eva - Value Enhancement: EVA and CFROI Aswath Damodaran 1...

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Aswath Damodaran 1 Value Enhancement: EVA and CFROI
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Aswath Damodaran 2 Alternative Approaches to Value Enhancement n Maximize a variable that is correlated with the value of the firm. There are several choices for such a variable. It could be an accounting variable, such as earnings or return on investment a marketing variable, such as market share a cash flow variable, such as cash flow return on investment (CFROI) a risk-adjusted cash flow variable, such as Economic Value Added (EVA) n The advantages of using these variables are that they Are often simpler and easier to use than DCF value. n The disadvantage is that the Simplicity comes at a cost; these variables are not perfectly correlated with DCF value.
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Aswath Damodaran 3 Economic Value Added (EVA) and CFROI n The Economic Value Added (EVA) is a measure of surplus value created on an investment. Define the return on capital (ROC) to be the “true” cash flow return on capital earned on an investment. Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment. EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project) n The CFROI is a measure of the cash flow return made on capital CFROI = (Adjusted EBIT (1-t) + Depreciation & Other Non-cash Charges) / Capital Invested
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Aswath Damodaran 4 In Practice: Measuring EVA n Capital Invested : Many firms use the book value of capital invested as their measure of capital invested. To the degree that book value reflects accounting choices made over time, this may not be true. In addition, the book capital may not reflect the value of intangible assets such as research and development. n Operating Income : Operating income has to be cleansed of any expenses which are really capital expenses or financing expenses. n Cost of capital : The cost of capital for EVA purposes should be computed based on market values. n Bottom line : If you estimate return on capital and cost of capital correctly in DCF valuation, you can use those numbers to compute EVA.
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Aswath Damodaran 5 Estimating Nestle’s EVA in 1995 n Return on Capital After-tax Operating Income = 5665 Million Sfr (1 - .3351) = 3767 Million Sfr Capital in Assets in Place1994 = BV of Equity + BV of Debt = 17774+(4180+7546) = 29,500 Million Sf Return on Capital = 3767 / 29,500 = 12.77% n Cost of Capital Cost of Equity = 4.5% + 0.99 (5.5%) = 10% Cost of Debt = 4.75% (1-.3351) = 3.16% Debt to Capital Ratio (market value) =11726/ 68376 Cost of Capital = 10% (56650/68376)+3.16%(11726/68376) = 8.85% n Economic Value Added in 1995 = (.1277 - .0885) (29,500 Million Sfr) = 1154.50 Million Sfr
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Aswath Damodaran 6 Discussion Issue n Assume now that the Book Value at Nestle had been understated at 14,750 Million. Assuming the Operating Income remains the same, estimate the EVA.
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Aswath Damodaran 7 EVA for Growth Companies n For companies, divisions or projects which make significant infrastructure investments, with long gestation periods, the current EVA may not be a good indicator of the quality of investments.
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Aswath Damodaran 8 Estimating Tsingtao’s EVA in 1996 n
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eva - Value Enhancement: EVA and CFROI Aswath Damodaran 1...

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