FINANCIAL VALUE ADDED Alfonso Rodríguez Sandiás Sara Fernández López Luis Otero González University of Santiago de Compostela (Spain) Avda. Juan XXIII s/n 15782 Santiago
[email protected]
I Introduction The search for measures or criteria to determine the economic and financial performance of a company is ever present in the scientific and professional realm. In recent years there has been, in our opinion, a new element introduced into the equation which is the desire of the giant international consulting firms to market their products. In many cases they design products which are little more than a return to fundamentals. In this paper we will analyse one of these measures, the EVA or Economic Value Added. We will compare it with Net Present Value and examine the breakeven point in both measures, moreover, we will propose and develop a new measure, the Financial Value Added, which attempts to reflect the virtues of EVA while aiming for a perfect alignment of outcomes with the Net Present Value.
II The EVA or Economic Value Added Presently, one of the star products in business finance is the EVA (Economic Value Added) developed by Stern Stewart & Company. It is determined by calculating the difference between net operating profit and the total financing costs of the business (both the explicit cost of debt and the implicit cost of the company´s own resources). If the first figure is greater than the second, then there is a positive EVA. On the other hand, if financing costs are greater than net operating profit, there is a negative EVA:
EVA = NOPAT − Financing Costs
That is:
EVA = NOPAT − k × TR
Expression 1
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 An alternative way of calculating EVA is the following: 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.
1
Alfred Rappaport (1998): Creating Shareholder Value, The Free Press
Figure 1: Links between EVA - Value drivers - Types of decision EVA= NOPAT MEASURE
-
k x TR
EVA=[(Px Q–vcxQ–FC–D)x(1-t)] - k x TR 1. Sales Growth
VALUE DRIVERS
2. Operating Profit Margin 7. Value Growth Duration
DECISIONS
4. Working Capital Investment 5. Fixed Capital Investment
3. Income Tax Rate
6. Cost of Capital
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 With this definition of EVA it is difficult to determine what the creation of value in a period is due to, and, more importantly, who is responsible and should be rewarded. The expression of EVA as it is shown in expression 1 indicates that the alternatives the company has to increase value are the following: 1. To increase net operating profits, that is, to increase efficiency in the use of assets and, therefore, of resources available. In other words, to increase the NPV of the projects under way. This option would increase the net operating profit while maintaining the cost of resources constant and would basically be the result of operating decisions. 2. To reduce total resources without jeopardising the net operating profit, therefore selling unuseful assets, thus increasing the NPV of the project to which they were assigned. This option would keep the net operating profit constant but would reduce the cost of resources. This would involve an investment decision, specifically a divestiture.
3. To reduce the cost of financing and thus the discount rate which implicitly means an increase in NPV. This reduction is due to an increase in the volume of debt, which is a "cheap" resource and has tax advantages, but it also carries along with it an increase in financial risk, which at high levels of indebtedness can also give rise to a higher average financing cost. Like the previous option, this option keeps net operating profits constant and at certain
levels
of
indebtedness
reduces
the
cost
of
resources.
Nevertheless, this is a purely financial decision. 4. Finally, several alternatives remain which are difficult to classify and which represent two sides of the same coin. These are the following: §
Increasing net operating profit by putting into place new investments that increase total resources and whose rate of return is greater to the cost of financing, that is, to carry out new projects with a positive NPV.
§
Reducing total resources by a reduction in the cost of financing which is greater to the reduction it causes in net profits, that is, the sale of assets which although they may generate profits do not generate enough profits to justify their presence in the company, and thus incrementing NPV. This would mean lightening the company of those assets that do not contribute effectively to the generation of value.
In both cases we are dealing with essentially investment decisions but they affect both components of EVA, NOPAT, and k X RT, and whose effects are difficult to isolate. The various strategies and their effects are summarised in figure 2:
Figure 2: Value creation strategies. Strategy 3 (financing)
Strategy 1 (operating)
EVA = NOPAT
-
k x TR
Strategy 4 (mix)
Strategy 2 (investment)
Of course, a combination of the actions indicated above is always possible. In fact, what is being said is as clear as saying, "You should invest in profitable projects, divest from projects with a low profitability, and in any case you should try to reduce your financing costs", someone could respond by saying “That’s obvious.There was no need to say it”. We agree, but the concept of the creation of value, i.e. NPV, no matter how it is calculated, is extremely simple and evident; that might just be the essence of its greatness and usefulness. As Vélez2 indicates, "We could coin the name and acronym of Common Sense Management, CSM". A number of authors have demonstrated the coincidence of Net Present Value and the Present Value of the annual EVA. This coincidence is of great importance given that we accept the usefulness of the NPV, we would be obtaining the same discounted results, but with an annual control measure. In this sense, we recommend the work of Shrieves and Wachowicz3. The usefulness of EVA does not arise from its ability to be adapted in order to analyse the viability of a project, for which we can use the NPV, but from its role as an instrument for control. How is the firm performing with respect to forecasts? The problem, in our opinion, arises from the fact that no clear standard exists to compare the EVA of each period in order to be able to infer if
2
Vélez-Pareja, I. (2000):”La creación de valor y su medida. Un análisis Crítico de EVA”, I Congreso de profesores de costos y contabilidad directiva, Colombia 3 Shrieves, R. E., Wachowicz, J. M. (1999): “Free cash flow, economic value added, and net present value: a reconciliation of variations of discounted cash flow valuation”, University of Tennessee Working Paper
the firm is performing adequately. In some periods the EVA may be inferior to others, or even negative, yet, nevertheless, the firm may be conducting itself exactly the same. NPV evaluation includes the financial cost of resources through the process of discount. EVA also includes the financial cost of the resources but, as we shall see later, i t does so in a different way.
III The Search for the EVA threshold 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:
Q=
FC × (1 − t ) + ED − t × D (1 − t ) × m
Expressión 3
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: EVA = NOPAT − k × TR = EBIT × (1 − t ) − k × TR = ( P × Q − vc × Q − FC − D) × (1 − t ) − k × TR = m × Q × (1 − t ) − ( FC + D ) × (1 − t ) − k × TR 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 Q=
( FC + D ) × (1 − t ) + k × TR m × (1 − t )
Expression 4
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.
IV EVA vs. NPV At this point, it would be helpful to analyse the discrepancies that exist between these two measures. Let us compare both breakeven points. We have seen that the NPV breakeven point is attained at the level where Net Cash Flow is equal to the so-called Equivalent Depreciation (expression 3 ), that is:
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 = Net Cash Flow = NOPAT + D And when depreciation is reinvested: ED = Net Cash Flow − D = NOPAT If the time horizon is unlimited: 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.
V. Financial Value Added We propose a new metric, the Financial EVA, or what we prefer to call, Financial Value Added (which could be referred to as FVA), and we define as follows: Financial Value Added = NOPAT − ( ED − D)
Expression 6
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 Financial Value Added = NOPATD − ED)
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 ; Q=
FC × (1 − t ) + D × (1 − t ) + ( ED − D ) FC × (1 − t ) + ED − t × D 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. Figure 3: Types of decision and measures of value. FVA
EVA
NOPAT
Operating
K x TR
Investment
Financing
Equivalent Depreciation
NOPATD
Operating
Investment
Financing
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) If we take depreciation from Net Operating Profit: FVA = [(P × Q − vc × Q − FC ) × (1 − t )] − D × (1 − t ) − ( ED − D ) FVA = [(P × Q − vc × Q − FC ) × (1 − t )] − ( ED + t × D )
If we consider that Equivalent Depreciation, assuming a system of constant annuity, is
TR , and we assume that straight line depreciation of fixed ∂ n¬k
assets is equal to TR/n, then, TR TR FVA = [(P × Q − vc × Q − FC ) × (1 − t ) ] − +t × n ∂ n¬ k 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 ∂ n¬ k n
Expression 9
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: Figure 4: L inks between FVA - Value drivers - Types of decisions
1 t FVA = gmc − + × TR ∂ n ¬k n FVA = [( P × Q − vc × Q − FC ) × (1 − t )]
1 1 + t × × TR n ∂ n¬ k
−
MEASURE 1. Sales Growth
VALUE DRIVERS
2. Operating Profit Margin
3. Income Tax Rate
7. Value Growth Duration
DECISIONS
4. Working Capital Investment 5. Fixed Capital Investment 6. Cost of Capital
OPERATING
FINANCING
INVESTMENT
With this new definition, the relation between decisions and value creation is clearer.
VI. FVA in the presence of new investments 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 In our opinion, Financial Value Added has the following advantages: If we start from the NOPATD, the Financial Value Added, in a single variable, Equivalent Depreciation, integrates all the contribution of the assets to the company’s performance as well as the opportunity cost of its financing; furthermore, this contribution remains constant for the life of the project. When we were developing EVA in section I, we indicated how this measure could be used to analyze the various alternatives a company has to create value. Among the value drivers we find value growth duration , in other words the time horizon. In the case of EVA, the contribution of this driver is not made clear; however, if we consider FVA, apart from all the aspects noted with respect to EVA, we can add another value creating element, which is the reduction of Equivalent Depreciation as a result of the lengthening of the time horizon in which the assets will be able to contribute to the firms performance. In some sense this is present implicitly in the EVA, if Net Operating Profit could be increased due to a reduction in depreciation of fixed assets, where the increased time horizon of assets is the origin of the reduction. Financial Value
Added makes it possible to observe this possibility and the consequent creation of value much more clearly. The greatest virtue of the EVA is its development of a measure of value creation in annual terms using accounting information from the income statement and commonly used by executives. The Financial Value Added which we propose takes advantage of this virtue, although it requires a bit more training in finance to understand the concept of Equivalent Depreciation and Accumulated Equivalent Depreciation, and in our opinion it is much more correct in how it reflects financing costs. Furthermore, it is able to align its results year by year with the Net Present Value, which at least for the moment prevails as the best measure of value creation. One of the problems with the NPV is that it is difficult to control in annual terms. The Financial Value Added, or Financial EVA , presents a solution to this problem basing itself on the widely accepted definition of EVA. Like EVA, FVA is able to match its results in discounted terms to the NPV, but FVA goes beyond to achieve alignment of results also in annual terms, making it more useful as a control instrument. Finally, it is enough to define the Equivalent Depreciation used to determine NPV and FVA break even points in terms of a constant amortization loan in order to obtain the same result as the EVA. Thus, EVA is nothing more than a special case of the Financial Value Added which we propose.
References Brealey and Myers (1997): Principles of Corporate Finance, Irwin McGraw Hill Rappaport, Alfred (1998): Creating Shareholder Value, The Free Press Redondo, et. al. (1997): “El umbral del Valor Actual Neto”, Actualidad Financiera, nº monográfico, 4º trimestre Shrieves, R. E., Wachowicz, J. M. (1999): “Free cash flow, economic value added, and net present value: a reconciliation of variations of discounted cash flow valuation”, University of Tennessee Working Paper Stewart, G. B., (1999): The quest for value , HarperCollins Vélez-Pareja, I. (2000): “La creación de valor y su medida. Un análisis crítico de EVA”, I Congreso de profesores de costos y contabilidad directiva, Colombia
