F402/F560

Corporate Valuation and Strategy

Part 2: Basic Corporate Performance Measures

Readings in The Quest for Value:

Chapter 3, pp. 68-76 and 83-95

The Economics of the Business

Market value is driven by the economics of the business.
- Cash is invested (by debtholders and equityholders) in
assets to operate the business.
- The assets are used to generate sales revenue.
- Operating expenses and income taxes are subtracted
from sales revenue.
- The resulting after-tax operating profit represents the
cash return to the investors.

Return on Capital
Paraphrasing Stewart:
Managers add value to their company only if they earn
rates of return on capital which exceed the returns offered
by other, equally risky businesses.
If they do not, then capital has been misallocated or
mismanaged.

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Invested Capital is the sum of all cash invested in the

operations of the business. It is equal to the net operating
assets (net of NIBCLs, see below):
Current assets + PP&E current operating liabilities.
Why are current operating liabilities netted out?

Return on invested capital (ROIC) is the after-tax, cash-oncash yield earned in operating the business with those
operating assets. It is the after-tax cash profits divided by the
amount of capital employed in the business:
NOPAT
Beginning Operating Capital

An important distinction among items on financial statements:

1. Operating invested capital and operating cash return
2. Financial invested capital and financial cash return
A third category: nonperating accounts, such as
extraordinary or nonrecurring items.
Companies should be valued on the economics of the
business, i.e., the results of operations: operating cash return
on operating invested capital.
Keep operating items and financial items separate
(though they must balance).
Maintains comparability among firms.
Eliminates distortions caused by different financial
structures.
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Measuring Capital (in Economic Terms)

Capital is the sum of all cash contributed to the business by all
investors (debtholders and equityholders).
Capital = cash invested in the operations of the business for
purposes of earning a return
= (debt + equity) in the business,
where debt means interest-bearing borrowings, not
things which have no interest cost.

= (net working capital + net fixed assets) in the

business
= operating invested capital
The amount of invested capital can be computed from the
accounting balance sheet.
Total assets
Deduct financial assets (e.g., cash and marketable
securities)
Deduct non-interest-bearing current liabilities (NIBCLs)

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Example:
Assets
Inventory
Accounts receivable
Total current assets
Property, plant & equipment
Total assets

6,000
3,000
9,000
11,000
20,000

Liabilities and equity

Accounts payable
Debt
Equity
Total liabilities and equity

2,000
6,000
12,000
20,000

Operating capital - operating approach

Net working capital
7,000
PP&E
11,000
Operating capital
18,000
Operating capital - financing approach
Debt
6,000
Equity
12,000
Operating capital
18,000

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Measuring Return on Capital (in Economic

Terms)
The cash returns in the business are the funds available for
distribution to debtholders and equityholders.
Cash returns are the profits derived from the operations
of the business, after taxes and before financing costs.
Net operating profit after tax =

NOPAT

=
Sales
revenue
operating
expenses
taxes on just the operating
profits
NOPAT does not include financing cash flows. They must be
reversed.
In other words, the effects of financing items in the
income statement (such as interest expense) must be
removed.
NOPAT = Net income + interest expense
after tax + other nonoperating
expenses after tax

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Example:
Firm A
100
(80)
20
0
20
(8)
12

Firm B
100
(80)
20
(9)
11
(4.4)
6.6

0
0
12

9
(3.6)
12

Assets

100

100

Liabilities
Equity
Total liabilities and equity

0
100
100

90
10
100

Sales revenue
Costs
Gross profit
Interest expense
PBT
Tax
Net income
Add back interest
Subtract tax savings from interest
NOPAT

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IDENTIFYING OPERATING ITEMS

IN FINANCIAL STATEMENTS
Objective: Determine the operating return on the operating
invested capital in the business.
Whether an item should be categorized as an operating
item depends on the answers to these questions:
Is this item used in or does it result from the normal,
everyday running of the base business? If yes, its part
of operating invested capital.
Does this item represent cash from the investors,
invested in the business with the expectation of earning
a return, or income or expense associated with such an
item? If yes, its part of financial invested capital.
If the answer is no to both, then the item is an unusual,
extraordinary or nonrecurring item. It should be excluded
from the calculations of operating and financial returns.
Operating items:
Inventory
PP&E
Accounts payable
Cost of goods sold
Rent
Depreciation
Financial items:
Debt, short-term or long-term
Interest expense (or income?)
Treasury stock
Deferred taxes
Nonoperating or extraordinary items:

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Short-term invested cash

Restructuring charges
Extraordinary income or expense
Charges for changes to accounting practices
The boss condo in Ft. Meyers

To compute operating return on operating invested capital,

reverse the effects of financial and nonoperating items from
the income statement:
Add back financial and nonoperating deductions (then
increase taxes, due to loss of tax shield).
Subtract financial and nonoperating income (then decrease
taxes, due to removal of taxable income).
On the balance sheet, include Other assets net of Other
liabilities as part of operating invested capital.
Any liability with an explicit interest cost or other explicit
rate of return should be included as part of financial
invested capital.

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NOPAT, FINANCING APPROACH

Start with Net Income (at the bottom of the income statement).
Reverse financing items, after tax, to arrive at an after-tax
operating profit number.
Use marginal tax rate (40%).
Add changes in deferred taxes, to arrive at cash operating profit
after tax (NOPAT).
See Abercrombie & Fitch example on the following pages.

NOPAT, OPERATING APPROACH

Start with Total Revenue (at the top of the income statement).
Add and subtract only operating items, leaving out any financial
income or expense, to arrive at an operating profit number before
tax (NOPBT).
Subtract the accounting Provision for Income Tax.
Reverse tax effects of financing or nonperating items (only the
tax effects, not the items themselves) to arrive at an after-tax
operating profit number.
Use marginal tax rate (40%).
Add changes in deferred taxes, to arrive at cash operating profit
after tax (NOPAT).
See Abercrombie & Fitch example on the following pages.

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OPERATING NOPAT: CASH TAXES

ON

NOPBT

Actual cash taxes on operating NOPBT can be approximated by

adjusting the accounting provision for taxes (shown on income
statement) to account for two things:
1. Reverse tax effects of nonoperating income statement
items.
2. Adjust for any changes in the deferred tax accounts on the
balance sheet, to arrive at an estimate of cash taxes
actually paid.

Reduce the taxes by the amount of increase in

deferred tax liability.
Increase taxes by the amount of increase in
deferred tax asset.
Reverse tax effects means:
Cash taxes are higher by the amount of any tax
shield from nonoperating deductions.
Cash taxes are lower by the amount of any taxes
paid on nonoperating income.
Tax rate: Always use the marginal tax rate for
making these line-item adjustments:
Use 40% at present.
Adjust for changes in deferred taxes means:
If deferred tax liability went up, then the amount of
the increase represents taxes computed by the
accountants which were not actually paid.
Therefore, there is no cash outlay for the amount of
the increased liability. This is equivalent to a cash
inflow.
If deferred tax liability went down, then the amount
of the decrease represents additional taxes paid on

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calculated taxes from previous years. This is

equivalent to a cash outflow.
Deferred tax assets have the opposite effect;
increase in deferred tax assets is an outflow;
decrease is an inflow.

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Basic example:
Year ending
2002
2003
Deferred tax liability
Sales
Costs and expenses
Interest expense
Profit before tax
Provision for taxes
Net income
Cash taxes on NOPBT
Accounting taxes
Tax shield from interest
Change in deferred tax
Cash taxes

1,200

1,500
25,000
(16,000)
(2,000)
7,000
(2,170)
4,830

(2,170)
(800)
300
(2,670)

See Abercrombie & Fitch example on the following pages.

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