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# Profitability&npv

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### Profitability&npv

1. 1. Residual Incomeand NPVThe ex-post evaluation ofproject selection
2. 2. Two important questions How do we motivate managers to create shareholder value? How do we evaluate their performance in terms of value creation.
3. 3. TOTAL SHAREHOLDER RETURN (TSR) TSR= Dividend per share + (share price at end of period – initial share price) Initial share price A share rises in price over a year from 1 to £1.10 and a 4p dividend is paid at the end of the year: 110 − 100 + 4 TSR = = 14% 100
4. 4. Issues to be borne in mind when making use ofTSR:1 Relate return to risk class2 It measures in percentage not absolute terms3 TSR is dependant on the time period chosen
5. 5. Illustration of TSR Year TSR Value of €1m investment at t0 1 +6% 1.06m 2 -40% 0.636m 3 +50% 0.954m 4 +4.822% 1.0m Sum of Annual 20.8% Returns Holding Period 0% Return 1.06 x 0.6 x 1.5 x 1.04822 = 1.0
6. 6. MARKET VALUE ADDED (MVA) MVA = Market value – Capital Market value = Current value of debt, preference shares or ordinary shares. Capital = All the cash raised from finance providers or retained from earnings to finance new investment in the business, since the company was founded.
7. 7. Illustration of MVA Spiggle plc was founded 10 years ago. Equity finance was £15m. It has no debt or preference shares. All earnings have been paid out as dividends. The shares are now valued at £40m. The MVA is therefore £25m: MVA = Market Value – Capital MVA = £40m – £15m = £25m MVA = Ordinary shares market value – Capital supplied by ordinary shareholders
8. 8. Creating Shareholder Wealth -Performance Evaluation Stock Market Returns  Affected by more than manager’s performance  Not useful at divisional level or when a company’s stock is not publicly traded  Cannot be used for the performance of a division in the company
9. 9. Call in the Accountant Earnings Per Share  Rob the future to pay the present  The cost of funds is ignored  The level of investment ignored Accounting Rate of Return  Same problems as above  Scale difference can cause problems
10. 10. The Solution ? Economic Profit
11. 11. The Terms• Economic Profit• Residual Income• Abnormal Earnings• EVA®are more or less synonymous
12. 12. Residual Income is:RIt = Xt - rBVt-1RIt = Residual IncomeXt = Equity Profitr = Cost of Equity Capital
13. 13. Alternative Formula  Xt  RI t =  BV −r BVt −  1  t−1  =( ROE −r )BVt −1
14. 14. RI is important because The Present Value of the Residual income of a project is equal to its NPV The equity value of business can be expressed as the sum of its Book Value plus the PV of its future Residual income. Vt = BVt + PV(RI) It can be used to evaluate managers performance.
15. 15. Time 0 1 2 3 4Cash Flows -1000 400 400 400 400Depreciation (1000/4) 250 250 250 250Profit 150 150 150 150NPV of Cash Flows @ 10% IR£267.95BVt-1 1000 750 500 250Residual Income 50 75 100 125NPV of RI @ 10% IR£267.95RI computed assuming S.L. Depreciation
16. 16. RI with Economic DepreciationTime 0 1 2 3 4Cash Flows -1000 400 400 400 400Value of project 995 694.21 363.64 0Depreciation 5 300.5 330.6 363.6Profit 395 99 69 36NPV of Cash Flows @ 10% 267.95BVt-1 1,000.00 994.741 694.215 363.6 0Residual Income 294.741 0 0 0NPV of RI @ 10% 267.95
17. 17. Illustration of why ProfitableProjects don’t always create value Let us assume that a company needs to invest €500M in a project that lasts 5 years. The table below shows the project to be profitable. However, the ROR is just equal to the cost of capital and RI is therefore zero. This means that the project just earns a fair rate of return and its NPV is zero.
18. 18. Time 0.00 1.00 2.00 3.00 4.00 5.00Cash Flows -500.00 145.00 136.00 127.00 118.00 109.00Depreciation (1000/5) 100.00 100.00 100.00 100.00 100.00Profit 45.00 36.00 27.00 18.00 9.00NPV of Cash Flows @ 9%0.00BVt-1 500.00 400.00 300.00 200.00 100.00ROI 0.09 0.09 0.09 0.09 0.09Residual Income 0.00 0.00 0.00 0.00 0.00NPV of RI @ 9% 0.00
19. 19. A profitable profit that destroysvalue! The next slide shows how a profitable project may destroy value. If the profits are not sufficient to cover the cost of capital NPV will be <0. Take the previous example and reduce profits – note no losses are made. ROE is sometimes < cost of capital
20. 20. Time 0.00 1.00 2.00 3.00 4.00 5.00Cash Flows -500.00 140.00 130.00 120.00 110.00 101.00Depreciation (1000/5) 100.00 100.00 100.00 100.00 100.00Profit 40.00 30.00 20.00 10.00 1.00NPV of Cash Flows @-25.91 9%BVt-1 500.00 400.00 300.00 200.00 100.00ROI 0.08 0.08 0.07 0.05 0.01Residual Income -5.00 -6.00 -7.00 -8.00 -8.00NPV of RI @ 9% -25.91
21. 21. Advantages of RI It is clearly linked to value creation (NPV) It makes managers aware that capital is not free
22. 22. Limitations of RI Book values are not equal to market values so the anticipated RI will be greater than zero. Thus if a positive RI is achieved it could mean that book value understates true value or that wealth is created. Put another way RI suffers from the same allocation problems as Accounting. How do you accurately measure value created over a short period of when value depends on what is going to happen over a much longer time frame.
23. 23. Limitations Continued Thus, while the PV of all the RI s over a period is the measure of wealth created. RI s for any individual period can be seriously biased.