Value Based Management Tools

3
The cost of capital is the weighted average return required by a company’s debt and
equity investors
Typical assumption is that the mix of debt and equity remains constant
In order to create value, companies must earn a return greater than the cost of capital
Cost of capital varies across business units, companies and industries and is affected by
capital structure
If the cost of capital is not known, it is impossible to know whether value is being created
The weighted average cost of capital is used to discount operating cash flows to
a present value
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5
Classical equation
WACC = E x Ke + D x Kd x (1-t)
(D+E) (D+E)
Ke = Rf + β x (MRP)
MRP = market risk premium
WACC real = (1 + WACC nominal) / (1 + inflation) - 1
β (asset) = β (equity) x (1 + (1 - t) x D/E)
Cost of equity is typically the key difficulty
A reminder of the basics

7Specific and market risks are reflected in different parts of a DCF valuation
Market Risk
(Systematic risk)
Specific Risk
(Unique, residual, or unsystematic risk)
Affects all companies and cannot be
reduced by diversification
inflation rises unexpectedly
Federal Reserve revises its
monetary policy
industrial or economic cycle
changes
Market risk should be reflected in the
cost of capital. It cannot be diversified
away and investors want to be
compensated for bearing it
Risk
Affects a particular company or
industry and can be reduced by
diversification
a firm discovers a new patent
a warehouse is destroyed by
fire
a new major competitor enters
the market
Specific risk should be reflected in the
forecasted cash flows, not in the
discount rate

9Levering / Unlevering Betas
Remove the effects of leverage on the beta estimates by
unlevering the peer beta estimates using the following formula:
betau = betaL_______
[1 + (1 - T r ) x D/E]
Calculate the arithmetic average of the unlevered betas
Relever average at the target D/E as follows:
betaL = betaU x [1 + (1 - T r ) D/E]
betaL = Levered beta
betaU = Unlevered beta
D/E = Debt/equity ratio
T r = Marginal tax rate

11Components of debt holder required return
The cost of debt is the after-tax expected required yield for the
company's new incremental debt issue
The cost of debt can be estimated as the expected yield-to-maturity of a
company's outstanding debt (not the coupon rate)
The average yield-to-maturity for the entire debt portfolio can be
computed as the weighted average of the individual instruments based
on market values
The after-tax cost of debt is the relevant rate of return associated with
debt financing because interest payments are tax deductible:
After-Tax Cost of Debt = Cost of Debt x (100% - Marginal Tax Rate)

13
Since DCF value depends on future cash flows, it is not useful for measuring
value created during historical periods
History ForecastToday
Based on an
assessment of
historical results
Performance
Measurement
&
Rewards
Based on
long-term
expectations
of cash flow
performance
Value-Based Performance Measurement Contradiction
Can't measure value by just looking at history
Can't measure performance by just looking at forecasts

15
Economic Profit measures result in significant benefits for the companies that
adopt them
Greater focus on capital
Increased ability to track value creation
Greater corporate memory of, and accountability for promised value
creation
Managers can be rewarded according to their ability to create value

17
The best ways to increase Economic Profits are also the best ways to increase
shareholder value
Undertake operating strategies that maximize the long term risk
adjusted cash flows
Minimize the cost of capital while maintaining appropriate financial
flexibility
Find the highest valued use for all assets
Limit investments to those with expected returns above the cost of
capital
Return excess cash to owners of the business

19Economic Profit and EVA in Summary
DCF is usually the most useful model for estimating value of a business
It relies on the factors that investors use to value businesses (cash flows timing and risk)
It is useful for identifying how different strategies and managerial decisions impact value
However, because DCF relies on projected cash flows, it is difficult to use for monitoring value created after investments are made
Economic Profit is designed to monitor value creation after investments are made
It avoids reliance on forecast cash flows
It can be tracked year after year
It reconciles to DCF value over the long term
Several adjustments to NOPAT and Capital are often required
You can choose financial products and services to assist clients in maximizing Economic Profit and value

21The precision of the EVA Calculation varies according to the need
Basic
EVA
Tailored EVA Tailored EVADisclosed
EVA
Basic EVA Disclosed EVA Tailored EVA True EVA
Slight improvement on financial
( GAAP) Accounting
Recognition equity capital has a
cost
Adjust publicity disclosed
Financial
( GAAP) income statements &
Balance Sheets.
Use for Peer Benchmarking
Custom-tailored for
Organization
Culture
Business Mix
Strategies
Processes
Optimized Using 5 criteria
Make all possible Adjustments
Theoretical but not useful
Except when level of EVA
matters;
Consider additional adjustments
for
Specific but limited decisions

23
Criteria
Accountability
Clearer Separation
Greater Objectivity
Better Matching
1. Provisions
2. Reserves
3. Asset Revaluation
1. Construction in Progress (Potential)
2. Economic Depreciation (Potential)
1. Interest Expense
2. Economic Taxes
3. FX Gain or Losses
4. Unusual Items
5. Operating Leases (Potential)
1. Non-Interest Bearing Liabilities
2. Minority Interest
3. Goodwill (Potential)
Materiality
Data Availability
Motivational Impact
Understandability
AdjustmentsPrinciples
Through four choosing criteria, we have identified nine
EVA adjustments and four potential adjustments

25Economic treatment and rationale of each adjustments
ADJUSTMENT ACCOUNTING TREATMENT RATIONALE ECONOMIC TREATMENT
Interest Expense Interest Expense is charged to the income
statement. Debt is included in liabilities
Including interest expense in NOPAT
would mix operating and financing
decision
Interest expense is excluded from
NOPAT and after tax cost of debt is
charged through WACC
Non-interest
bearing liabilities
Part of Liabilities on the right hand side of the
balance sheet
NIBLs are a free form of financing provided
by suppliers and charged already in cost
of supplies
NIBLs are removed from both the
sides of the balance sheet
Minority Interest Income attributable to minority shareholders is
excluded.
Minority interest is recorded on the balance sheet
to reflect the contribution of minority shareholders
EVA is based on a total firm perspective,
regardless of ownership stake. This
adjustment holds managers fully
responsible for all shareholders including
minority shareholders
NOPAT will include the income
attributable to minority
shareholders. Capital will include
what is contributed by minority
shareholders
Economic Taxes Income tax provision is computed at the end of
each year to represent how much the company will
pay the tax authorities. Income tax provision
captures many items which are not directly related
to the operations such as interest expense
Taxes are supposed to be assessed on
operating items and should not be
impacted by leverage and unusual items
Charge NOPAT with taxes on
current operations (excluding
financing and non-operating
items) charged to income

27Economic treatment and rationale of each adjustments
ADJUSTMENT ACCOUNTING TREATMENT RATIONALE ECONOMIC TREATMENT
Construction in
Progress
Construction in progress (CIP) is a PP&E
account for self-constructed assets not yet
placed in service. When CIP is expected to
extend for a significant period of time, it
may accrue capitalized interest until the
asset is placed into service
Since assets which are not in service are unable to
generate a return, EVA is not charged for CIP. To
recognize that shareholders expect a return on CIP
even though it is not yet in service, a capital
charge is accumulated and becomes a permanent
addition to capital when CIP comes on line.
CIP assets are excluded from
capital, accumulating a capital
charge until the asset is placed in
service
Goodwill Amortized in the income statement and
gradually reduced from the balance sheet
Capital should represent the entire investment
made by the shareholder in the acquired assets
All amortization is undone
Operating
Leases
Accounting treatment of operating leases
simply charges rental payments to income
with no record on the balance sheet
Unlike depreciation on owned assets, rent expense
contains both depreciation, which represents the
decline in asset value, and
interest. The cost of using equity is not explicitly
considered
Only the non-interest portion of
the operating lease payment is
expensed against NOPAT. The
present value of the future
operating lease commitments are
included in capital
Economic
Depreciation
Book/Straight-line depreciation causes a
natural increase in EVA
Managers will focus more on actions that will
cause real improvements to EVA rather than free
ride on the improvements arising from Book
depreciation
“Sinking fund depreciation” is
used to counter this effect where
an asset is depreciated the way a
loan is amortized

291. Interest Expense
INCOME STATEMENT 2004
Earning before Interest and Tax 40231
Interest expense 8568
Earning before Interest 31663
Tax 36
Profit After Tax (before Minority Interests) 31627
Minority Interests 3428
Profit After Tax (after Minority Interests) 28199
Interest Expense
Excluded from NOPAT
(Million Dollars) 2004
8,568

31
3. Allowance for doubtful accounts and 4. Allowance for obsolete inventory
BALANCE SHEET ( ASSETS 2003 2004
Current Assets
Cash & near cash 25,253 19.297
Marketable securities (net) 12,066 6,018
Trade receivable (gross) 38,827 54,473
Allowance for doubtful accounts 80 12
Trade provisions (net) 38,747 54,461
Inventory 8,456 9,870
Allowances for obsolete inventory 3,108 3,305
Inventory (net) 5,348 6,565
Other current assets 3,542 3,428
Total Current Assets 84,956 89,769
Million Dollar 2003 2004
Include in NOPAT
Increase ( decrease ) in allowance
for doubtful account
- 68
Include in Capital
( Add back to Net
Balance
Allowance for doubtful account 80 12
Include in NOPAT
Increase ( decrease ) in allowance
for obsolete inventory
- 197
Include in Capital
( Add back to Net
Balance)
Allowance for obsolete inventory 3,108 3,305

336. Minority Interest
( Million Dollar 2004
Earning before Interest and Tax 40,231
Interest Expense 8,568
Earning before Interest 31,663
Tax 36
Profit after Tax ( before Minority Interests) 31,627
Minority Interests 3,428
Profit After Tax ( after Minority Interests 28,199
Excluded From NOPAT

358) Economic Taxes
Economic Taxes Adjustment Mechanics
1 Determine the company’s Net Operating Profit Before Tax (NOPBT)
2
Perform all adjustments on a pre-tax basis
3
Multiply the NOPBT by the long-run tax rate (30%) to calculate the economic taxes
4
Calculate the Cash Operating Taxes (COT)
Determine tax provision (Normally this item is shown in income statement)
Deduct the deferred portion of the taxes from the tax provision
Add/Deduct the taxes associated with the EVA adjustments made to NOPAT
(i.e. interest expense, losses/gains on foreign exchange and unusual losses tax shields)
5
Calculate the difference between COT and economic taxes
If COT is greater than the economic taxes, add the difference to Capital
Otherwise, subtract the difference from Capital

37Company’s NOPAT Statement for 2004
Income Statement
2004
NOPAT
2004
Operating Revenues
2,32,107 Sales of goods + 2,32,107
918 Interest Income + 918
1,397 Share of gains ( losses ) of associate companies + 1,397
1,248 Other revenues + 1,248
2,35,670 Total 2,35,670
Operating Expenses
1,65,606 Cost of goods sold - 1,65,606
9,465 Selling and administration expenses - 9,465
16,025 Depreciation - 16,025
825 Other expenses - 828
Adjustment increase ( Decrease ) of allowances doubtful account and other allowances - 315
1,91,924 Total 1,91,609
Non- operating Revenue
8 Gain on foreign exchange -
Non -operating Expenses
31 Loss on sales of assets -
Financial expenses
10,463 Interest expenses -
33,261 Profit before tax and minority interest
3,193 Minority interest -
30,068 Profit before tax 44,061
67 Tax provision / Economic Tax - 13,218
30,001 Net profit NOPAT 30,843
(Million Dollar)

39EVA of Company in 2004
30,304 3,71,429
NOPAT Invested Capital
Simple Average between
Beginning Capital and Ending Capital
=Average (2003 Capital, 2004 Capital)
= Average (362,170, 380,687)
EVA =
X 10..8%
In 2004, Company WACC was estimated at 10.8%
X WACC
-9,948 Mn THB
=
=

41Linking EVA Scheme with Business Cycle
TLCs shall select EVA-based funding formulae which is aligned to companies’business nature
Growth Maturity DeclineIntroduction
X% of EI + Y% of (AI - EI)1
X% of Actual EVA + Y% of
EVA Improvement (AI)
3
Target Bonus + Y% of
(Actual EVA – Expected EVA)
4
Target Bonus + Y% of EVA5X% of Expected EVA + Y% of (AI - EI)2
Expected EVA is used to
emphasize EVA preservation
AI – EI formulae used to reward
for EVA growth
Note: EI: Expected EVA Improvement = Expected Current Yr EVA – Previous Yr EVA
AI: Actual EVA Improvement = Actual Current Yr EVA – Previous Yr EVA
Sales
Time

43
The functioning of “hurdle rate” bonus bank
Year -1 Year -2 Year -3 Year -4
Calculate bonus 100 190 60 30
- Pay out up to single bonus -100 -100 -60 -30
= Deposit bonus bank 0 90 0 0
+ Previous bonus bank balance - 0 60 40
“C” = Available bonus bank balance 0 90 60 40
“D” Pay out of bonus bank Pay out rate 33% 0 30 20 13
+ Pay out up to single bonus 100 100 60 30
= Total bonus pay out 100 130 80 43
Financial bonus bank balance ( “C”-”D” ) 0 60 40 27
In a hurdle rate bonus bank, bonus are paid out immediately up to the single bonus – the remaining amount is deposited in the
bonus bank
Assumption: Single bonus 100

45Summary: Characteristics of a “hurdle rate“ and an “all in“ bonus bank
“All in“ bonus bank“Hurdle rate“ bonus bank
Only boni that exceed the single bonus are
deposited in the bonus bank
A certain percentage of the bonus bank balance
is paid out in addition to the single bonus
Pay out of a bigger portion of the calculated
bonus compared to the "All In“ approach
Medium term oriented
Low risk involved for the participant
All calculated boni are immediately credited in
the bonus bank, only then a certain percentage
is paid out
Pay out of a smaller portion of the calculated
bonus compared to the „hurdle rate“ approach
Long term oriented
Higher risk for participants

47Agenda
04
03
02
01Cost of Capital
Economic Profit and EVA
Bonus Banking
Total Shareholder Return and
Wealth Added

49
TSR is defined as the annualized total return to shareholders from maintaining
their investment in a stock over a period.
5.00
5.80
0
1
2
3
4
5
6
7
Opening share
prices
Closing share
prices
Dividends paid Total value of
share
Total Shareholder Returns
Total Shareholder Return =
(5.80 - 5.00) =
16%
5.00
Maintaining the investment means not taking any net
cash out during the period.
This involves immediately reinvesting all cash receipts
(such as dividends), participating in all capital
transactions (such as rights issues) and selling stock as
required, so as not to contribute any new capital

51

53

55

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