is less than the funds invested. Company A on the other hand adds 80m tothe wealth of its investors.

This is a simple but important point. Shareholder wealth is not simply the increase in stockmarket value over the period; rather it is the increase in stock market value less fundssubscribed by shareholders.

This concept can be enlarged to cover the whole life of the business. Over a longer time periodthe market value added is the difference between the cash that investors have put into thebusiness (either by purchase of shares or the reinvestment of potentially distributable profits)and the present value of the cash they could now get out of it by selling their shares.

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The link with NPVNone of the above is particularly new. NPV is a well-established rule that measures the impactthat new projects will have on shareholder wealth. Table 2 adds some more detail to the twoprojects being considered by companies A and B.

Table 2 Cash Flows

m

Company A Project

m

Company B Project

t0 Initial investment (20) (150)

t1-t4 Net cash flow pa 35.03 46.35

CAPM based required rate of return 15% 20%

Net Present value Project A = (20) + Annuity factor for 4 years @ 15% * 35.03=(20) + 2.855 * 35.03=80

Net Present value Project B = (150) + Annuity factor for 4 years @ 20% * 46.35=(150) + 2.589 * 46.35=(30)

Both of these figures correspond with the Market Value Added in the period and the NPV ruleshould guide managers to select projects that maximise shareholder wealth.

Economic Value AddedSo far we have established that the prime objective of financial management is to maximiseinvestor wealth and that this can be achieved by using NPV in decision making. What is lackingis an operating performance measure for management that will guide managers to maximiseNPV and thus shareholder wealth.

Traditionally operating managers are judged on accounting profit based measures (controllableprofit, return on investment, etc), which we have noted, often lack correlation with shareholder

wealth and largely ignore NPV. It seems very strange that we expect managers to evaluate newprojects on the basis of NPV but that we subsequently ignore NPV in appraising managerialperformance.

Economic value added attempts to cure this problem. Economic value can be defined as:Cash Earnings before interest but after tax* an imputed charge for the capital consumed.

*often referred to as NOPAT (net operating profit after tax)

In this way a managers operating performance is judged after charging a amount for capitalfunds used.

It will be noted that this is very similar to residual income, a performance measure you will haveconsidered in earlier studies.

Crucially the present value of the economic value added figures equals the NPV of the project.Economic Value added is sometimes referred to as EVA. EVA is the registered trademarkof Stern Stewart and Co who have done much to popularise and implement this measure ofresidual income.

Table 3 shows the calculation of economic value added for our two projects and demonstratesits equivalence with NPV.

Table 3




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m

t1 t2 t3 t4

Company A Project

Year beginning Capital employed (net) 20 15 10 5

Net of tax operating cash flow 35.03 35.03 35.03 35.03

Economic depreciation* (5) (5) (5) (5)

Imputed capital charge (15% of capital employed) (3) (2.25) (1.5) (0.75)

Economic Value added 27.03 27.78 28.53 29.28

Company B Project

Year beginning Capital employed (net) 150 112.5 75 37.5

Net of tax operating cash flow 46.35 46.35 46.35 46.35

Economic depreciation* (37.5) (37.5) (37.5) (37.5)

Imputed capital charge (20% of capital employed) (30) (22.5) (15) (7.5)

Economic Value added (21.15) (13.65) (6.15) 1.35

Equivalence with NPV

Company A Economic Value Added 27.03 27.78 28.53 29.28

PV factors @15% 0.870 0.756 0.658 0.572

Present Value 23.52 21.00 18.77 16.75

Total Present Value = 80.04 million = Project NPV (difference due to rounding)

Company B Economic Value Added (21.15) (13.65) (6.15) 1.35

PV factors @20% 0.833 0.694 0.579 0.482

Present Value (17.62) (9.47) (3.56) 0.65Total Present Value = (30million) = Project NPV

*Economic depreciation measures the true fall in the value of assets each year through wearand tear and obsolescence. Although depreciation would not normally be charged incalculating discounted cash flow in this case it must be recovered from a companys cashflow to provide investors with a return of their capital before they can enjoy a return on theircapital. G Bennett Stewart . Alternatively it could be viewed as the capital expenditure the firmwould have to make each year to maintain its capital base. In this example, for simplicity,economic depreciation is assumed to occur on a straight-line basis though clearly otherpatterns are possible.

The LinkagesTo recapThe increase in shareholder wealth= Market value added= Project NPV= Present Value of Economic Value added.

Therefore if we tell managers that their performance will be judged upon economic valueadded, this should result in the maximisation of NPV and thus shareholder wealth. We nowhave a performance measure that corresponds exactly with NPV based decision-making.Proponents therefore recommend that managers and divisions operating performance should




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be measured on an economic value added basis.

Some complications

Geared companiesNot all companies are financed entirely by equity many fund substantial parts of their plantand equipment by using debt finance. The principles of economic value added still apply. Cashearnings before interest but after tax are charged for capital at a rate that blends the after taxcost of debt and the cost of equity in the target proportions the firm would plan to employ(rather than the actual mix used in a particular year). Imagine that company A financed its

project by 50% equity finance and 50% risk free debt finance and that this was considered toreflect the target capital structure. To reflect this higher gearing As cost of equity financeincreases to 18.5%. Its post tax cost of debt is 7%. This gives a weighted average cost ofcapital for the project of

18.5% * 50% + 7% * 50% = 12.75%

The capital charge to the project will now be at 12.75% of year beginning capital employed.Note that interest on the loan should not be deducted from the net of tax operating cash flow asit is allowed for in the imputed capital charge. The tax relief on interest should not be allowed forin the tax bill, as once again this is included in the capital charge. Students will note that this issimilar to the approach taken in estimating net cash flow in NPV calculations. This approach isillustrated in Table 4 together with other adjustments.

Table 4 XYZ plc Profit and loss account year ended 31/12/2000 (Unadjusted)

m

Sales Revenue 50

Cost of sales 28.3

Depreciation 0.8

Interest paid 1.6

R&D 2.1

Advertising 2.3Amortisation of goodwill 1.3

Profit before tax 13.6

Tax paid (30%) 4.08

Available to equity 9.52

XYZ plc Balance Sheet as at 31/12/1999 (unadjusted)

m

Fixed assets (net) 40

Current Assets 125

Less Current Liabilities 98

Borrowings 27

Net assets 40

Ordinary shareholders funds 40

XYZ plc Profit and loss account year ended 31/12/2000 after adjustments

m

Profit before tax 13.6




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AddInterest paid 1.6 note 1

R&D 2.1 note 2

Advertising 2.3 note 3

Goodwill 1.3 note 4

Less

Adjusted Tax bill 4.56 note 5

Adjusted profit 16.34 note 7

XYZ plc Balance Sheet as at 31/12/1999 after adjustments

m

Ordinary shareholders funds 40

Add borrowings 27 note 1

R&D 13.4 note 2

Advertising 15 note 3

Goodwill 8.9

Adjusted capital employed 104.3

Adjusted return 16.34

Required Return 104.3 m * 15% = 15.645 note 6

EVA 0.695

Economic value added and reported accounting resultsPublished accounting profit figures are more complicated than operating cash flow lesseconomic depreciation as featured in Table 3. For reasons of prudence, losses are oftenrecognised at an early date and accruals accounting makes many timing adjustments to cashflow in converting it to accounting profit.

As we are really interested in economic profit rather than accounting profit these adjustmentshave to be eliminated or added back in. The consulting firm Stern-Stewart have identified 164performance measurement issues in its calculation of EVA from published accounts. Theadjustments mainly involve:

1. Converting accounting profit to cash flow2. Distinguishing between operating cash flows and investment cash flows

They include such issues as treatment of stock valuation, revenue recognition, bad debts, thetreatment of R&D, advertising and promotion, pension expenses, contingent liabilities etc.Whist it is unlikely that you would have to make 164 adjustments in the exam some simple

changes may be required! Some of these are demonstrated in Table 4 which includes acalculation of EVA from a set of published results. See Table 4.

Conclusion: this company has added value for its shareholders.Notes

1. Interest paid is added back as this will be charged in the imputed capital charge.Borrowings are added to the capital base as profits must cover the cost of borrowings(see geared companies above).

2. R&D is considered an investment in the future in the same way as expenditure on capitalequipment. 2.1m is therefore removed from the P&L account. At the same time the lastsay 5 years R&D expense (assumed 13.4m) is added back to the balance sheet. This




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w ncrease e cap a ase an us e mpu e cap a c arge. sma c arge orR&D may remain in the P&L to reflect the economic depreciation of the capitalised value.

3. Advertising is a market building investment and is removed from the P&L. The last say 5years advertising expense is added to the capital base (assumed 15m). A small chargefor advertising may remain in the P&L to reflect the economic depreciation of thecapitalised value.

4. Goodwill represents the premium paid for a business on acquisition. Again this is aninvestment in the future and similar adjustments as for R&D and advertising apply. Thecumulative advertising write off of (assumed) 8.9m is added to the capital base.

5. The tax figure will include tax relief on debt interest. As this will be allowed for in theweighted average cost of capital it should be adjusted out. The tax bill will rise to 4.08 +(30% * 1.6m)= 4.56m.

6. This is an assumed 15% WACC applied to the adjusted capital employed. Note thatWACC would be calculated following the approach outlined in geared companies above.

7. No adjustment is made for depreciation as this is assumed to approximate economicdepreciation on physical assets as discussed above.

Arguments for and against Economic Value Added

FOR

It makes the cost of capital visible to managers. Under conventional managementaccounting performance measures the only profit and loss charge for capital is depreciationon the asset. Under the economic value added approach managers will also be charged thefinancing cost of capital employed. This should cause managers to be more careful ininvesting new funds and to control working capital investment. It can also lead to under-utilised assets being disposed of. To improve their performance managers will have to:

Invest in positive NPV projects; or Eliminate negative NPV operations; or Reduce the firms Weighted average cost of capital.Or hopefully all three.

It supports the NPV approach to decision making. If managers pursue negative NPV projectsthey will eventually find that the imputed capital charge outweighs earnings and will lead to adeterioration in their reported performance.

AGAINST

Economic Value added does not measure NPV in the short term. Some projects have poorcash flows at the beginning but much better ones at the end (and vice versa). Projects withgood NPVs may show poor economic value added in earlier years and thus be rejected bymanagers with an eye on their performance measure. Managers who have a short-termtime horizon (possibly due to impending promotion or retirement) could still make decisionsthat conflict with NPV and thus the maximisation of shareholder wealth.

If we return to projects being considered by companies A and B but this time alter the pattern ofcash flows (but not the NPVs) the point will be clearer. Table 5 illustrates this point.

Table 5 Cash Flows

m

Company A Project Company B Project

t0 Initial investment (20) (150)

t1 5 133.52

t2 5 5

t3 5 5

t4 154.87 5




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CAPM based required rate of return 15% 20%

NPV 80 (30)

NPVs are unchanged and should therefore have the same effect on Market value added asbefore.

Economic Value added computation

Company A Project Year beginning Capital employed (net) 20 15 10 5

Net of tax operating cash flow 5 5 5 154.87

Economic depreciation (5) (5) (5) (5)

Imputed capital charge(15% of capital employed)

(3) (2.25) (1.5) (0.75)

Economic Value added (3) (2.25) (1.5) 149.12

Company B Project

Year beginning Capital employed (net) 150 112.5 75 37.5Net of tax operating cash flow 133.52 5 5 5

Economic depreciation (37.5) (37.5) (37.5) (37.5)

Imputed capital charge(20% of capital employed)

(30) (22.5) (15) (7.5)

Economic Value added 66.02 (55.0) (47.5) (40.0)

ConclusionThe present value of the economic value added figures is still equal to the projects NPV(check it for yourselves) but the year-by-year distribution of economic value added haschanged. Managers with a short term time horizon may well accept company Bs project butreject company As project

Validity of EVA adjustmentsPart of the problem with economic value added in the short-term lies in the accountingmeasurement of profit. In table 5 company As project might show poor cash flow earlier ondue to large investments in R&D. To a certain extent this problem can be removed by usingthe adjustments proposed by Stern and Stewart covered above. However Brealey andMyers question if these adjustments to accounting profit are sufficient. They cite the case ofMicrosoft and question whether its capital base has been understated in published SternStewart EVA figures. The value of its intellectual property- the fruits of its investment insoftware and operating systems is not shown in the balance sheet This would undervalueits capital base and result in imputed capital charge being too small and thus overstate its

EVAShareholder Value Added (SVA)Shareholder value is a much-discussed concept and many companies now express acommitment to it. It should be noted however that economic value added is simply one way ofmeasuring the increase in shareholder wealth achieved by the company.

Kevin Mayes gave a useful overview of the various shareholder value metrics in a studentsnewsletter article in the November/December 2000 edition. Of these competitors to EVAShareholder Value Added is also included in the Paper 3.7 syllabus.

Shareholder Value Added involves calculating the present value of the projected future free




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.increase in market value added and thus increase shareholder wealth.

Free cash flow is the cash flow available to a company from operations after interestexpenses, tax, debt repayments and lease obligations, any changes in working capital andcapital spending on assets needed to continue existing operation (i.e. replacement capitalexpenditure equivalent to economic depreciation)). Although different definitions of free cashflow exist they all relate to cash flow after replacement capital expenditures. Free cash flow inour definition represents the cash available to shareholders, which in principle could be used to

invest in new positive NPV projects, paid out as dividend or used for share repurchase. Thepresent value of this free cash flow should equal the current equity market capitalisation of thebusiness, and any changes in this present value (less shareholder funds subscribed)represent the market value added.

Table 6 gives an example of the types of calculation involved.

Table 6A company prepares a forecast of future free cash flow at the end of each year. A period of 15years is used as this is thought to represent the typical time horizon of investors in thisindustry. The companys CAPM derived cost of equity is 10%. During 2000 a rights issue of5m is made which is invested in a project that will increase future earnings. Note that present

values are calculated at a cost of equity as free cash flow is measured after debt servicingcosts i.e. it represents a return to equity holders. If debt interest and principal payments hadbeen excluded from the free cash flow calculation then the present value would have beencalculated at the WACC as this version of free cash flow represents a return to both equityand debt holders. The resultant present values would then represent the value of debt plusequity in the company. The value of equity could be calculated by subtracting the stock marketvalue of debt.

Free cash flow forecast as at 31 /12/99 m

t1 t2 t3-t15

Sales 10.000 12.000 14.000

Operating costs -4.000 -5.000 -6.000

Interest -1.000 -1.000 -0.500

Debt repayments 0.000 -4.000 0.000

Working Capital -0.500 -0.500 -0.500

Replacement capital Expenditure 0.000 -3.000 0.000

Tax -1.000 -1.000 -1.000

Free cash flow 3.500 -2.500 6.000

PV factors @10%the companys cost of equity 0.909 0.826 5.870

Present Value of free cash flow 3.182 -2.065 35.220

Total present value 36.337

Free cash flow forecast as at 31 /12/00 t1 t2 t3-t15

Sales 12.000 14.000 15.000

Operating costs -5.000 -6.000 -6.000

Interest -1.000 -0.500 -0.500

Debt repayments -4.000 0.000 0.000

Working Capital -0.500 -0.500 -0.500




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Tax -1.000 -1.000 -1.000

Free cash flow -2.500 6.000 7.000

PV factors @10%the companys cost of equity 0.909 0.826 5.870

Present Value of free cash flow -2.273 4.956 41.090

Total Present Value 43.773

Present value of free cash flow as at 31/12/99 36.337

Present value of free cash flow as at 31/12/00 43.774

Increase in present value 7.436

Funds subscribed by shareholders in the year 5.000

Market value added 2.436

ConclusionThis company has increased the wealth of its shareholders.

Arguments for and against the Shareholder value added approachFor

It takes a multiperiod view and should therefore overcome some of the short termism ofEVA.

Against

The estimates of future free cash flow are very subjective and are very difficult to verify.This technique would almost be impossible for outsiders to the business use.

The time horizon over which free cash flow is forecast is difficult to determine. If you use ashort period you lose the present value earned in later years, but if a long period is used theforecasting of cash flows becomes very subjective.

ConclusionsShareholder value is high on the agendas of many companies as shareholders increasingly

look for competitive rates of return on their investments.The two metrics discussed here draw heavily on traditional financial management andmanagement accounting theory. EVA, SVA and free cash flow are all included in the PaperP4 syllabus and are 'fair game' for future exam questions.

References and Acknowledgements

1. G. Bennett Stewart III, EVA Fact or Fantasy, Journal of Applied Corporate Finance,Summer 1994.

2. R. Brealey & S. Myers, Principles of Corporate Finance, McGraw Hill, 6th Edition, 2000.3. K. Mayes Shareholder Value, ACCA Students Newsletter, November/December 2000.

Thanks to Scott Goddard for his valuable comments on the drafts of this article.


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