Managing for Value Introduction to EVA May 2004

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Copyright 2004 by Stern Stewart & Co. All rights reserved. No part of this report may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system without the express written consent of Stern Stewart & Co.

EVA is a registered trademark of Stern Stewart & Co.

Objectives of the Training Session After this training session, you should be able to understand: What EVA is and key concepts related to EVA How does EVA relate to shareholder wealth creation How to compute EVA and Cost of Capital

What is MFV & Why MFV??

Managing for Value is not so much about the choice of performance metric
It is more about changing managerial decision making behavior

It is about systematically maximizing the business fundamental Net Present Value (NPV) 5 elements to an effective holistic VBM implementation
how you set strategic financial goals that are forward looking based on NPV of next best alternative how you evaluate strategic options and investments as well as operating decisions that tradeoff: short vs.long-term, P/L vs. B/S to maximize long-term economic profit how you cascade accountability and decision rights below the SBU level to focus explicitly on identifying & managing value drivers how you align the interests of owners and managers by sharing the excess returns how widely and effectively you educate & train employees in shareholder value creation

Its 80% about the people and 20% about the numbers Its 80% about the people and 20% about the numbers
CEO Cadbury Schweppes, VBM pioneer CEO Cadbury Schweppes, VBM pioneer

The project at AVB Group is being implemented in 6 phases over a period of 12 months
2003 PHASE 2004
Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

0 1 2 3 4 5 6

PREPARATION AND KICKOFF VALUE MEASURE REFINEMENT INTEGRATING EVA AND CAPITAL BUDGETING GOAL SETTING REFINEMENTS TO LTIC TRAINING & MINDSET CASCADING EVA BELOW CONSOLIDATED

Involvement at both corporate & businesses Involvement at businesses only Involvement at corporate only

Agenda Introduction to EVA EVA measurement and Cost of Capital Summary

What would you rather have?

OR ... Rs 100 today Rs 112 one year from now

That is the same as asking

What is the Rs 100 received today worth one year from now - i.e. what is the Future Value of the Rs 100? OR What is the Rs 110 received one year from now worth today i.e. what is the Present Value of the Rs 112?
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Time value of Money exists as investors require certain returns in the future for investing the money today Time value exists as money is a scarce resource and there is an opportunity cost of money Opportunity cost is the return investors forgo by not investing their money in other available investment opportunities Present Value (PV) of money received in future is equal to the Future Value (FV) multiplied by the PV Factor:
PV = FV x PV Factor, where PV Factor = 1/(1 + Discount Rate)n n is the number of years until the future value is received Discount Rate is the rate investors can expect to earn in other similar investment opportunities

Going back to our original problem what would you rather have? Given that the opportunity cost is 12%, Present Value of Rs 112 received one year from now is Rs 100:
PV = Rs112 x [1/(1+12%)]= Rs100

The answer is we dont care whether we get Rs 100 today or Rs 112 one year from now

Given that there exists Time Value of money, what does Net Present Value (NPV) mean Cost of Capital for the Business is 12% The yearly cashflows are discounted as shown:
Cost of capital Year Cash flows PV of Cash Flow at Yr 0 PV of Cash Flow at Yr 1 PV of Cash Flow at Yr 2 PV of Cash Flow at Yr 3 12% 0 -100 -100 178 120 85 283
x 0.89 x 0.80 x 0.71

1 200

2 150

3 120

Total NPV

1 1 (1+12%)

1 2 (1+12%)

1 3 (1+12%)

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Net Present Value NPV, is a true reflection of value creation

Enterprise Value is the present value of all the future cash flows. NPV is the PV of all the future cash flows minus the initial investment. It is therefore a measure of value created by the project or company. A company / project therefore creates value if NPV is positive.
Enterprise Value

NPV Or MVA

Invested Capital

However, this simple concept is often forgotten in real life, when Companies focus on the size based measures and not on value add
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Illustrating EVA: The Pizzeria Story...

You have Rs 500,000 in savings that is currently invested in an investment fund that generates a 20% post tax return every year. Your annual return from your investment is thus Rs100,000 (Rs 500,000 x 20%). You decide to fulfill a lifelong ambition, and invested the entire amount in opening a small Pizzeria. At the end of the year, your pizzeria shows the following results:
Sales Operating Expenses = Profit Taxes @ 35% = Actual Profit 950,000 825,000 125,000 43,750 81,250

Are you pleased with the performance of the new business? Did you really make a profit?
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The profit from the Pizzeria was less than what you expected as a minimum

Whats Left Over (Rs 18,750) Your Minimum Profit Rs 100,000

Your Actual Profit Rs 81,250

Your actual profit in the Pizzeria is Rs 81,250.

NOPAT

Minimum Expectation Had you kept your money in the investment fund, you would have expected to make Rs100,000 in profits. Capital 13 Charge

The amount by which your actual profit exceeds/ falls short of your minimum profit expectation is Economic Value Added (Rs 18,750)

The Case for the RIGHT GOAL

What is the primary responsibility of management of a company?

To provide customers with high-quality products and service? To provide secure employment for your employees? To make its lenders - the banks - happy? To provide the government with tax revenues? To create value for its shareholders?

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To create sustainable value for shareowners, all other stakeholders have to be satisfied first
Suppliers Employees Consumers Bankers Government Shareholders

Community

Shareholders are the last stakeholder in the queue

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What is the best measure of shareholder value creation?

Sales? Sales? Earnings? Earnings? Dividends? Dividends? Return on Assets? Return on Assets? Enterprise Value? Enterprise Value?
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Enterprise Value could be the same despite having different underlying amounts of invested capital

Scenario A
Pizzeria continues with its existing outlet

Scenario B
Pizzeria opens a second outlet

Enterprise Value 20

NPV 15

Enterprise Value 20 Capital 10

NPV 10

Capital 5

the focus must be on the VALUE ADD

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What drives the different Market Values of Pizzeria?

Several factors may influenced the Market Value, including Brand Value Network of outlets The Market Value of the firm is the Present Value (PV) of the businesss cash flows, and NPV of the firm is the difference between Present Value (PV) of the businesss cash flows and the Capital Invested, and a measure of wealth creation

However, key to the Market Value is the expectations of future cash flows

NPV

= Capital Investment

PV (cash flows)

Cash flows

How much did we have to put in to get what we have? 19

EVA is the Real Key to Creating Wealth

NPV = Enterprise Value - Total Capital = Present Value of EVA

EVA
EVA EVA

Enterprise Value

NPV NPV

EVA

EVA

EVA

EVA
Total Capital

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Why make changes to the management system?

Setting Goals Paying Bonuses
Production EBIT Sales EPS NPV Cash Flow

Communicating

Measuring Performance

IRR Margins

Evaluating Strategies

Returns

Evaluating Operational Initiatives Analysing Acquisitions

Reviewing Capital Projects

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Aiming to maximise any of these incomplete measures of valueadded could destroy shareholder value Increase earnings per share Increase EBITDA Increase RONA/ROI/ ROE Increase capacity Increase production Increase margins Reduce costs Increase annual cash flow per share!

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For example, decisions based on ROCE maximization may be value destroying

New Existing Business + Investment = Income Capital (Net Assets) RONA Cost of Capital Capital Charge EVA 150 1,000 15% 20% 200 (50) 180 1,000 18% 20% 200 (20) Results After Investment 330 2,000 17% 20% 400 (70)

An investment can increase income and RONA, but reduce EVA

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A Common Focus, Language & Mission

Setting Goals Paying Bonuses Communicating

Measuring Performance

Evaluating Strategies

Evaluating Operational Initiatives Analysing Acquisitions

Reviewing Capital Projects

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Pizzeria Re-visited: Investments in the business are made with certain expectations of future EVAsthe Market Value of the business is a function of these expected future EVAs
Market Value 20 Lakhs
40000 30000 20000

Present Value of Future EVA plus Capital

30,000 15,000 0
1 2 3 4 5

EVA (Rs)

Capital 5 Lakhs

10000 0 -10000 -20000 -30000

-18,750

-15,000
Years

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Targets are set in terms of EVA the performance measure is (Actual EVA Target EVA) in Rupees

Yr 2 Yr 2

Target EVA Actual EVA

Performance Measure ( EVAactual - EVAtarget )

3,750 10,000 10000 3750 = +6250

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Key Takeaways Maximizing the NPV of the business is the overarching goal EVA is a mileage tracking measure on the journey to achieve that goal EVA is a complete measure
Captures all costs in the business Marries both P&L and the Balance Sheet

However, absolute EVA does not matter On a periodic basis it is the improvements in EVA that matter The true reflection of performance is the improvements in EVA relative to the expectations.

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EVA Measures Fundamental Economic Profitability From the Owners Perspective

Performance Measurement
EVA

Wealth Creation

Net Operating Profit After Taxes (NOPAT)

NPV
Market Value Invested Capital

Cost of Capital

X
Capital

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EVA of a company can be improved by the following Fundamental Strategies

4.

Fund - Lower the Cost of Capital

NOPAT Cost of X EVA = Capital Capital

1.

Capital

Operate - Improve the return earned on existing Capital

2.

Grow - Invest as long as returns exceed the cost of capital Harvest - Divest capital when returns fail to achieve the cost of capital
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3.

Agenda Introduction to EVA EVA measurement and Cost of Capital

Refinements to Value Measure Cost of Capital

Summary

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What is NOPAT?

Operating Operating Revenues Revenues

Operating Operating Expenses Expenses

Depreciation Depreciation

Interest on WC Interest on WC borrowing borrowing

Operating Operating Taxes Taxes

NOPAT NOPAT

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What is Capital?
WC funded through WC funded through ST borrowing ST borrowing WC funded through WC funded through long-term funds long-term funds

Net Working Capital

Fixed Assets Fixed Assets

Long term debt Long term debt

CAPITAL

Other Assets Other Assets How We Use It

Equity funds Equity funds Where We Get It

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EVA is a simple period measure of economic profitability

Sales - Operating Expenses and Depreciation - Interest on Working Capital Borrowing - Taxes = Net Operating Profit after Tax or NOPAT - Capital Charge =
Unlike accounting profit which accounts only for the cost of debt, EVA accounts for a required return on the entire capital employed
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Illustration: Although interest on long-term interest is excluded from NOPAT, its effect is captured in Capital and in the WACC
Item Sales Operating Expenses Interest on WC Borrowing Long Term Interest Depreciation Tax@35% Accounting Profit Item Long-Term Debt Equity Funds 40 60 100 40 5 10 15 11 19 Sales Operating Expenses Interest on WC Borrowing Long Term Interest Depreciation Tax@35% NOPAT Item Long-Term Debt Item 100 40 5

X 10
15 14 26 Item

40 60
100 11% 11 15

Net Fixed Assets Net Wking Capital Capital

80 20
100

Equity Funds Capital WACC Capital Charge EVA

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Agenda Introduction to EVA EVA measurement and Cost of Capital

Refinements to Value Measure Cost of Capital

Summary

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What is the minimum expected return (Weighted Average Cost of Capital)?

Market Risk Premium Beta Risk Free Rate

Required Return to Equity holders ((Cost of Equity)

Debt / Equity ratio for the Business

Weighted Average Cost of Capital

Risk Free Rate Spread based on Credit Rating Tax Rate

Required Return to Debt holders (Cost of Debt)

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Cost of debt is the marginal rate of interest that business would have to pay on additional borrowings Marginal cost of debt for a business is dependent on:
Interest rates in the economy Credit rating of debt taken by a business

Cost of debt is therefore measured as:

Risk free rate + Credit spread implied by credit rating Both the risk free rate and the credit spread correspond to the long term (10 year) bonds When credit rating is not available interest rate on recent loans (if required adjust for tenure) taken by the business can be used as a proxy
Rf + Spread 0.5% = Rd = 5.7%
Pre-tax Cost of Debt

5.2% +

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Capital Asset Pricing Model (CAPM) approach has been used for computing the Cost of Equity
Required Return (%)
Near Bankrupt Co's Insurance & Banks Cyclical Stocks Large consumer goods Public Utilities New Technology Co's

Market Return Food Co's Risk-Free Rate

0.0 1.0

MRP 8%

Airlines, Hotels Construction Co's

Broad Market Return

Re = Rf

Risk (eta)

BETA x

(R m - R f)
Market Risk Premium

Risk free Rate

R e = 5.2% +

1.0
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8%

= 13.2%

How to calculate WACC? 13.2% * 0.6

Market Risk Premium Beta Risk Free Rate Required Return to Equity holders ((Cost of Equity)

Equity / (Debt+Equity) ratio for the Business

40:60
Debt / Equity ratio for the Business

9.5%
Weighted Average Cost of Capital

Risk Free Rate Spread based on Credit Rating Tax Rate

Required Return to Debt holders (Cost of Debt)

5.7%*(1-36%)* 0.4
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Debt / (Debt+Equity) ratio for the Business

WACC for all businesses in AVB Group for FY05

Risk free rate (Rf) Market Risk Premium : : 5.2% 0.5% 8.0% Tax rate Debt/ Equity : : 35.88% 40 : 60

Credit spread (AAA rating) :

Business Beta Aluminium 1.0 Carbon black 1.0 VSF 1.0 Caustic soda 1.2 Cement 1.2 Copper 1.2 Industrial gases 1.2 Insulators 1.2 Mining 1.2 VFY 1.2 Fertilizer 1.4 Garments 1.4 Sponge Iron 1.4 Software 2.0 * rounded up to nearest 50 basis points.

Cost of Equity 13.2% 13.2% 13.2% 14.8% 14.8% 14.8% 14.8% 14.8% 14.8% 14.8% 16.4% 16.4% 16.4% 21.2%

WACC* for FY05 9.5% 9.5% 9.5% 10.5% 10.5% 10.5% 10.5% 10.5% 10.5% 10.5% 11.5% 11.5% 11.5% 14.5%

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WACC for each of the businesses will be recomputed on an annual basis by the CFD/ CFG and communicated to the businesses
Parameters Risk free rate Basis / Source Trigger for updating

Average yield over the last Update annually for changes in year of government bonds prevalent interest rates maturing in a ten-year period Based on credit rating and corresponding spread Maximum marginal rate of tax Risk relative to other businesses and risk profile of the business. Survey of MRP estimates by leading financial institutions CFD/CFG Updated annually for change in risk free rate, credit spreads and companys credit rating Update annually or with change in Income Tax rates Reviewed once every 3 years or when there is substantial change in nature of business Reviewed every 3 years When company / business changes its target capital structure. Reviewed every 3 yrs.

Cost of Debt

Tax Rate Beta

Market Risk Premium Target D/E

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We have come a long way. To end the session, let us review a few important points

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Agenda Introduction to EVA EVA measurement and Cost of Capital

Refinements to Value Measure Cost of Capital

Summary

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Why EVA? Congratulations, We Have Come A Long Way

The primary responsibility of management is to create wealth for shareholders EVA is a better measure of wealth creation. It reminds you that using Capital has a cost and that money has a time value
Avoids problems with approaches that focus on percentage measures

EVA is your true, economic profit i.e. it is your actual profit less the minimum profit to satisfy the opportunity cost of investors Capital To create wealth, a company has to earn profits greater than its capital charge Through EVA, management can see the value they create EVA can align people from the shop floor to the board room with a common language and encourage employees to think and act like owners

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How to improve EVA? Have Come A Long Way Congratulations, We

There will be an improvement in EVA as long as incremental NOPAT is greater than the increase in the Capital Charge. There are three Operating ways to improve EVA - Improve NOPAT through operating more efficiently - Grow in profitable areas by investing more capital - Divest / Harvest unprofitable operations

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For further information, please refer to the EVA microsite at www.adityadisha.com

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