Ans 1.

Value chain analysis (VCA)is a process where a firm identifies its primary and support activities that
add value to its final product and then analyze these activities to reduce costs or increase differentiation.

 Value chain represents the internal activities a firm engages in when transforming inputs into
outputs.
 Value chain analysis is a strategy tool used to analyze internal firm activities. Its goal is to
recognize, which activities are the most valuable (i.e. are the source of cost or differentiation
advantage) to the firm and which ones could be improved to provide competitive advantage.
 As per the diagram in the reference section for the 1st question M. Porter introduced the generic
value chain model in 1985. Value chain represents all the internal activities a firm engages in to
produce goods and services.
 VC is formed of primary activities that add value to the final product directly and support activities
that add value indirectly.
 Although, primary activities add value directly to the production process, they are not necessarily
more important than support activities. Nowadays, competitive advantage mainly derives from
technological improvements or innovations in business models or processes. Therefore, such
support activities as ‘information systems’, ‘R&D’ or ‘general management’ are usually the most
important source of differentiation advantage.
 On the other hand, primary activities are usually the source of cost advantage, where costs can
be easily identified for each activity and properly managed.
 Firm’s VC is a part of a larger industry VC. The more activities a company undertakes compared to
industry VC, the more vertically integrated it is. Below you can find an industry value chain and its
relation to a firm level VC.

Ans 2. Although it is quite a simple indicator to calculate, the P/E can be difficult to interpret. It can be
extremely informative in some situations, while at other times it is difficult to parse. As a result, investors
often misuse this ratio and place more evaluative power in the P/E than is sometimes warranted.

The P/E ratio measures the market price of a company’s stock relative to its corporate earnings, which
can then be compared with other companies. In theory, $1 of earnings at company A should be worth the
same as $1 of earnings at a similar company B. If this is the case, both companies should also be trading
at the same price, but this is rarely observed in reality. If company A’s stock is trading for $5 and company
B is trading for $10, it means the market values company B's earnings at a higher level. This may be a sign
that company B's shares are overvalued, but it could also mean that company B deserves a premium on
the value of its earnings due to superior management or a better business model. As a rule of thumb, a
high P/E suggests that the stock price is relatively high compared to earnings and might point to it being
overvalued. Likewise, a low P/E can signal the market is undervaluing these shares. Investors, analysts and
corporate managers alike all look to the P/E ratio as an important indicator on how a company is doing
relative to others in its industry or to the market more broadly, as well to how it has performed in the
past.

The price-to-earnings ratio, or P/E is the ratio of the market price of a company’s stock to its earnings per
share
(EPS): P/E Ratio = Market Value per Share / Earnings per Share (EPS)

Many times, investors look to the past four quarters of earnings and calculate annual earnings per share.
This is known as the trailing P/E.

Sometimes, analysts are interested in long term valuation trends and consider the P/E 10 or P/E 30
measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often
used when trying to gauge the overall value of a stock index.

The trailing P/E ratio will change as the price of a company’s stock moves, since earnings are only released
each quarter while stocks trade day in and day out. As a result, some investors prefer the “forward” or
leading P/E. The forward P/E ratio is similar to the trailing, but uses estimates of projected future earnings,
typically forecast over the next twelve months. If the forward P/E ratio is lower than the trailing P/E ratio,
it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E
ratio, analysts expect a decrease in earnings.

Companies that aren't profitable, and consequently have no earnings – or negative earnings per share,
pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say
there is a negative P/E, others assign a P/E of 0, while most just say the P/E doesn't exist or is not
interpretable until a company becomes profitable for purposes of comparison.

Ans 3. Value Based Management

To help firms create value for shareholders, value based management (VBM) approaches have been
developed. VBM represent a synthesis of various business disciplines. From finance, VBM has adopted the
goal of shareholder value maximization and the discounted cash flow model from business strategy, VBM
has borrowed the notion the value creation stems from exploiting opportunities based on the firm’s
comparative advantage. This chapter discusses the principal VBM approaches developed by leading
consulting organizations. It is organized into eight sections as follows:-

•Method and key premises of VBM

•Marakon approach
•Alcar approach
•McKinsey approach
•Stern stewart approach
•BCG approach

Key Difference:-

The key difference between these methods relates to VBM metrics. For example, the LEK/Alcar methods
uses shareholder value added (SVA), the stern Stewart method emphasizes EVA and MVA, and the BCG
method focus on CFROI and CVA. Each camp argues that is measures are the best and cites supporting
evidence for the same. It is difficult to objectively assess the validity of the claims. While the different
methods to VBM have their own fan clubs, the EVA/MVA method seems to have received more attention
and gain more popularity
MARAKON APPROACH:-

Marakon Associate, an international management consulting firm founded in 1978, has donepioneering
work in the area of value based management.The key steps in the marakon approach as follows:-

• Specify the financial determinants of value

• Understand the strategic drivers of value
• Formulate higher value strategies
• Development superior organizational capabilities

ALCAR APPROACH:-

The Alcar Group Inc., a management education and software company, development and approach to
VBM which is based on discounted cash flow analysis. The Alcar approach is described fully in the book
creating shareholder Values

Determinants of Shareholder Value:-

According to Rappaport, the following seven factors he calls them “value drivers” affect shareholder
value:

• Rate of sales growth

• Operating profit margin
• Income tax rate
• Investment in working capital
• Fixed capital investment
• Cost of capital
• Value growth duration

MCKINSEY APPROACH:-
Mckinsey & company, a leading international consultancy firm, has developed an approach to VBM which
has been very well articulated by Tom Copeland, Tim Koller, and Jack Murrir of Mckinsey & company
according to them “properly executed value based management is an approach to management whereby
the company’s overall aspiration, analytical techniques, and management processes are all aligned to help
the company maximize its value by focusing decision making on the key drivers of the value.

STERN STEWART APPROACH (EVA ®APPROACH)

Originally proposed by the consulting firm Stern Stewart & Co, Economic Value Added (EVA)is currently a
very popular idea. Fortune magazine has called it “today’s hottest financial idea and getting hotter “ and
management guru Peter Drucker referred to it as a measure of total factor productivity. Company’s across
a broad spectrum of industries and across a wide range of countries have joined the EVA bandwagon. EVA
is essentially the surplus left after making an appropriate charge for the capital employed in the business.
It may be calculated in any of the following, apparently different but essentially equivalent ways:

EVA = NOPAT – C* × CAPITAL

EVA = CAPITAL (r - c*)
EVA = [PAT +INT (1 – t) – c* CAPITAL
EVA = PAT _ K EQUITY
Where EVA is the economic value added, NOPAT is the net operating profit after tax, c* is the cost of
capital, CAPITAL is the economic book value of the capital employed in the firm.

STERN STEWART APPROACH (EVA ®APPROACH)

Originally proposed by the consulting firm Stern Stewart & Co, Economic Value Added (EVA)is currently a
very popular idea. Fortune magazine has called it “today’s hottest financial idea and getting hotter “ and
management guru Peter Drucker referred to it as a measure of total factor productivity. Company’s across
a broad spectrum of industries and across a wide range of countries have joined the EVA bandwagon. EVA
is essentially the surplus left after making an appropriate charge for the capital employed in the business.
It may be calculated in any of the following, apparently different but essentially equivalent ways

EVA = NOPAT – C* × CAPITAL

EVA = CAPITAL (r - c*)
EVA = [PAT +INT (1 – t) – c* CAPITAL
EVA = PAT _ K EQUITY
Where EVA is the economic value added, NOPAT is the net operating profit after tax, c* is the cost of
capital, CAPITAL is the economic book value of the capital employed in the firm.
What Cause EVA to increase
From the above analysis it is clear that EVA will rise if operating efficiency is improved, if value adding
investments are made, if uneconomic activities are curtailed, and if the cost of capital is lowered. In more
specific terms, EVA rises when

•The rate of return on existing capital increases because of improvement in operating performance. This
means that operating profit increases without infusion of additional capital in the business.
•Additional capital is invested in projects that earn a rate of return greater than the cost of capital.
•Capital is withdrawn from activities which earn inadequate returns.
•The cost of capital is lowered by altering the financing strategy.

BCG APPROACH:-
Boston Consulting Group (BCG), an international consulting organization, has developed an approach to
shareholder value management that builds on the pioneering work of their specialist group HOLT Value
Associates. Two concepts are at the foundation of the BCG approach:
total shareholder return and total business return. For applying these concepts, two performance metrics
are used: cash flow return on investment and cash value added.
Total shareholder return
The total shareholder return (TSR) is the rate of return shareholders earn from owning a company’s stock
over a period of time. The TCR for a single holding period is computed follows.
Dividend Ending market value – Beginning market valueTSR= Beginning market value Beginning marke
t value
The TSR for a multiple holding period is computed using the conventional internal rate of return
computation
Ans 4. EVA is just a refinement of residual income. Residual income is defined as the difference between
profit and the cost of capital. It differs from EVA in the fact that profits and capital employed are book
figures i. e. the same appearing in the financial statements. No adjustment to profit and capital employed
figures as reported in profit and loss account and balance sheet are made unlike EVA.

EVA can be improved in any of the following ways:

(a) Increasing NOPAT with the same amount of capital.

(b) Reducing the capital employed without affecting the earnings i.e., discarding the unproductive assets.

(c) Investing in those projects that earn a return greater than the cost of capital.

(d) By reducing the cost of capital, which means employing more debt, as debt is cheaper than equity or
preference capital.

The EVA concept is very closely related to the NPV concept. The present value of an investment’s annual
EVA stream is the same as its NPV. NPV analysis is a one-time measure of the value added by an
investment. EVA is a continuous annual value added measure.

Steps in Implementing EVA:

The implementation of EVA is a 4-step process which includes:

(a) Measurement,

(b) Management System,

(c) Motivation and,

(d) Mindset.

(a) Measurement:

Any company that wishes to implement EVA should institutionalize the process of measuring the metric,
regularly. This measurement should be carried out after carrying out the prescribed accounting
adjustments.

(b) Management System:

The company should be willing to align its management system to the EVA process. The EVA based
management system is the basis on which the company should take decisions related to the choice of
strategy, capital allocation, merger and acquisitions, divesting business and goal setting.

(C) Motivation:

The companies should decide to implement EVA only if they are prepared to implement the incentive plan
that goes with it. An EVA based incentive system, however, encourages managers to operate in such a
way as to maximize the EVA, not just of the operations they oversee but of the company as whole.
(D) Mindset:

The effective implementation of EVA necessitates a change in the culture and mindset of the company.
All constituents of the organization need to be taught to focus on one objective – maximizing EVA. This
singular focus leaves no room for ambiguity and also it is not difficult for employees to know just what
actions of their will create EVA, and what will destroy it.

Superiority of EVA:

EVA is a superior measure of corporate performance and reflects all the dimensions by which
management can increase value.

It helps in creation of wealth on the following grounds:

(a) EVA is most directly linked to the creation of shareholder’s wealth over time. The term ‘maximizing
value’ in the EVA context, means maximizing long-term yield on share-holders investment and not just
the absolute amount of earnings/profits.

(b) The mechanism of EVA forces management to expressly recognize its cost of equity in all its decisions
from the board room to the shop floor. The inclusion of this element in overall cost of capital results into
the goal congruence of the managers and owners.

(c) An EVA financial management system removes all the inconsistencies resulting from the use of
different financial measures for different corporate functions under the typical traditional financial
management system.

(d) EVA compensation system ties management’s interest with those of shareholders.

(e) EVA captures the performance status of corporate system over a broader canvas i.e., to arrive at true
profits, cost of borrowed capital as well as cost of equity capital should be deducted from net operating
profits. Further to maximize earnings is not sufficient, at the same time consumption of capital should be
minimum/optimum under an EVA based system.

(f) EVA framework provides a clear perception of underlying economics of a business and enables
managers to make better decisions.

(g) A regular monitoring of EVA emphasizes on problem areas of a company and helps managers to take
corrective actions.

(h) It is used to assess the likely impact of competing strategies on shareholder’s wealth and thus helps
the management to select the one that will best serve shareholders.

(i) It also fits well with the concept of corporate governance. EVA bonus systems do this by giving
employees an ownership stake in improvements in the EVA of their divisions or operations. This causes
employees to behave like owners and reduces or eliminates the need for outside interference in decision
making.

(j) EVA also helps in brand valuation. The brand equity or value created by a particular business unit for
its brand could be equated with the value of wealth that the brand has generated over a period of time.
Ans 5. The increasing volatility of the global economy has caused investors to search out safer investment
alternatives. Investors use a capital budget when selecting their investments. A capital budget is a plan
for investing in long-term assets such as buildings and machinery. Risk is inevitable to these investments.
The various risks include cash flows not being paid in time as agreed, the risk of the investee company
collapsing and also the management sinking the invested funds in risky projects. By incorporating risk in
capital budgeting, investors can minimize losses.

Risk Premium

Investors try to avoid risk. To encourage investors to invest their funds into risky projects, the returns from
such projects should be higher than returns from less risky investments such as treasury bonds. A risk
premium is a discount rate that is added to the risk-free rate of borrowing. The risk-free rate is the rate
of return of low-risk investments such as government-backed securities. The investments are then
appraised using the resulting discount rate. Investments that offer better returns are chosen.

Payback Period

The time it takes for a project to pay back the amount of money invested is a matter of concern to the
investor. Investors set a time limit within which they expect to receive returns. Each project's cash flow is
determined. A project whose return falls beyond the time limit will deemed to be risky.

Certainty Equivalent

While appraising projects, future cash flows are estimated using probability measures like forecasting
techniques. These measures do not give a true picture of future events. To avoid uncertainty, convert
expected future cash flows into certain cash flows. Certain cash flows are cash flows obtained by
multiplying uncertain cash flows with a predetermined base known as certainty-equivalent coefficient. A
certainty-equivalent coefficient is factor that determines the risk associated with future cash flows. Risky
investments have a low certainty equivalent rating, hence they are avoided. This is because the probability
of netting the estimated cash flows is unlikely.

Sensitivity Analysis

A project's return on investment is affected by factors such as sales, investments, tax rate and cost of
sales. Sensitivity analysis measures the extent to which the project's cash flows change in response to
changes in one of these factors. The sensitivity analysis process involves identifying the factors that
influence the project's cash flows, establishing a mathematical relationship between these factors and
analyzing how a change in each of these factors affect the project's cash flows. If a project's cash flows
are sensitive to changes in any of the above-listed factors, it is considered risky and hence avoided.