EVA

The Evolution of Value Based Management
Basic Notion
Firm value = PV (future free cash flows).
Strategic Value Analysis LEK / Alcar

Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)
EVA Stern Stewart & Co.

Firm value = ΣPV t (EVA t ) + Invested Capital.
CVA BCG and HOLT Value Associates

Firm value = ΣPV t (CVA t ) + Invested Capital.
Free Cash Flow Approach
Firm’s FCF = Financing or Investors’ cash flow
Firm’s perspective Investor’s perspective
EBITDA FCF = The amount received

– cash tax payments by investors
– incremental investment
interest payment to creditors
in operating assets
+ repayment of debt principal
- additional debt issued
+ dividends
+ share repurchases
1. Net working capital (CA-CL) - additional stock issued
2. Capital expenditures and Financing cash flow

long-term assets.
Free Cash Flow& Firm valuation
Firm = Present value of ＋

Value of
Value free cash flow Non-operating assets
- Marketable securities
- Excess real state
- Over funded pension plan
Firm = ＋
Future claim Shareholder value
Value
- 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” Through value
a) Sales growth drivers, we can
b) Operating profit margin analyze how to
c) Cash tax rate improve to firm’s
d) Net working capital / sales FCF.
e) Other long-term assets / sales
3. Determine the discount rate.

- Based on opportunity cost.
Forecasting Free Cash Flow
Case： Ashley Corporation
Value driver assumptions 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
Weighted cost of capital

【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％
Percentage After-Tax Weighted

of capital Cost Cost
Debt 25％ 5.61％ 1.40％

Equity 75％ 16.80％ 12.60％
WACC 14.00％
Free Cash Flow Calculations
Planning period present value
Residual value in year T
Free cash flow in year T  1

Cost of capital - Growth rate
Residual value in year 10=＄18,623/(0.14-0.026)=$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 ＄ 38.52

Present value of the cash flows for the residual value ＄ 44.06
Firm’s economic value ＄82.58
Excess real estate 7.5

Firm value ＄ 90.08
Debt ＄ 42.00
Shareholder value ＄48.08
Further Dissuasion of Value Driver
sensitivity Analysis of operating margin
Operating Equity Change in

Profit Margin
Value Base case of EV
-
6.00% $27,369
$20,718
Base case 6.50% 37,731 -10,353

7.00% 48,084 0
7.50% 58,436 10,352
8.00% 68,789 20,705
8.50% 79,141 31,057 Thousands of dollars
9.00% 89,494 41,410
Through sensitivity Analysis of different Value Divers

We can find the one affects firm’s value most ！
Magic Value Drivers
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
Sales growth increase Firm value increase
Threshold profit margin=7.2%
Sales growth increase Firm value decrease
Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)

Economic Value Road Map
Operating
Decision
Investing
Decision
Financing
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 Cost of Operating Interest

profits
= Sales - goods - expenses
- expense
- Taxes
sold
Charge
Cost of Operating
Economic Taxes - for all
profits
= Sales - goods - expenses - capital
sold
or used
Residual
income
NOPAT
Net operating profits after taxes
Free Cash flow & Residual Income Approach
Firm Present value of

Value
= future free cash flow
Invested Present value of

= ＋
Capital future residual Income
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%
g=7.5% g=7.5%
Residual Income: 1,250-10,000 × 10% = 250
g=7.5% g=7.5%
Free cash flow or Residual Income?
The weakness of free cash flow：
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
Residual Income provides better measure of period performance！

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

EVA Drivers
 EVA = NOPAT- (k*Capital) = (r- k)*capital
 NOPAT = operating profits after taxes but before financing

costs and noncash bookkeeping entries except depreciation
 Return on capital (r) = NOPAT Capital
Turnover Cash tax rate
Capital
Profit Margin
Return on capital = NOPBT Sales  Cash tax 

  1  
Sales Capital  NOPBT 
 NOPBT = firm’s net operating profits before taxes
EVA Drivers
EVA Calculation
Convert NOPAT and Capital form accounting book

value to economic book value
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
NOPAT
CAPITAL
Example :Hobbs-Meyer Co.
Example: Hobbs-Meyer co
Finance
Equity Equivalents
Tax
Equity Equivalents
Example: Hobbs-Meyer co
 法一
EVA=NOPAT-Cost of capital* Capital
=686000-10%*3984000=288000
 法二
EVA=(Return on capital-Cost of capital)
*Capital
=(686000/3984000-10%)*3984000
=288000
EVA V.S MVA
Market Value Added

= Market Value of Equity - Book Value of
Equity
= Present value of all future EVA
Market Value of Equity

= 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

Advantages of EVA
 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 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
Side Effects of EVA with minimize risk
 increases in current EVA come at the

expense of future EVA
 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

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The Evolution of Value Based Management

Strategic Value Analysis LEK / Alcar

EVA Stern Stewart & Co.

CVA BCG and HOLT Value Associates

Firm’s FCF = Financing or Investors’ cash flow

Firm’s perspective Investor’s perspective

EBITDA FCF = The amount received

2. Capital expenditures and Financing cash flow

Firm = Present value of ＋

Free cash flow and firm’s valuation

1. How long should we calculate?

2. How to forecast free cash flow? (Value drivers)

3. Determine the discount rate.

Value driver assumptions Residual

Sales of prior year=＄240,000

Incremental asset investment in year t =

Weighted cost of capital

Percentage After-Tax Weighted

Debt 25％ 5.61％ 1.40％

Planning period present value

Residual value in year T

Free cash flow in year T  1

Residual value in year 10=＄18,623/(0.14-0.026)=$163,36

Economic value=present value of all cash flows

Present value of the cash flows for year1-10 ＄ 38.52

Excess real estate 7.5

sensitivity Analysis of operating margin

Operating Equity Change in

Base case 6.50% 37,731 -10,353

9.00% 89,494 41,410

Through sensitivity Analysis of different Value Divers

Myth of Growth & Firm Value

In Case Table 4.2 PV of cash flow=＄82.6 million

Sales growth increase Firm value increase

Threshold profit margin=7.2%

Sales growth increase Firm value decrease

Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)

Accounting profits v.s. Economic profits

Accounting Cost of Operating Interest

Firm Present value of

Invested Present value of

1. Profit margin = 6.25%

2. Retention ratio = 60%

3. Investment (WC & real) = 0.5 per

4. Cost of capital = 10%

Residual Income: 1,250-10,000 × 10% = 250

The weakness of free cash flow：

Doesn’t provide readily apparent measure of

Residual Income provides better measure of period performance！

Economic Value Added (EVA)

 EVA = NOPAT- (k*Capital) = (r- k)*capital

 NOPAT = operating profits after taxes but before financing

Convert NOPAT and Capital form accounting book

1.Convert from accrual to cash accounting

Market Value Added

Market Value of Equity

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

 EVA is closely related to NPV.

 It avoids the problems associates with

 EVA = NOPAT- (kCapital) = (r- k)capital