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I Introduction
That is:
where:
NOPAT: Net Operating Profit After Taxes
K: Weighted Average Cost of Capital
TR: Total Resources of the company at the start of the period
EVA = NP − ke × C Expression 2
where:
NP: Net Profit
Ke: rate of return requested by shareholders
C: the amount of the company’s own resources at the start of the period.
The difference between the two formulas is that the explicit financing
burden deriving from debt in the second case is reflected in the calculation of net
profit, while in the first case it is transferred by way of the total cost of resources.
It is important to point out that both the Total Resources and the Own
Rosources under consideration should be those that the company had at the
start of the year in question. The total resources at the end of the period already
include that year's results, and this could lead to an over-estimation of the
financing costs, and therefore, an underestimation of the value created.
Figure 1, adapted from the Shareholder Value Network of Rappaport 1,
shows the link between the EVA, calculated using expression 1, the value
drivers and the main types of decisions which can be taken in the firm.
EVA= NOPAT - k x TR
DECISIONS
OPERATING FINANCING INVESTMENT
Where:
P: Price of the product
Q: Quantity of production
vc: Variable cost per unit
FC: Fixed Costs
D: Depreciation
t: Income tax rate
Strategy 1 Strategy 3
(operating) (financing)
EVA = NOPAT - k x TR
Strategy 4 Strategy 2
(mix) (investment)
In an earlier paper4, and in line with the analyses carried out by other
authors5, we demonstrated how the breakeven point analysis could be
transferred to the analysis of what we call the Net Present Value breakeven
point. The question seemed obvious; why not look for the breakeven point of the
NPV? If the decision of whether or not to carry out a project is based principally
on this criterion, let us determine the units of production that obtain a NPV of
zero. We developed a process capable of determining these levels of
production, and establishing the differences with respect to the traditional
breakeven point.
In the simplest case, (the firm’s assets have no residual value) the
producti on level of zero NPV or NPV breakeven point is obtained as follows:
FC × (1 − t ) + ED − t × D
Q= Expressión 3
(1 − t ) × m
where:
Q: number of units to be sold
FC: fixed costs
t: tax rate
m: unit margin, or price less variable costs per unit.
D: depreciation
ED: equivalent depreciation
And the Equivalent Depreciation being the total financial charge which
the business bears for having made payment of the investment, that is, the
constant annuity equivalent to the investment carried out in financial terms.
4
Redondo, et. al. (1997): “El umbral del Valor Actual Neto”, Actualidad Financiera, nº
monográfico, 4º trimestre
Thus, if EVA is used as a criteria for evaluating the performance of the
firm and its management team, these executives and any interested analyst may
find it useful to know the level of activity or amount of production which is needed
in each period to obtain a zero EVA. In other words, to know the EVA threshold
or the EVA breakeven point.
If we carry on with the EVA formula:
Where EBIT is Earnings Before Interest and Taxes, and the other terms having
been previously defined.
Thus, if we wish to find the zero EVA level, it will be the following:
EVA = m × Q × (1 − t ) − ( FC + D) × (1 − t ) − k × TR = 0
( FC + D ) × (1 − t ) + k × TR Expression 4
Q=
m × (1 − t )
The breakeven points obtained for NPV and EVA coincide in discount
terms. The difference is that at zero NPV the production may remain constant
and may be considered an appropriate standard or target to aim for. However,
on the other hand, to obtain zero EVA, the production level needed changes
from year to year and, thus, makes it less useful as a control and reward
measure.
ED = Q × m × (1 − t ) − FC × (1 − t ) + t × D
The Equivalent Depreciation which we proposed for determining the NPV
breakeven point is based on paying off a loan with a constant annuity system.
For its part, as we have already seen, a zero EVA is attained when:
5 See, for example, Brealey and Myers (1997): Principles of Corporate Finance , p. 173
Q × m × (1 − t ) − FC × (1 − t ) − D × (1 − t ) − k × TR = 0
Making both expressions equivalent:
ED = k × TR + D Expression 5
If we rearrange terms:
k × TR = ED − D Expression 5(a)
Both breakeven points will coincide if the Equivalent Depreciation is
equal to the depreciation plus “interest on total resources”. When we use the
straight-line depreciation method, the EVA implicitly assumes that loan
repayment is made by means of the system of constant amortization of principal
and variable annuity (due to the descending volume of interest) .
They will also coincide when the firm reinvests all the depreciation and the
time horizon is unlimited. Why? Well, in this situation the Equivalent Depreciation
would only be the interest (kxRT), as in a loan that is never repaid:
The equivalent depreciation, which leads to a zero NPV, is:
ED = k × TR
The equivalent financial cost of a loan with unlimited time horizon is the
same as the interest rate on the principal of this loan, and therefore:
NOPAT = k × TR
Which is precisely a situation of zero EVA.
Where (ED – D) is the contribution of the fixed assets and its consequent
financing which is not included in its accounting process of depreciation. We
should note that NOPAT would be an adequate measure of value generation if
the depreciation of fixed assets equals the Equivalent Depreciation; of course,
the fiscal authorities do not allow this. Parting from this definition we can go a bit
further and see other ways of expressing FVA.
We can begin with expression 7
Where NOPATD is the After Tax Profit, but before Depreciation and
Interest (Net Cash Flow). That is, on one side we calculate the profit, which
strictly includes the operating aspect of the business, putting aside even the
investment component (depreciation) and, of course, financing (just as is done
with EVA). And on the other side we calculate the true Financing Costs of the
business, which is none other than the Equivalent Depreciation. The business
with a positive Financial Value Added would be obtaining a net cash flow,
(NOPAT + D) greater than the Equivalent Depreciation, and therefore a positive
NPV.
Let us calculate the break even point of our Financial Value Added:
FinancialValue Added = NOPAT − ( ED − D) =
( P × Q − vC × Q − FC − D) × (1 − t ) − ( ED − D) = 0 ;
FC × (1 − t ) + D × (1 − t ) + ( ED − D ) FC × (1 − t ) + ED − t × D
Q= = Expression 8
m × (1 − t ) m × (1 − t )
Where this is the same expression as the NPV break even point, and
thus the two expression coincide completely.
After analyzing the EVA we can see that the following lines are deducted
from the income of the business:
a) Both fixed and variable operating costs.
b) Depreciation, reflecting the loss of value of the fixed asset, because of
its contribution to the production process.
c) Operating taxes.
d) Financing costs, the “interest payments” which reflect the application
of resources to the business.
The Financial Value Added substitutes Equivalent Depreciation for parts
b) and d). Thus, the system used in determining EVA, straight line depreciation
plus interest, is substituted by the constant annuity, making it possible to obtain a
stable level of production that yields a zero NPV and zero FVA.
Figure 3 illustrates how the value measures we have analyzed reflect the
various types of decisions. By perfectly isolating the operating decisions from
investment decisions, FVA clarifies the creation of value and makes it possible
to determine which factor is responsible for the gain or loss of value.
EVA FVA
Equivalent
NOPAT K x TR NOPATD Depreciation
Another way of defining FVA which attempts to go even deeper into this
separation of decisions and the identification of responsibility is what we obtain
when we part from expression 6 as follows:
FVA= [(P × Q − vc × Q − FC − D) × (1 − t )] − ( ED − D)
FVA = [(P × Q − vc × Q − FC ) × (1 − t )] − D × (1 − t ) − ( ED − D )
FVA = [(P × Q − vc × Q − FC ) × (1 − t )] − ( ED + t × D )
TR TR
FVA = [(P × Q − vc × Q − FC ) × (1 − t ) ] − +t ×
∂ n¬ k n
Where n is fixed assets´s useful life, and ∂ n¬k the present value of 1 $
received each year from one to n.
And if we call (P x Q - vc x Q - FC) x (1 - t), Gross Margin of Contribution
(gmc), that is, the margin before depreciation and interest, but net of taxes, a
margin which is dependent on purely "operative" matters, we are left with the
following:
1 t
FVA = g mc − + × TR Expression 9
∂ n¬ k n
If we relate this new definition of FVA to the value drivers and the main
types of decisions taken by a firm, we obtain figure 4:
1 t
FVA = gmc − + × TR
∂ n ¬k n
1 1
FVA = [( P × Q − vc × Q − FC ) × (1 − t )] − + t × × TR
MEASURE ∂ n¬ k n
1. Sales
Growth
4. Working Capital
Investment
3. Income Tax
VALUE 2. Operating 5. Fixed Capital
Profit Margin Rate
DRIVERS Investment
7. Value Growth
Duration 6. Cost of
Capital
DECISIONS
OPERATING FINANCING INVESTMENT
With this new definition, the relation between decisions and value
creation is clearer.
One of the criticisms, which can be made of the proposed analysis, is its
lack of realism in the case that the project (the company) carries out new
investments during the reference time horizon. EVA would reflect this situation in
an immediate way by increasing assets, and ,therefore, the total resources
committed to the business. How can we include this fact into the determination
of the break even point of the NPV and the FVA?
We believe that a redesign of the so-called Equivalent Depreciation
would be enough. Thus, we will consider the Equivalent Depreciation to be the
sum of the Equivalent Depreciation of the various investments carried out, while
considering in each case the individually corresponding time horizon.
Thus, given a project with investments in years "1" to "n", which we
assume to be carried out at the beginning of each period, in such a way that
those carried out in year "1" may have "n" years of useful life, those carried out in
year "2" have "n-1" years of useful life, and so on successively. The individual
Equivalent Depreciation will be the amount which discounted in the
corresponding number of years and at the corresponding discount rate equals
the outlay of each investment. At the time of calculating the breakeven points we
will use the Accumulated Equivalent Depreciation which corresponds to the
investments carried out up to that date.
VI. Conclusions
Brealey and Myers (1997): Principles of Corporate Finance, Irwin McGraw Hill
Redondo, et. al. (1997): “El umbral del Valor Actual Neto”, Actualidad
Financiera, nº monográfico, 4º trimestre