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Author: PatrickCoteContributors:KateMcGreevy JulianCritchlow

bcCorporatePerformanceMeasurementApril1999Copyright©1999Bain&Company,Inc.

ExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-DiageoAgenda2

Corporateperformanceevaluationhasevolvedfromthe1960sfocusonROEtothecurrentvariationsofeconomicprofitthatmeasureimpactonshareholdervaluemanyfirmshavedevisedtheirownvariationsofeconomicprofitSternStewart’sEconomicValueAdded(EVA)TMisbestknownofthesemeasuresHolt/BCG’sCashFlowReturnonInvestment(CFROI)isasimilarconceptpresentedin%returnformatBothROEandEParebusinessmetrics,toolsusedtomeasuretheperformanceofthebusinessseparatefromfundamentalbusinessdrivers,theactualfactorsthatinfluenceshareholdervalue,andoutputmeasuresthebackward-lookingrecordsofoverallcompanyperformanceFocusingonEPinsteadofROEdecreasesthelikelihoodofdestructivebehaviorbymanagersByevaluatingmanagersbasedonEP,managerbehaviorcanbealteredsuchthatonlyprojectsthataddvalue(withNPV>0)areundertaken,whichdoesnotalwaysoccurwithROE

ExecutiveSummary(1of2)3ExecutiveSummary(2of2)

EndgoalofEP

exercisesisconsistentwithtraditionalBainfocusofmaximisingshareholdervalueBainhasmeasuredhistoricalperformancewithTotalShareholderReturnSternStewartdevisedMarketValueAdded(MVA)TMasmeansofmeasuringmarketexpectationsofEPthatmanagerswilladdinthefuturemanagers’objectiveshouldbetomaximiseMVAAlleconomicprofitmeasuresdeductchargeforuseofequitycapitalfromaccounting’stypicalnetincomeorprofitaftertaxtoreflecttheopportunitycostassociatedwithequityinvestmentsSternStewarthastrademarkedEVATMbyspecifyingadjustmentstomaketoEP

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AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo5Objectives

TherearethreeobjectivesoftheCorporatePerformanceMeasuresModule:TodefinethemostpopularmeasuresofcorporateperformanceToexplainthesignificanceofthesemeasuresinthecorporateenvironmentandpotentialapplicationsinBain’sstrategyworkTooutlinecalculationsofeachperformancemeasure6

AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo7

Withtheriseofconglomerates,mostcompaniesfocusedonReturnonEquity,orROE,astheirprimarymeasureofperformanceledmostmanagerstoundertakeacquisitionssolelytomanipulateaccountingfigures1960s/70s1980s/90sWiththeincreasedfocusondeliveringshareholdervalue,managershaveacceptedsystemsthatmeasurethechangeinvaluemanagersrealisedequityisnotfreeeconomicprofit(EP)meetstheseneedsbytellingmanagerswherevaluehasbeencreatedandwhereithasbeendestroyedAsaligninginterestsbetweenownersandmanagershasbecomemoreimportant,tyingmanagementcompensationtoEPprovidedapopularsolutionCorporateperformanceevaluationhasevolvedfromthe1960sfocusonROEtothecurrentvariationsofeconomicprofit(EP)thatmeasureimpactonshareholdervalueBackgroundCorporatePerformanceEvaluation8

BainwasthefirstofmajorconsultingfirmstofocusoncreatingshareholdervalueToachievethis,BainhasusedtheoutputmeasureofTotalShareholderReturnandtheaccountingmeasuresofROEandROIModifiedaccountingmeasures,suchasEP,provideanalternativemeansofmeasuringthecreationofshareholdervalueBackgroundRelevancetoBain9

Toillustratetheroleofcorporateperformancemeasuresandresourceallocationtostrategywork,anexaminationofMarakon’s“program”isusefulMarakonappliesthefollowingprogram,whichcantakeseveralyearstocomplete,toallofitsclients:assesstheeconomicprofitofallcustomersegmentsandproductlinescomparecompanyperformancetoindustryperformanceinvestigatethreeormorestrategiesforeachbusinesseveryplanningcycleshiftresourceallocationfromeconomicallyunprofitableproducts/customerstoeconomicallyprofitableleadstoyieldlossforMarakonandclientssinceadditionalscenariosfrequentlyevaluatedMarakonhasmadeeconomicprofit(EP)thecentralfocusofthe‘program’theyapplytoeverycaseBackgroundLinktoStrategy10EVAisaregisteredtrademarkofSternStewartAcenturyago,AlfredMarshallexplainedthatforacompanytohavegenuineprofits,theprofitsmustbesufficienttocoverthecostofcapitalaswellasthefirm’’soperatingcostsSternStewarthasre-packagedtheconceptintoEVA,whichisessentiallyamorepalatableformofthesameideaMcKinseyhasbeenusingeconomicprofitformanyyearsBCGusesCashFlowReturnonInvestment(CFROI)forasimilaranalysisToavoidinfringinguponSternStewart’strademark,manyconsultingfirmshavedevelopedtheirowntermsforthesameconceptHownewisEconomicValueAdded(EVA)?EVATMisonevariationofEPBackgroundEconomicValueAdded11AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo12Measures*ForadiscussionofWACCanddiscountrates,pleaseseetheInvestmentAppraisalModuleintheBVUDescription:EVA/MVA,EP,andCFROIaremodifiedaccountingmeasuresusedtomeasuretheperformanceofthebusinessInputs/Measures:FundamentalBusinessDriversBusinessMetricsOutputMeasuresPrimarybusiness-specificfactorsinfluencingshareholdervalueToolsusedtomeasureperformanceofbusinessBackward-lookingmeasuresofoverallcompanyperformanceasviewedbymarketOperatingprofitsvolumepricecostsFinancialCostofCapitalEmployedfixedassetsworkingcapitalWACC*AccountingROEROAModifiedaccountingEVA/MVAEPCFROICVATotalShareholderReturn(TSR)TotalBusinessReturn(TBR)Framework13ThefundamentalbusinessdriversprovideaframeworkforidentifyingthesourcesofshareholdervaluecreationordestructionShareholderValueCreation/DestructionOperatingProfitCostofCapitalVolumePriceCostsWorkingCapitalWACCFixedAssetsX+XDirectcostsmateriallabourIndirectcostsSG&ADepreciationAveragesellingprice#ofunitssoldWeightedaveragecostofcapitalbasedonmarketvaluesofdebtandequityUseafter-taxcostofdebtCurrentassetslesscurrentliabilitiesProperty,plant&equipmentIntangiblesLIFOvsFIFODepreciationestimatesCostofequityforprivatefirmsIntangiblemeasurementComponents:Issues:FrameworkFundamentalBusinessDrivers14*SometimesreferredtoasReturnonInvestment(ROI)ROEmeasuresreturnstoshareholders,whileROAmeasuresreturnstoinvestorsofallformsofcapitalFormula:Measures:ROAProfitabilityofallcapitalemployed,includingdebtUses:ReturnonAssets(ROA)*ReturnonEquity(ROE)NetIncomeAssets=ROENetIncomeEquity=Profitabilityofequityinvestedinbusiness(netequityissuedplusretainedearnings)ReturnsofenterpriseasawholeReturnstoshareholdersFrameworkAccountingBusinessMetrics15TheDuPontformulaisusedtoseparateROEintoitscomponentsinordertoassesstheperformanceofthebusinessROENetIncomeEquity=NetIncomeSales=SalesAssetsAssetsEquityXXROSAssetTurnoverLeverageROE=ProfitabilityAssetTurnoverLeverageXX=ROAFrameworkAccountingBusinessMetrics-DuPontFormula16*EVA=EVAwithdepreciationaddedbackManyconsultingcompaniesattempttobrandthemodifiedaccountingbusinessmetricstheyuseEconomicProfitMeasureConsultingCompaniesBainMcKinseyMarakon(throughValue-BasedManagement)LEKEVA/MVASternStewartATKearneyAccountingfirmsBCGHoltBCGCashValueAdded*(CVA)CashFlowReturnonInvestment(CFROI)FrameworkModifiedAccountingBusinessMetrics17*onlybackward-lookingThemodifiedaccountingbusinessmetrics,whichincludeEP,enablerelativelyaccuratelevelsofcorporateperformancemeasurementatlowerlevelsofdecisionmakingintheorganisationAccuracyasMeasureofCorporatePerformanceLevelofDecisionMakingHighLowLowHighMVAModifiedAccountingBusinessMetricsTSR*ROE/ROAFundamentalBusinessDriversEP/EVA/CFROIRoleinOrganisationFramework18*AdjustedforallstocksplitsandassumingalldividendsreinvestedWhileTSRcalculatesreturntoshareholdersforpublicly-listedcompanies,BCG’sTBRcalculationestimatesequivalentreturnsforprivately-heldfirmsTotalShareholderReturn(TSR)inCAGRFormatMarketvalueofshareatendofperiod*Marketvalueofshareatbeginningofperiod=TotalBusinessReturn(TBR)=Estimatedmarketvalueofsharesofprivately-heldcompanyatendofperiod*numberofyears1numberofyears111Estimatedmarketvalueofsharesofprivately-heldcompanyatbeginningofperiod*FrameworkOutputMeasures19Bain’’sclientstockperformanceslideiscalculatedusingTSR,whichisusedtomeasuretheshareholdervaluecreatedFrameworkOutputMeasures20AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo21MarketValueAdded(MVA)InvestedCapitalGoalofManagersshouldalwaysbetocreatemoreshareholdervalue,ormaximiseMVATotalMarketValueofFirm

(includesalldebtandequity)Bain’’sfocushasalwaysbeentohelpthemanagementofthefirmtomaximiseshareholdervalue,whichisequivalenttomaximisingMVAMarketValueAddedDefinition(1of2)22MVAequalsthetotalmarketvalueofthecompanylessinvestedcapitalornetassets.EithertheOperatingorFinancingApproachcanbeused,butBaintypicallyusestheOperatingapproachNote:*Short-termnon-interestbearingliabilitiesOperatingApproach(TypicallyusedbyBain)FinancingApproachMarketValueAddedDefinition(2of2)23ThefirststeprequiredtocalculateNetAssetswiththeOperatingApproachistoidentifyexcesscash,whichistotalcashlesscashrequiredintheoperatingcycleNote:*Short-termnon-interestbearingliabilitiesAmount($)MarketValueAddedOperatingApproach-ExcessCash24Next,Theworkingcapitalrequirementsarethefirm’snetinvestmentsintheoperatingcycle,orthenetamountofshort-terminvestmentrequiredtofundoperationsAmount($)WorkingCapitalRequirementsMarketValueAddedOperatingApproach-WorkingCapitalRequirements25WhencalculatingMVA,NetFixedAssetsisdefinedasNetPP&EplusotherInvestment(tangibleandintangible).ThethirdandfinalsteptocalculateNetAssetsisNetPP&E,whichistheamountoflong-terminvestmentrequiredtofundoperationsAmount$NetPP&EMarketValueAddedOperatingApproach-NetFixedAssets26Marketvalueadded(MVA)reflectsthemarketsexpectationsoftheEPmanagerswilladdinthefuturePercentofTotalMVAisthemarket’sexpectationofdiscountedfutureEPsMarketValueAddedLinktoEP27AfterextensiveworkbyadiligentBainteam,AcmeIndustriesisexpectedtogenerate$25Mineconomicprofitsnextyear,whichisexpectedtogrowat3%forever.Ifthecostofcapitalis13%andtheinvestedCapitalis$100M,whatistheMVAandthemarketvalueofthecompany?MarketValueAddedLinktoEP-Example28AfterextensiveworkbyadiligentBainteam,AcmeIndustriesisexpectedtogenerate$25Mineconomicprofitsnextyear,whichisexpectedtogrowat3%forever.Ifthecostofcapitalis13%andtheinvestedCapitalis$100M,whatistheMVAandthemarketvalueofthecompany?MVA=PVofEPs=$25M13%-3%=$250M=MVA+InvestedCapital=$250M+$100M=$350MMarketValueoftheCompanyMarketValueAddedLinktoEP-Solution29EPmeasuresmanagers’performanceinthepast,sinceitrepresentsthemarketvalueaddedcreatedoveroneyearNote:*AssumesInvestedCapitalConstantMarketValueAddedLinktoEP(1of2)30EPisusedtoevaluatemanagerperformancebecausethechangeinMVAoveraperiodoftimeismeasuredGoalofcompany’’smanagersshouldalwaysbetomaximiseMVAWhenmanagersmakeanyinvestmentdecisions,iftheprojectis:value-creatingNPV>0MVAincreasesvalue-destroying NPV<0MVAdecreasesReasonthatEPisthefocusofmostattentionisbecauseMVAisastockorwealthmeasure,soMVAwillshowhowmuchvaluehasbeenaddedatthatpointintimeEPmeasurestheamountofvalueaddedoveraperiodoftime,whichisfarmoreusefulwhenmeasuringmanagerperformanceMarketValueAddedLinktoEP(2of2)31WhichUKsectorswouldyouexpecttohavethehighestmarketvalueadded?andthelowest?WhichUKcompanieswouldyouexpecttohavethehighestmarketvalueadded?andthelowest?MarketValueAddedActualPerformance32Banks,integratedoilanddrugsweretheUKsectorswiththehighestmarketvalueaddedSource:SternStewart,SundayTimesSectorMarketValueAdded(Sept98)MarketValueAddedUKSectorPerformance-10Best33Distributors,printandpackagingandconstructionhadthelowestmarketvalueaddedintheUKSource:SternStewart,SundayTimesSectorMarketValueAdded(Sept98)MarketValueAddedUKSectorPerformance-10Worst34Shell’’s£69.5BofmarketvalueaddedisthelargestintheUKSource:SternStewart,SundayTimesCompanyMarketValueAdded(Sept98)1998EVA(£B)(1.506)0.4160.8030.7100.402(0.024)1.4000.231n/a0.098MarketValueAddedUKCompanyPerformance-10Best35BritishSteel’s££3BofmarketvaluedestroyedwastheworstofBritain’’s200largestcompaniesSource:SternStewart,SundayTimesCompanyMarketValueAdded(Sept98)1998EVA(£B)(0.071)(0.012)(0.054)(0.087)(0.050)(0.108)(0.120)(0.320)(0.284)(0.352)MarketValueAddedUKCompanyPerformance-10Worst36AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo37DefinitionAdvantages/DisadvantagesFrameworkUseinStrategyWorkEconomicProfitAgenda38Definition(1of2)Note:EconomicProfit(EP)=OperatingProfit-(CostofCapital*AmountofEquityCapitalInvested)EconomicProfit(EP)isaresidualprofitconceptaccountingfortheopportunitycostofholdingcapitalAmount($)TraditionalaccountingconceptofprofitsEconomicProfit39Definition(2of2)Note:NOPAT=NetOperatingProfitAfterTax(SeeAppendixfordetails)WACC=WeightedAverageCostofCapitalEconomicProfitdeterminesacompany’’svaluecreationordestructionEasytouse,basedonaccountingrecords(forhistoricalvalues)NotprisonersofGAAPCanbeusedtoshowrelativeperformanceofproducts,segments,regions,etc.inagivenyearCanbecalculatedforfutureyearsanddiscountedtoshowvaluecreationWhenEconomicProfitsarepositiveovertimevaluecreationispositivemarketpricepershareismorethanbookvaluepersharegrowthcreatesvalueEPNOPAT$Chargefor

Capital

EmployedOperating

ProfitEffective

TaxationInvestedCapitalWACCGrossProfitA&PNetWorkingCapitalNetFixed

AssetsOverheadsEconomicProfit40InordertounderstandEPitisimportanttogobacktothebasicincomestatementWhatdidweearn?

(usingwhatweown)IncomeStatement(%)Whogetsaccesstotheseearnings?$100$100EBITPATTaxInterestObservationsDebtprovidershavefirstaccesstotheinterestpaymentsdueonmoneylentGovernmentstaxcorporateprofitsShareholders(equityproviders)haveaccesstoallresidualprofits(afterpayinginterestandtax)Note:EconomicProfit(EP)=OperatingProfit-(CostofCapital*AmountofCapitalInvested)KeyPrinciples:AccesstoCompanyEarningsEconomicProfit41Note:NIBL=Non-interestbearingliabilitiesAssetsareacompany’’seconomicresources,itemswhichhavethepotentialtoprovidefuturebenefitstotheorganisationNIBLsrepresentafreesourceoffundstothecompany.ItismoneylenttoafirmwithnochargeorexpectedreturnDebtisanyinterestbearingcapital,includingpreferredstockShareholder'sEquityistheaccountant'sestimateofthevalueoftheshareholder'sinvestmentinthecompanytotalassetslesstotalliabilitiesKeyObservationsBalanceSheetMakeupWhatdoweown?AssetsNIBLsDebtShareholder's

EquityHowdidwepayforit?$500$500100%BalanceSheetThebalancesheetseparateswhatisownedbythefirmfromhowitwaspaidforUnderstandingtheBalanceSheetEconomicProfit42EconomicProfitBalanceSheetNote:NIBL=Non-interestbearingliabilitiesInordertodeveloptheEPbalancesheet,short-termnon-interestbearingliabilitiesmustberemovedandadjustmentsforaccountingdistortionsmustbemadeShort-termNIBLareremovedfromtheEPbalancesheetsincecapitalreturnsarenotexpectedontheamountsowed(e.g.wagespayable)EPBalanceSheetNetAssetsamountmaybemuchlargerthanthetraditionalaccountingvalueafteradjustmentsforaccountingdistortions(e.g.,addinginternally-generatedintangibleassets)aremadeRegularBalanceSheetEPBalanceSheetFinancingApproachOperatingApproachEconomicProfit43DividendPolicyThetraditionallinkageoftheIncomeStatementandBalanceSheetistheconnectionbetweennetincomeandretainedearningsordividendsIncomeattributabletoshareholders(EBIT-Interest-Tax)Cash““in””fromshareholdersperspectiveCash““out””fromshareholdersperspectiveNetIncomeRetainedEarningsDividendsManagementDecisionReinvestitintheCompanyDistributeittoShareholdersIncomeStatementandBalanceSheetTraditionalLink(1of2)EconomicProfit44EconomicConsequenceThetraditionallinkageoftheIncomeStatementandBalanceSheetistheconnectionbetweennetincomeandretainedearningsordividends=RetainedEarnings=NetIncome-DividendsRevenue-CostsIncomeStatementBalanceSheetAssetsLiabilitiesCurrentAssetsNetFixedAssetsOtherAssetsNIBLsDebtEquityIncomeStatementandBalanceSheetTraditionalLink(2of2)EconomicProfit45Ifyoucouldbuythesamefactoryfor££100K,butcouldonlyfinance70%withdebtandrequiredequityfortheremaining30%,howmuchafter-taxprofitwouldyourequiretobreak-even?assumetaxrate=40%assumecostofequity=15%Break-EvenExample-70%Debt/30%EquityRevisitedEconomicProfit46Ifyoucouldbuythesamefactoryfor££100K,butcouldonlyfinance70%withdebtandrequiredequityfortheremaining30%,howmuchafter-taxprofitwouldyourequiretobreak-even?assumetaxrate=40%assumecostofequity=15%Debt:Equity:£70K@7%(£30@15%)(1-40%)£4.9K£7.5K(coverinterestpayments)(coverequitycharge,whichisnottax-deductible)Therefore££12.4Kisrequiredtobreak-evenwith30%equity,comparedto££7Kwith100%debtfinancingAnyafter-taxprofitsbeyond££12.4Kwillbeeconomicprofits£12.4KBreak-EvenExample-70%Debt/30%Equity-SolutionEconomicProfit47EconomicProfitAgendaDefinitionAdvantages/DisadvantagesFrameworkUseinStrategyWork48AdvantagesSource:SternStewartEPismoresuccessfulthanothermeasuresinexplainingshareholderreturnsTMEconomicProfit49Advantages(1of3)AmanagerwithhighROEwillnotundertakeprojectswithROEgreaterthanrequiredbutlowerthancurrentROE,creatingmissedopportunitiesManagersaretypicallyevaluatedbasedonmaximisingROEAmanagerwithROElevelofRwillnotundertakeanyprojectswithROE<R1AnyprojectswithROE>R0butROE<R,willstillhavepositiveNPVbutwillnotbeundertakenbymanagercreatesmissedopportunitiesNPV00R1R0(afterequitycharge)ROEEP>0EconomicProfit50Advantages(2of3)AmanagerwithlowROEwillundertakeanyprojectthatincreasesROE,evenifitisbelowrequiredlevel.IfprojectROEisbelowrequiredlevel,valueisdestroyed00Ro(AfterequityCharge)AmanagerwithROElevelofR2willundertakeanyprojectthatincreasesROEIfanyprojectswithROE<Roareundertaken,valueisdestroyedNPVR2EP>0ROEEconomicProfit51Advantages(3of3)Note:*SomeprojectsmayhavenegativeEPinearlyyearsbutlargepositiveEPinlateryears.Toadjustforthis,MVA,orPVandEPcanbeusedByevaluatingmanagersbasedonEP,theirincentiveswillbetofocusonallprojectsthatcreatevalue00Ro(AfterequityCharge)ByevaluatingmanagersbasedonEP,managerbehaviourcanbealteredsuchthatonlyprojectswithNPV>0areundertakenNPVEP<0Donotundertakeproject*EP>0UndertakeprojectROEEconomicProfit52DisadvantagesCriticsofEPciteunder-investmentbymanagersandsizebiasasreasonstousedifferentmeasurestoevaluatemanagersUnder-investmentbyManagersSizeBiasEPdiscouragesnewinvestmentsthatdonotgeneratepositivereturnsininitialphasesbecausemanagerwillbechargedforanycapitalusedfromthestartofprojectsolutionistounder-chargecapitalatstartofprojectEPgenerallyrewardslargerdivisionsbecauseperformancemeasuredby$generated,not%Divisionalmanagersarguethat%returnisbettermeasureoftheirskillsthan$return$returnistheimportantmeasureforshareholdersDiageolooksatOperatingEconomicProfitpercaseofspiritstonormaliseROCEbasisEconomicProfit53Evenmeasuresthattieintheassetsideofacompany'sfinancialperformanceneedtobeunderstoodcarefully...Assetrevaluations(especiallyinAustralia)Ingeneralaccountingratioswilltendtobiasperformanceupwardsinrelationtotrueeconomicreturnsbecausetheyignoreinflation,assetlifeandassetmixROEtendstoincreaseduetoinflation,whichmaybecontrarytoactualeconomicperformanceinrealtermsFurthermore,theotherissuetobeawareofisthatolderPPEassetstendtogeneratehigherreturns(RONA,ROC,evenROE)becausetheyaremorefullydepreciatedOneconsequenceofthisisthatcompaniesgrowingassetsquicklywillappeartohavealowerreturnthanthosewithslowgrowthEconomicProfitBeware:CapitalisintheRatioFormula54ByavoidingcommonpitfallswithEP,managerscanpreventsignificantoverorunder-investmentLookingatabsoluteEPlevelsinsteadofchangesinEPbusinesswithhighEPmayunderinvestand/orbecomecomplacentFocusingoncurrentEPlevelsinhighlycyclicalbusinessesmayleadtosignificantoverorunderinvestmentIgnoringnaturaltrendsinEPthatoccurincertainbusinessese.g.high-techstartupwouldhavelowornegativeinitialEPthatincreasesovertimeEconomicProfitCommonPitfalls55AgendaEconomicProfitDefinitionAdvantages/DisadvantagesFrameworkUseinStrategyWork56FrameworkNote:*NetOperatingProfitAfterTaxBoththeOperatingandFinancingApproachescanbeappliedtotheEPframework.TheseapproacheswillgiveidenticalEPfigures,butBaintypicallyusestheOperatingApproachOperatingApproach:EP=NOPAT-(NetAssets&WACC*)EstimateWeightedAverageCostofCapital(WACC)CalculateNetAssetsAdjustOperatingIncome(EBIT)CalculateNOPATAdjustBalanceSheetEstimateCost

ofCapitalCalculateEPFinancingApproach:EP=NOPAT-(InvestedCapitalWACC*)EstimateWeightedAverageCostofCapitalCalculateCapitalEmployedorInvestedCapitalAdjustNetIncomeEconomicProfit57NOPATNote:*AdjustmentdiscussedinAccountingAdjustmentssectionTheOperatingandFinancingApproachesadjustdifferentincomefigurestocalculatethesamelevelofNOPATOperatingApproachFinancingApproachNOPATCalculationNOPAT=Operatingincome(EBIT)+Non-operatingincome/(loss)+Accountingadjustments*-CashoperatingtaxesNOPAT=Netincome+After-taxinterestexpense+Financingadjustments+AccountingadjustmentsEconomicProfit58Note:NOPAT=Netoperatingprofitaftertax;Investedcapital=Alldebtequityinvestedinformatatbookvalue;WACC=WeightedaveragecostofcapitalROIC=Returnoninvestedcapital=(NOPAT/investedcapital)alsoknownas:ReturnonNetAssets(RONA)orReturnonCapitalemployed(ROCE)EPcanbecalculatedbeginningwitheitherprofits,NOPAT,orreturns,ROIC,dependingontheavailabilityofdata.TheNOPATmethodismorecommonlyusedEPCalculationUsingROICUsingNOPATEP=NOPAT-CapitalChargeEP=(ROIC-WACC)*InvestedCapitalSpreadbetweenwhatisachievedandwhatisrequiredInvestedCapital*WACCDiscountRates-FrameworkEconomicProfit59*MaybereferredtoasReturnonCapital(ROC)orReturnonInvestment(ROI)Therearetwodifferentframesofreferenceforcalculatingthe““economicvalue”ofanybusiness-analogoustotheperspectivesusedinROIandROEanalysisTotalCapitalPerspectiveEquityCapitalPerspectiveBanksandShareholdersShareholdersEP=NOPAT-(AssetsxWACC)...the"profitability"ofthebusinessfromtheframeofreferenceofthedebtandequityholders"...profitability"ofthebusinessfromtheframeofreferenceoftheequityholdersOpportunitycostofthe(blended)debtandequitycapitalOpportunitycostoftheequitycapital"Profitability"ismeasuredasincomeearnedlesstheopportunitycostoftotalcapitalinvested"Profitability"ismeasuredasincomeearnedlesstheopportunitycostofequitycapitalinvestedStakeholder:EPdefinition:Perspective:...giventhat,whatistheframeofreference?Accordingly:PerformanceMeasurementLinkages:-Ratio:-EP:TotalCapitalSpread=ROA-WACCEP=TotalCapital*(ROC-WACC)EquityCapitalSpread=ROC-KeEP=EquityCapital*(ROC-Ke)ReturnonAssets(ROA)*ReturnonEquity(ROE)KeyRatio:DiscountRates-TwoDifferentDefinitionsofEPEconomicProfit60DiscountRatesCalculateWACCCalculateFirmTaxRateCalculateIndustryAverageforUnleveredbDetermineAppropriateMarketRiskPremiumDetermineMarketValueofDebtandEquityDetermineAppropriateCostofDebt,KDRe-LeverTargetLeverageforyourFirmtoCalculateKeUse10yearT-Bondor30YearT-Bondlessliquiditypremium(of1.7%forUS)forappropriatecountryOnlyusegovernmentbondsiflittleornoriskofdefaultforcountryinquestionUselong-termaverageofdifferencebetweenexpectedmarketrateofreturnandrisk-freerateE(Rm)-RfForUS,Copeland,KollerandMurrinrecommend5%to6%basedongeometricaveragefrom1926-1993Findcomparablefirmsforindustryinquestionandunleverbbasedonformula*UseaverageofbuofcomparablefirmsUsetargetleverageinformula*tocalculatebLOncebL

calculated,useCAPMformulaKe=Rf+bL[E(Rm)-Rf]tocalculateKeKDisnotnecessarilyequaltocouponrateofbond(e.g.IBM20057.5%doesnotnecessarilyhaveKD=7.5%MustcalculateorobtainyieldonoutstandingdebtIfnotavailable,useKDoffirmswithsimilarratingfromagenciessuchasMoody’sorS&PBookvalueofdebtcangenerallybeusedaproxyformarketvalueofdebtMarketvalueofequity=currentsharepricemultipliedby#ofsharesoutstanding**IffirmnotpubliclytradeduseP/EratiosofcomparablefirmsDivideincometaxpayable(notincometaxexpense)bynetearningsUseWACCformula:Where:E=marketvalueofequityD=marketvalueofclientKE=costofequityKD=costofdebtT=corporatetaxrateDetermineAppropriateRisk-FreeRateUsePublishedEstimatesofbTakeaverageofhighestqualitysourcesForUSfirmsBARRApublishesestimatesofb()()ED+EDD+EKe+KD(I-T)Publiclytraded:Non-publiclytraded:Note:**Sinceinvestedcapitaliscalculatedbasedonbookvalueofdebt+equity,WACCcanbecalculatedforEVApurposeswithbookvalueweighting*Bu=UnleveredBeta=BL1+(1taxrate)(marketvalue÷÷ofdebtmarketvalueofequity)EconomicProfit61EVAandMVAmeasuresdifferfromothermorestandardEconomicProfitandMarket/Bookmeasuresprimarilydue