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Antonio Majocchi

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Title: Antonio Majocchi


1
International Business and Management
  • Antonio Majocchi
  • antonio.majocchi_at_unipv.it
  • Associate Professor in international business

2
Teaching Faculty
  • Roger Strange, Professor of international
    business, Sussex University (18 hours)
  • David Needle of Professor of management, King's
    College London (4 hours)
  • A business case will be discuss under the
    supervision of an external business consultant
    (Dr. Ucci from Oliver Wyman)
  • Attendance even if not compulsory is highly
    recommended

3
Assessment
  • The course will be assessed by a final exam and
    assignments
  • The final exam will cover mainly the theoretical
    arguments of the course and will count 50 of the
    final mark (this year the exam will be realised
    in 2 parts)
  • The assignment is a group projects that count for
    40 of the final mark
  • The class discussion of the business case
    (compulsory) will count for the remaining 10

4
Class assignment
  • The goal of the class assignment is to present
    the international strategy of a MNCs
  • Group should be formed by no more then 3 students
  • A lecture (18 of March?) will be devoted to
    discuss and present the main criteria to be
    followed in the presentation (sources, aim of the
    presentation, methodology etc etc.)

5
Assignment
  • The assignment should be completed for the end of
    the course and presented discussed in the last
    week of the lecturing period (exact dates to be
    defined)

6
Reading materials
  • There is no single recommended text. Readings
    will be assigned to students at every group of
    thematic lectures
  • The reference book for Professor Strange's
    seminars is
  • Bartlett, C.A., Ghoshal, S. and Beamish, P.W.
    (2008). Transnational management text, cases,
    and readings in cross-border management. London
    McGraw-Hill (available in the faculty library)

7
Course brief Contents part I
  • Market selection and Market Entry
  • What is globalisation data and trends
  • The Strategy and Structure of MNCs
  • Control in MNCs
  • The balance scorecard
  • EVA principles and application

8
Course brief Contents part II
  • Financial management in MNCs
  • International pricing policy
  • foreign exchange risk
  • foreign exchange management
  • Market forecast
  • Methodology to forecast market potential
  • Elasticity and pricing

9
To sum up
Antonio Majocchi Lectures Written exam (25). To be held in the planned exam dates
Group Assignments Group presentation (31st May, 1st June) (40)
Business case 15 March (tentative date) (10)
Roger Strange Written exam (25). 27th May
Final Mark
  • if either the Business case or the Group
    assignment are missed then the student will have
    to sustain the full exam based on the Bartlett,
    Ghoshal, and Beamish (2008) book

10
Market selection and market entry
  • Compulsory Readings
  • Ghauri Cateora, International marketing, Mc
    Graw Hill (2 ed), Chapter 7 and Chapter 11 (530
    781)

11
Barriers to international business
  1. Tariffs
  2. Non Tariff Barriers
  3. Specific limitations on trade (Quotas, local
    content requirements..)
  4. Customs and administrative entry procedures
  5. Standards
  6. Government participation in trade
  7. Risk (political and economic risk)
  8. Knowledge (business, market, consumers,
    cultural.)

12
Political Risk
  • The likelihood that a government or society will
    undergo political changes that negatively affect
    local business activity
  • Political risk arises from a variety of sources
  • Corrupt or poor political leadership
  • An unstable political system
  • Conflict between races, religions, or ethnic
    groups
  • Economic problems

13
Examples of political risk
  • Confiscation (take a piece of equipment )
  • Expropriation (take the whole company )
  • Nationalization (all the companies in a business
    sector)
  • Political sanctions
  • Violence
  • Political reprisals
  • Corruption

14
Economic Risk
  • Any economic events that negatively affect local
    business activity
  • As usual economic risk is measured with the
    volatility of economic variables
  • Political and Economic risk define overall
    country risk

15
An assesment of country risk
The ICRG Rating System The ICRG Rating System The ICRG Rating System
Political
Economic expectations versus reality 6
Economic planning failures 6
Political leadership 6
External conflict 5
Corruption in government 3
Military in politics 3
Organized religion in politics 3
Law and order tradition 3
Racial and nationality tensions 3
Political terrorism 3
Civil war 3
Political party development 3
Quality of bureaucracy 3
Total Political Points 50
Financial
Loan default or unnfavourable loan restructuring 5
Delayed payment of suppliers credits 5
Repudiation of contracts by government 5
Losses from exchange controls 5
Expropriation of private investments 5
Total Financial Points 25
Economic
Inflation 5
Debt service as a of exports of goods and services 5
International liquidity ratios 3
Foreign trade collection experience 3
Current account balance as of goods and services 8
Parallel foreign exchange rate market indicators 3
Total Economic Points 25
16
Country risk agency
  • http//www.prsgroup.com/

16
17
www.aon.com/
17
18
Factors Influencing Market Entry Strategy
19
Market selection
  • The market selection process depends on the kind
    of investment
  • resource seeking
  • market seeking
  • efficiency seeking
  • strategic assets seeking

20
Market choice
20
21
Resources (example)
SCHOOL-LEAVING EXAMINATION GRADUATED
JOB FORCE
HUMAN CAPITAL
STRUCTURES FOR INSTRUCTION
PER CAPITAL INCOME
ROSOURCE ASSETS
GDP GROWTH
MARKET SIZE
TOTAL POPULATION
21
22
Resources (example)
PRODUCTION RESOURCES
Agglomeration of FF
BUSINESS COSTS
Industrial districts
22
23
Infrastructure
23
24
Alternative Market Entry Strategies
Alternative Market Entry Strategies
  • Exporting
  • Licensing
  • Franchising
  • Joint ventures
  • Foreign Direct Investments
  • Low risk...low control
  • High risk...high control

24
25
Entry Mode
Financial Capital
0
100
Control/flexibility
Control
Minority holdings
JV
Licensing
Franchising
Flexibility
Export
Agreements
FDI
26
FDI
  • There are 2 different kind of FDI
  • Greenfield investments
  • Mergers Acquisition (MA)

27
Data and trends
  • FDI general trends

28
Regional trends
29
MA activity
Source www.unctad.org
30
Newcomers
Source www.unctad.org
31
Strategy and Structure
  • Compulsory Readings
  • Bartlett, Goshal and Beamish, (2008), (510
    2368),
  • Chapter 1 (pp. 1- 13)
  • Chapter 3 (pp. 197 209)
  • Reading 3-2, G. S. Yip, Global strategyin a
    world of Nations? (pp. 291 304)
  • Chapter 4 (p. 333- 349) and Case 4- 1 (p.350
    365)
  • Chapter 7 (p. 648 660)

32
Organizational Designs
  • Types of structures used by companies to manage
    foreign activities

Little/No Formal Organization
International Division
Global Organizations
33
No formal organisation
  • Domestic operations assume responsibility for
    international activities in the early stages
  • The organizational structure reflects the
    increased demands from the international
    marketplace
  • The export department structure becomes obsolete
    as the firm becomes more involved in foreign
    markets

34
International division
  • Centralizes in one entity all of the
    responsibility for international activities
  • Best serve firms with few products that do not
    vary significantly

35
The Stopford Wells Model
Product Division
Improved cost efficiency is a major benefit
Follows the marketing concept most closely
Degree of product diversification
Area Divisions
Int division
Foreign sales/Total sales
36
The international division
37
International strategies
Local Adaptation
low
high
Standardization
Global
high
Transnational
Multi-domestic
low
37
38
Strategy implementation
  • Multidomestic (Decentralized) systems have loose
    and simple controls. Subsidiary operates as a
    profit center
  • Global (Centralized) systems have tight controls.
    Strategic decision making is at headquarters.
  • Transnational (Coordinated decentralization)
    calls for overall strategy to come from
    headquarters
  • Subsidiaries are free to implement within
    agreed upon range

39
A typical area division
  • Telefónica has a regional structure
  • The different operations of the Telefónica Group
    in 25 countries are organised into three
    geographical regions Spain, Latin America and
    Europe.
  • The Corporate Centre is in charge of global
    strategy and corporate policies, management of
    common activities and coordination of the
    activity of business units.

40
A global company
41
Multidomestic
  • Subsidiaries are managed as a portfolio of
    international assets
  • Coordination is very limited
  • Control is mainly financial
  • Subsidiaries have an high level of autonomy and
    are focused on localisation issues

42
Global
  • All value added activities are concentrated in
    the MNCs headquarter
  • There is no adaptation and the world market is
    considered as an homogeneous market
  • The role of subsidiaries is very very limited

43
The transnational model
  • geographic dispersion
  • economies of scale
  • interdependence intense relationships among
    units characterised by an high of cooperation and
    competition (both horizontal and vertical)
  • formal and informal methods of control
  • diversified role for the subsidiaries

44
The complexity of the model
Source Bartlett Goshal, 1987
45
The new role of subisdiaries
Relevance of the local market
low
high
A competent national subsidiary that may be
serving as a partner in developing and
implementing strategy
Country organization with a distinctive
competence
Subsidiary Competences
STRATEGIC LEADER
CONTRIBUTOR
high
Most entities hold this role. It provides
critical mass
The international company has a low competence
country organization, or none at all
BLACK HOLE
EXECUTOR
low
45
46
The transnational model
  • The model try to avoid problems of effort
    duplication and inefficiency
  • Subsidiaries are able to make local business
    development decisions within the global framework
  • Subsidiaries can take a leading role with regard
    to specific functions/business or areas

47
Control in transnationals
  • Control evolves in transational corporation and
    became a very complex function
  • i.e. RD not only has short-term objectives
    (product development) but also medium and long
    term ones (patents/research projects)
  • Even aspects which cannot be expressed strictly
    in quantitative terms are considered

48
Strategic Control in MNCs
  • Compulsory Readings
  • The balanced scorecard. Measures that drive
    Performance, Kaplan R.S. Norton D.P. 1992
    Harvard Business Review, Jan/Feb, pp. 71-79
  • Putting the balanced scorecard to work, Kaplan
    R.S. Norton D.P. 1993 Harvard Business Review,
    Sept/Oct, p. 71-79
  • Balanced scorecard for multinationals, S.P.
    Landry, W. Y. Canri Chan, T. Jalbert, Journal of
    Corporate Accounting Finance, 2002, 13(6), p.
    31-40

49
Control
  • Control refers to the general function of
    overseeing business unit performance
  • Typically the corporate development function
    oversees strategy and the controllers (financial
    function) budget and measure short-term financial
    performance

50
Control
  • Different categories of control

Personal/Cultural
Impersonal/Burocratic
Personal centralised control
Burocratic formalised control
Direct/ explicit
Control by Socialisation and Network
Output Control
Indirect/ implicit
51
Socialisation and Network
  • It combines a lot of relatively diverse
    mechanisms.
  • Socialisation instrument to ensure that
    employees share organisational values and goals
  • Informal, lateral exchange of information
    mutual adjustment, informal communication
  • Formalised cross-departmental relations
    temporarily formalised devices such as task
    forces, cross-functional teams

52
Performance measurement
  • The organisations measurement system strongly
    affects the behaviours of managers and employees
  • However, as the experience of Multidomestic firms
    showed, relying only on financial performance
    measurements is a too limited approach

53
The Balanced Scorecard (BSC)
  • The BSC is a strategic planning and management
    system that is used to align business activities
    to the strategy of the organization, improve
    internal and external communications, and monitor
    organization performance against strategic
    goals
  • The BSC includes financial measures but also
    operational measures on customer satisfaction,
    internal processes and the firms innovation
    activities

Kaplan Norton, 1996
54
BSC and strategy
  • The BSC is not just a list of performance
    indicators but provides executives with a
    comprehensive framework that translate companys
    vision and strategy into a coherent set of
    performance measures
  • Therefore, managers should first define the
    companys goal and then define the measurement
    and the goals

55
The Strategy process
  • Given the firms strategy for each perspectives
    firm defines
  • Goals
  • Measures
  • Targets
  • Actions

56
BSC the implementation
  • BSC Metrics allow the managers to know how well
    their business is running
  • The financial perspective indicates whether or
    not the firms strategy and implementation is
    contributing to bottom-line improvement
  • In the customer perspective managers define the
    segments in which the business units will compete
  • In the internal perspective executives identify
    the internal process in which the firm must excel
  • The learning and growth process identify the
    processes that the organisation must develop to
    create long-term growth and improvement

57
The Strategy process
Actions
Measures (KPI)
Goals
Goals
Actions
Measures
Mission
Strategy
4 perspectives
Goals
Actions
Measures
Goals
Actions
Measures
58
The Strategy process
  • A scorecard makes sense primarily for business
    unites and divisions with a well defined
    strategy
  • A corporate-level scorecard can be defined only
    after a BSC has been defined at a business level
  • This explain the difficulties in implementing BSC
    for MNCs and multi-business firm

59
Goals measures examples
  • The customer perspective goal time to market
  • lead time (existing products)
  • time to market (new products)
  • on-time delivery
  • The internal business perspective goal cost
    saving
  • production time
  • safety
  • defect rate

60
Goals measures examples
  • Innovation and learning perspective goal tech
    leadership
  • Employee turnover
  • Job satisfaction
  • Training/Learning opportunities
  • The financial perspective goal profitability
  • ROE
  • Shareholders value

61
How to choose the goals for each perspective
  • Building a balanced scorecard should encourage
    managers to define the objectives according to
    corporate strategy
  • By this point of view the objectives of the 4
    perspectives should be part of a coherent
    framework

62
Financial perspective
  • Financial goals could differ considerably at each
    stage of a businesss life cycle
  • Lets just consider three stages
  • Growth
  • Sustain
  • Harvest

63
Financial perspective
  • The growth stage is generally a cash burning
    phase
  • Growth rate in sales
  • Number of new market segments
  • of sales from new products introduced within a
    specific period
  • The sustain stage is the most common stage and
    typical profitability measure are used
  • Operating income (Ebit)
  • Return on capital employed

64
Financial perspective
  • The harvest phase is the mature stage when firms
    try to harvest the investments made in the two
    previous phases
  • The goal is typically to maximize cash flow back
    to the corporation
  • Operating cash flow
  • Reduction in working capital requirements
  • Cash-to-cash cycle

65
Example Cash-to-cash cycle
  • It is the sum of days cost-of-sales in inventory
    days sales in account receivables less days
    purchases in accounts payables

Days inventories
Days Receivables
Cash to cash cycle
Days payables
66
Cash-to-cash cycle
  • The case of a construction company
  • Cash-to-cash 89 days

67
The Customer perspective
  • The customer perspective of the BSC is aimed at
    identifying the customer and the market segment
    in which they have to compete
  • The core measurement group includes measures of
  • Satisfaction
  • Market share
  • Retention
  • Acquisition
  • Profitability

68
The Customer perspective
Market share Is the proportion in a given market in terms of sales, customers, unit volume that a business sells
Acquisition Measures, in absolute and relative terms, the rate at which a business unit attracts or win new customers or business
Retention Tracks, in absolute and relative terms, the rate at which a business unit retains ongoing relationships with customers
Satisfaction Assesses the satisfaction level of customers along specific performance criteria
Profitability Measures the net profit of a customers after allowing for the unique expenses required to support the customers
69
Customer profitability
  • In order to have measure of customer
    profitability firms should have implemented an
    activity-based cost system
  • Not all clients demand can be satisfied in ways
    that are profitable to an organisation

70
The internal business perspective
  • For the internal business perspective managers
    identify the process that are most critical for
    achieving customers and shareholders objectives
  • Typically firms concentrate on things such as
    quality, time, productivity

71
The internal business perspective
  • The BSC framework identify three main business
    processes
  • Innovation
  • Operations
  • After-sales services

72
Innovation
  • Measures for basic and applied research
  • of sales from new products
  • of sales from proprietary products
  • New product introduction vs competitors or vs
    plan
  • Time to develop next generation products
  • Productivity measure

73
Operations
  • Operations start with receipt of a customer order
    and finish with the delivery
  • Typical measures are
  • Standard costs
  • Machine efficiency
  • Operating processes quality
  • Cycle time

74
Post sales
  • Measures
  • Cycle times from customers requests to
    resolutions of the problems
  • Costs of after-sales services
  • Dispute resolution time

75
Learning growth perspective
  • This perspective develop objectives and measures
    to drive organisational learning and growth
  • The previous three perspectives identify where
    the organisation must excel to achieve
    breakthrough performance
  • Forward looking investments are generally treated
    as period expenses so that cutbacks in these
    investments are an easy way to produce
    incremental short-term earnings

76
Learning growth
  • The BSC identify 3 main categories for this
    perspective
  • Employee capabilities
  • Information system capabilities
  • Motivation, empowerment and alignment

77
Employee capabilities
  • Core employee measurement group are
  • Employee satisfaction (typically through survey)
  • Employee retention (key staff turnover
    measurement)
  • Employee productivity (ranging from simple
    measures such as revenue per employee to
    value-added per employee

78
Information system capabilities
  • The information system is nowday a critical
    resource
  • It not only interlink all the activities of the
    firm worldwide
  • It supply also rapid, timely and accurate
    information and feedback on the product just made
    or the services just delivered

79
Motivation empowerment
  • Measures of motivation
  • Suggestions made and Suggestions implemented
  • Implementing a reward structure for implemented
    suggestions
  • Measures of improvements
  • Late deliveries
  • Number of defects
  • Scraps
  • absenteeism

80
Alignment
  • Alignment focus on whether or not units and
    individuals have their objectives aligned with
    the company goals (as articulated in the BSC)

81
Alignment
  • In the implementation process a typical initial
    measure is the percentage of top managers exposed
    to BSC then the same ratio considering all the
    staff employees
  • At a later stage it is considered the degree of
    accomplishment of the BSC goals introducing
    incentives to achieving these targets
  • Incentive can be referred to single employees
    (pay raise) or to subunit and division
    (resources, autonomy)

82
A tentative strategy map
Objective KPI Targets Actions
Financial share value EVA share increase larger benchmark positive EVA standardis. product program p discrimination
Customer premium p on competition complaints gt 10 vs comp price lt 5 of clients Loyalty program targeted sales force
Internal workforce retention av. Time lt 5 days after 1 contact gt 90 gt 90 Continuos learning program Contact centre
Learning workforce stockholders trained workforce stockholders Stock ownership plan training
Saherholder value
Retention Satisfaction
Premium price
Improve service contact time
Sales force empowerment
83
BSC web-service solutions
  • The BSC is now implemented through web services
    applications
  • At http//www.bscdesigner.com/download you can
    find a freeware version (BSC Designer Light) of
    one - among the thousands available applications

84
A practical example
  • Tata Tea started building EVA as a key
    performance indicator in the balanced scorecards,
    so that the performance-management system centres
    around EVA

85
Economic value added (EVA)
  • Compulsory Readings
  • Journal of Applied Corporate Finance
  • EVA Momentum The One Ratio That Tells the Whole
    Story G. Bennett Stewart III, 21(2), pp. 74-86,
    (Spring 2009)
  • How To Fix Accountingmeasure And Report
    Economic Profit, G. Bennett Stewart III, 15 (3),
    pp. 63-82 (Spring 2003)
  • The Eva Revolution, Al Ehrbar, G. Bennett
    Stewart III, 12 (2), pp 18 31, (Summer 1999)
  • (SUGGESTED) Specific Knowledge and Divisional
    Performance Measurement, M. C. Jensen, W. H.
    Meckling, pp. 49-57, 21(2), (Spring 2009)

86
Shortcomings of accounting numbers
  • The classical ratios considered for businesses
    control such as EPS, ROI or ROE have a series of
    limitation as standards for measuring business
    performance
  • Standard earning numbers are sensitive to
    accounting methods, do not measure proper cash
    inflow and ignore the time value of money

87
Cash flow estimation
  • Cash flow from operation (CFFO) may be calculated
    as follows
  • CFFO sales-op expenses - tax Depreciation (
    other noncash items) incremental working
    capital investments Capital expenditures

88
Incremental Working Cap
  • Any increments in Net working capital is a cash
    absorption activity
  • NWC increase
  • increase in receivables
  • increase in inventories
  • increase in payables
  • increase in deferred taxes

89
EPS
  • A Subsidiary is planning a new investments of
    15M which will generate a 10 increase of sales
  • Consider that
  • Subsidiary has no debt
  • the cost of equity is 12
  • The business is a mature business and the profit
    could be consider a perpetuity
  • Remember that the present value of a perpetuity
    is

90
EPS
  • Even if earnings increase the equity value of
    the investment does not change
  • EPS fails to measure changes in economics value

Sub A with no debt Sub A 10
Sales 200 220
Op expenses 170 187
Earnings before tax 30 33
Income tax (0.4) 12 13.20
Earnings 18 19.80
Equity value (CF/CoE) 18/0.12150 19.8/0.12-15150
91
Roi
  • Roi Roe are popular financial performance
    indicators. Roi is a frequently used measure of
    divisions performance
  • Roi remains a good indicator of business
    profitability but still is an accrual accounting
    return and not a full economic measure
  • This is true even when Roi is compared to an
    hurdle rate that generally equals the business
    unit cost of capital

92
ROI
  • Roi is computed by a wide variety of methods
  • This is one
  • EBIT
  • Net Book value of FA Net Working Capital
  • In this case the tax shield effect is not
    considered

93
ROI
  • Moreover, both the numerator and the denominator
    are affected by arbitrary accounting assumptions
  • The recent drive towards fair value accounting
    has mitigated the problem
  • Nonetheless, operating income (EBIT) is not the
    CF generated by the business

94
ROI
  • Roi depends on capitalisation and depreciation
    policies that are strictly accounting decisions
  • For example, RD expenses are customarily
    expensed in the current period and not considered
    as an investment (thus increasing the Roi rate)
  • Thus, using Roi to compare RD intensive and not
    intensive business can be highly misleading

95
ROI
  • Overall Roi has 3 main additional shortcomings
  • It depends on the investments base of the
    business unit considered (the larger the
    investment base the lower the accounting return)
  • Aggressive strategies (RD spending, new
    investments) typically lower Roi while
    harvesting strategies increase Roi
  • Does not take in account the overall risk (i.e
    the cost of capital)

96
ROE
  • Roe is the ratio of net profit on total
    shareholder capital
  • Roe is seldom used at the divisional level where
    debt is rarely allocated but is more widely used
    at the corporate level
  • Roe has all the shortcomings of Roi but in
    addition it is sensitive to leverage
  • Roe increases as more then optimal debt is issued

97
Time value of money
  • Earning calculations ignore the time value of
    money i.e. the risk free rate, the cost of risk
    compensation and the expected rate of inflation
  • This is not the case with NPV calculation (CF
    cash flow rinterest rate)

98
The risk/return relationship
Expected return
Risk free rate (Rf)
Return
Risk
99
EVA
  • EVA (Economic Value added) is a methodology aimed
    at measuring shareholder value creation
  • EVA is increasingly becoming the global standard
    for measuring business performance
  • Shareholder value is created only if a business
    earns a rate of return on investments greater
    than the rate investors can expect to earn by
    investing in alternative, equally risky,
    securities

100
EVA
  • Eva take in account both the real cash flow
    generated by the business divisions and the
    overall risk of the business
  • By this point of view Eva is an economic profit
    measure as opposed to the typical accounting
    measures
  • Eva can be calculated for any entity including
    divisions departments, products lines

101
Eva balance sheet
Regular Balance Sheet
EVA Balance Sheet
Short term Debt
Short term Debt
Cash
Cash
NWC
Short term Not Interest-bearing liabilities
Long term Debt
Receivables Inventories Prepayments
Fixed Assets
SH Equity
Long term Debt
Net Assets
Invested Capital
Fixed Assets
SH Equity
Nopat
Wacc
102
The EVA approach
  • Eva NOPAT (WACC?Invested Capital)

Weighted average cost of capital
Net operating profit after tax
Net Fixed asset net working capital
103
The EVA
  • The return on net assets is defined as the ratio
    of Nopat on Net Assets (RONA)
  • Eva will be positive if
  • RONAgtWACC
  • Eva can be also be expressed as
  • Eva(RONA-WACC)?Invested Capital

104
NOPAT
  • Nopat is the firms profit assuming that the firm
    has no debt
  • The term net means that Nopat is net of
    amortization (which is a real economic cost)
  • The idea is that Nopat captures the profit that
    accrue to all capital holders (both lenders and
    shareholders)

105
NOPAT adjustments
  • The main adjustment is the reclassification of
    some expenses as investments (typically RD) and
    the subtraction of provision and extraordinary
    expenses i.e. all non-monetary costs such as
    provisions (except amortization!)

106
NOPAT
  • Nopat is equal to
  • Ebit (adjusted)-corporate taxes (without debt)
  • or more precisely
  • profit(adjusted)interest expenditures(1-t)

107
Nopat the formulas
Ebit () 100
Interest cost (-) 20
PTP () 80
Tax rate 50 40
Profit 40
Option 1 Option 1
Ebit () 100
Interest cost (-)
Tax rate 50 50
Nopat 50
Option 2 Profit IC(1-t) Option 2 Profit IC(1-t)
Profit () 40
Interest cost (1-t) () 10
Nopat 50
Option 3 Ebit (1-t) Option 3 Ebit (1-t)
Ebit () 100
(1-t) (-) 50
Nopat 50
108
Income statement (basic)
Sales () 100
Costs of Goods and Services (-) 20
Labour Costs (-) 10
Earnings before Interests, Taxes DA - EBITDA () 70
Depreciation Amortization - DA (-) 20
Interest costs (-) 10
Pre-tax profit (t40) PTP () 16
Profit 40
109
Adjusted Profit
  • In order to estimate the adjusted profit
    exceptional costs (i.e. integration costs)
    should be deducted and RD costs should be
    amortised according to the amortisation period
    considered

Profit 40
Integration costs () 5
Research cost capitalised 50
n. of years of capitalisation of RD costs 10 years
Costs to be added and deducted 50 and 5
Adjusted Profit 90
110
Nopat
  • Nopat is not affected by the firms capital
    structure choices

  Unlevered firm levered firm (1) levered firm (2)
Invested capital 10,000 10,000 10,000
Equity 10,000 5,000 2,000
Debt 0 5,000 8,000
Sales 16,667 16,667 16,667
Cogs 13,000 13,000 13,000
Depreciation 2,000 2,000 2,000
EBIT 1,667 1,667 1,667
Interests (i5) 0 250 400
Pre-tax Profit 1,667 1,417 1,267
Tax (0.4 tax rate) 667 567 507
Net Profit 1,000 850 760
NopatNPInt(1-t) 1,000 1,000 1,000
111
EVA BS at the divisional level
  • When Eva is measured at the divisional levels,
    cash is typically excluded from invested capital
    (cash is typically managed centrally)

EVA BS at the Divisional Level
EVA Balance Sheet
Short term Debt
Cash
ST debt
NWC
NWC
Long term Debt
Long term Debt
Fixed Assets
SH Equity
Fixed Assets
SH Equity
112
The Cost of capital
  • The cost of capital is the rate of return a
    capital provider would expect to receive if the
    capital were invested in a project/division of
    comparable risk
  • Therefore, the cost of capital is an opportunity
    cost
  • Since risk is a crucial element investors require
    higher returns from equity capital than they do
    from debt

REgtRD
113
WACC
  • The WACC is calculated as follows
  • Where the cost of debt is the pretax rate the
    company pays to its lenders (since interest
    payments are as a rule tax deductible)
  • The cost of equity should be estimated and
    depends on the overall risk of the investment

114
WACC
  • If the market value of debt is 30M the
    market value of equity is 50M, the cost of
    debt 9 and the cost of equity is 15 then,
    geiven a tax rate of 40 the weighted cost of
    capital is equal to..

115
CAPM
  • The CAPM (Capital Asset Pricing Model) offers is
    one of the methodologies (among others!) to
    estimate the cost of equity
  • The cost of equity is equal to the return on
    riskless assets plus a risk premium which reflect
    the price paid by the stock market to all equity
    investors, adjusted for beta which is a specific
    risk factor

116
Beta
  • Beta is the volatility of a company stock price
    with respect to the overall stock market
  • Therefore Beta is the company-specific risk that
    the asset adds to a market portfolio
  • Analytically Beta equals

117
Riskless rate
  • The only securities that have not default risk
    are government securities. Nonetheless they bear
    interest rate risk. The most common rates used
    are
  • T-bill rate
  • Treasury notes rate
  • Inflation-indexed Treasury rate

118
Equity risk premium
  • Risk premium should measure what investors on
    average demand as extra return for investing in
    the market portfolio relative to a risk free
    assets
  • RP is usually estimated looking at the historical
    premium earned by stocks over Treasury bills and
    bonds

119
US Equity risk premium
Arithm. Av. Stock T bill T bond
1928-2003 11.82 3.90 5.28
1963-2003 12.10 6.01 7.40
1993-2003 12.63 4.20 7.76

Geom. Av. Stock T bill T bond
1928-2003 9.85 3.86 5.02
1963-2003 10.82 5.97 7.00
1993-2003 10.87 4.19 7.30
Source www.Damodaran.com
120
Some Beta Examples
121
Some Beta Examples
122
Some Beta Examples
123
Some Beta Examples
124
Beta for divisions
  • The procedure for estimating betas for operating
    divisions within firms depends largely on whether
    the divisions are organized by product line or
    geography

125
Geographical divisions
  • In this case the cost of equity is set adding to
    the company cost of capital a risk premium
    equals to
  • the rate of return on local bonds if the division
    is mainly funded in the home currency
  • A measure of country risk if financing comes
    mainly from the parent company
  • Typical measure of country risk are spread on
    local government bond denominated in foreign
    currency or DCS

126
Product divisions
  • When division are based on product line betas can
    be estimated from comparable firms in the same or
    similar industries
  • This simple approach assumes that the capital
    structure of all the firms in the industry is
    similar (beta increases when the D/E ratio
    increases)

127
The levered Beta
  • If our capital structure is different from the
    industry average structure then we have to
    unlevered and then relevered the Beta
  • Since we know that

128
Estimating business Beta
  • If the average industry beta is 1.27 and the
    average industry D/E ratio is 0.45, assuming
    t0.4, then the unlevered industry beta is
  • This means that if the average industry beta is
    1.27, if all the firms had been all-equity firms,
    with no debt, their average beta would be 1.00

129
Estimating business Beta
  • Now to derive the beta for our division we just
    have to take the unlevered beta and then lever it
    back up again to out capital structure
  • Lets assume that our D/E ratio is 0.25, then

130
Eva guidelines
  • Given that Eva is
  • EvaNopat-(WACC)?Invested Capital
  • The main indications of EVA methodology to
    managers is that they should implement action
    either to increase Nopat or the decrease the
    invested capital
  • Wacc depends on overall risk and capital
    structure (a financial decision)

131
EVA and time value of money
  • EVA is much better than conventional measures in
    explaining the market value of a company
  • The market value of a company depends directly on
    the future EVA-values
  • The market value of a company
  • Book value of equity present value of future
    EVA

132
MV and EVA
  • If the company produces a return that is equal to
    capital costs then the market value of the
    company will equal the book value of equity
  • I.e. when EVA 0, then companys market value of
    equity equals its book value of equity

133
The firm MV
Market value premium
Market value of the firm
Firms market value equity book value NPV of
future EVA Positive EVA builds up a premium to
the market value of equity, since investors pay
for excess return
Book value of equity
134
Marginal EVA and pricing
  • When EVA is computed at the division level, the
    computation requires estimation at the divisional
    level
  • This will involve allocation mechanisms and
    allocation of fixed headquarters expenses becomes
    an issue
  • The initial estimates of EVA are likely to
    reflect the allocation mechanisms used and the
    mistakes made in those allocations
  • Changes in EVA over time are more useful measures
    than the initial EVA estimates themselves
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