Bcg Value Management Framework an Overview for Mba Students

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- 1 -Copyright 1996

BCG/HOLT Planning AssociatesAll Rights Reserved

BCG’S VALUE MANAGEMENT FRAMEWORKAN OVERVIEW FOR MBA STUDENTS

By

Rawley Thomas

Director of Research

The Boston Consulting Group200 South Wacker DriveChicago, Illinois 60606

[email protected]



- 2 -Copyright 1996


WHAT GETS MEASURED GETS DONE



- 3 -Copyright 1996


Traditional Valuation Techniques Versus BCG’s Valuation Framework

Traditional Valuation Techniques

Forecast nominal cash flows by estimating P&L line items and changes to the balance sheet

Estimate terminal value with a perpetuity of the forecasted last year’s net cash flow

Determine cost of capital by weighting equity CAPM cost with debt cost

Discount the cash flows and terminal value to present value with the weighted average cost of capital

Observations on Missing Elements

No performance measure to determine if the business is achieving returns above or below the cost of capital or if the trend in those returns is up or down

No fade in performance to determine likely cash flows in a competitive environment

Discount rates determined by past price changes, not future likely cash flows

No extensive empirical testing

BCG’s Valuation Framework

Translate accounting statements to gross cash flows and gross cash investments in constant dollars to produce cash on cash returns

Translate cash on cash returns to economic performance measures (CFROIs) by adjusting for asset life and mix of depreciating versus non-depreciating assets

Determine sustainable asset growth rates

Fade CFROIs and asset growth rates toward corporate averages consistent with life cycle theory and empirical evidence to estimate future cash flows (replaces terminal valuation)

Estimate market derived real discount rate by equating the present value of the cash flows for a large aggregate to the sum of the prices of debt and equity

Apply the market derived discount rate to the cash flows derived from fading economic performance to determine market valuation; subtract debt to determine equity valuation

Test model values against actual stock prices for thousands of firms for 10-40 years across many countries; refine, refine, refine



- 4 -Copyright 1996


MANY ASSETS FOLLOW THE SAMEUSEFUL OUTPUT PATTERN AS A CAR ...

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

0 1 2 3 4 5 6 7 Year

UsefulOutput

(orSurvivors)

ConstantDollarLevelAnnuity

EconomicLife

LikelyActualOutputOutput Decline

with StraightLine Depreciation



- 5 -Copyright 1996


ISSUES WITH TRADITIONAL RETURN MEASURES

(*) Economic depreciation = amount of annual sinking-fund payment earning COC required to replace assets ($357 = {0.1/[1.114 - 1)](12,000 - 2,000)})

Investment profile of a new plant Subsequent annual measurement

Yr 1 Yr 6 Yr 12

Income 843 843 843

Depreciation 714 714 714

Cash flow 1,557 1,557 1,557

Cash invested 12,000 12,000 12,000

Book capital 11,286 7,716 3,432

ROCE (%) 7.5 10.9 24.6

ROGI (%) 13 13 13

CFROI (%) 10 10 10

ROCE= Income/book capitalROGI = Cash flow/

cash investedCFROI= (Cash flow - economic depreciation(*))/cash

invested

$12,000

$1,557

$2,000

IRR = 10%



- 6 -Copyright 1996


Yr 1 Yr 6 Yr 12

NOPAT(1) 843 843 843

Book capital(2) 11,286 7,716 3,432

Cost of capital(3) x10% x10% x10%

Capital charge(4) 1,129 772 343

EVA(1-4) (286) 71 500

Cash flow(6) 1,557 1,557 1,557

Cash invested(7) 12,000 12,000 12,000

Cost of capital(8) x10% x10% x10%

Capital charge(9) 1,200 1,200 1,200

Economic dep.(*)(10) 357 357 357

CVA(6-9-10) 0 0 0

VALUE-ADDED MEASURES REFLECT RETURN,COST OF CAPITAL AND SIZE

Return on New Plant—Measured Over Time

(*) Economic depreciation = amount of annual sinking fund payment earning COC required to replace assets ($357 = {[0.1/(1.114 - 1)](12,000 - 2,000)})

Investment profile of a new plant

$12,000

$1,557

$2,000

IRR = 10%



- 7 -Copyright 1996


Accounting Measures Fail(E.P.S. Growth)

Value Line Industrials - 1994

R2 = 0.07

0

5

10

15

20

25

30

35

40

45

50

-100 -80 -60 -40 -20 0 20 40 60 80 100

E.P.S. Growth 1993-1994

Pri

ce

/Ea

rnin

gs

Accounting Measures Fail(ROE Spread)


R2 = 0.33

0.1

1

10

-50 -40 -30 -20 -10 0 10 20 30 40 50

ROE minus CAPM Cost of Equity

Pri

ce

/Eq

uit

y B

oo

k

Accounting Measures Fail(ROCE Spread)


R2 = 0.32

0.1

1

10

-20 -15 -10 -5 0 5 10 15 20 25 30

ROCE minus CAPM Cost of Capital

Tota

l Ca

pit

al

Pri

ce

/Bo

ok

Economic Cash Flow Measures DoubleAbility to Explain Value

CFROI Spread - V/L Industrials - 1994

R2 = 0.61

0.1

1

10

-10 -5 0 5 10 15 20 25 30

CFROI minus Discount Rate

Va

lue

/Co

st



- 8 -Copyright 1996


Value/Cost Versus ROCE - CAPM Cost of Capital


R2 = 0.28

0.1

1

10

-20 -15 -10 -5 0 5 10 15 20 25 30

ROCE - CAPM Cost of Capital

Va

lue

/Co

st

Value/Cost Versus ROE - CAPM Cost of EquityValue Line Industrials - 1994

R2 = 0.26

0.1

1

10

-50 -40 -30 -20 -10 0 10 20 30 40 50

ROE - CAPM Cost of Equity

Va

lue

/Co

st

Economic Cash Flow Measures DoubleAbility to Explain Value

CFROI Spread - V/L Industrials - 1994

R2 = 0.61

0.1

1

10

-10 -5 0 5 10 15 20 25 30

CFROI minus Discount Rate

Va

lue

/Co

st



- 9 -Copyright 1996


High Returns Fade Downward and Low Returns Fade Upward;The Fade Pattern Occurs No Matter What the Starting Year ...

Average Operating CFROI by Decile - 1970, 1980 or 1987

-10

-5

0

5

10

15

20

25

1970 1975 1980 1985 1990

Year

AverageOperating

CFROI

1-Decile

2-Decile

3-Decile

4-Decile

5-Decile

6-Decile

7-Decile

8-Decile

9-Decile

10-Decile

Tracking the Sampleof 1970 Companies

through time


through time


through time

Note the averages &dispersions have risenbetween 1970-1987,hypothesized to be

related to supply-sidepolicy changes



- 10 -Copyright 1996


THE MARKET EXPECTS THE PERFORMANCEOF MERCK TO FADE ...

(REGRESS TOWARD MEAN PERFORMANCE)

Fade = 0%

Fade = 10%Illustrates Perpetuity

Trap:Overvalues High

Return FirmsDramatically





Relative Total Shareholder Return (TSR) versus Stern Model TSR 1990-1991

-100

-50

0

50

100

150

200

-100 -50 0 50 100 150 200 250 300

Stern Model TSR

Ac

tua

l TS

R

Relative Total Shareholder Return (TSR) versus E.P.S. Model TSR 1990-1991

-100

-50

0

50

100

150

200

-100 -50 0 50 100 150 200 250

E.P.S. Model TSR

Ac

tua

l TS

R

Relative Total Shareholder Return (TSR) versus Cash Flow Model TSR 1990-1991

-100

-50

0

50

100

150

200

-100 -50 0 50 100 150

Cash Flow Model TSR

Ac

tua

l TS

R

Relative Total Shareholder Return (TSR) versus BCG Model TSR 1990-1991

-100

-50

0

50

100

150

200

-100 -50 0 50 100 150 200 250

BCG Model TSR

Ac

tua

l TS

R

R2=0.13N=750

R2=0.40N=750

R2=0.25N=750

R2=0.25N=750





Stern Stewart Performance 1000Market Value Added vs. Economic Value Added 1988 - After Outlier Elimination

-5000

0

5000

10000

-1000 -500 0 500 1000

Economic Value Added

Ma

rke

t V

alu

e A

dd

ed

On the 24 groups of 25 firms, Stewartclaims a 44% R2. This higher correlationrelates to the elimination of 300 companiesinstead of 31 extreme outliers and the grouping of companies that serves toeliminate the intra-group variance.

N=861R2=0.27

MVA versus EVA Stern Stewart 1991

-20000

-10000

0

10000

20000

30000

40000

50000

-3000 -2000 -1000 0 1000 2000

Economic Value Added (EVA)

Ma

rke

t V

alu

e A

dd

ed

R2 = 0.21

MVA versus CVA BCG 1991

-20000

-10000

0

10000

20000

30000

40000

50000

-2000 -1000 0 1000 2000 3000

Cash Value Added (CVA)

Ma

rke

t V

alu

e A

dd

ed

R2 = 0.67

Total Shareholder Return (TSR) Versus % Change in Economic Value Added (EVA)

1992-1993

-60

-40

-20

0

20

40

60

80

100

-100 0 100 200 300 400

% Change in EVA

TS

R

R2 = 0.10





APPROACH TO IMPLEMENTATIONWhat Full Effort Might Look Like

Module 1

Analytical diagnostic:

“value audit”

Module 2

Measure selection

and tailoring

Module 3

Value Driver

analysis of BU’s

Module 4

Install in planning, budgeting & reporting

Module 5

Install in compensation

Module 6

Apply to portfolio

management

• Value analysis of company and business units

• Identify priorities and issues

• Review options against applica-tions

• Tailor as required

• Transfer approach to BUs

• Link to operating decisions

• Re-examine processes and linkages

• Provide training and document-ation

• Structure

• Measures

• Targeting

• Resourceallocation

• Portfolio balancing

• External reporting





COMPARISON OF COST OF CAPITAL MEASUREMENT METHODS

CAPM Market Derived

Assumes investor discount rate risk premiums did not change during the past measurement period. Therefore, future risk premiums equal past risk premiums.

Assumes future cash flows can be estimated so that the discount rate equates the present value of those cash flows to the price.

BondInterestRates

DividendDiscountModels

BCGMarket DerivedCost of Capital

P = Net Cash Flow

(1 + DR)t

tt=1

n=





STUDIES USING MARKET DERIVED METHODS

Blanchard, Oliver J., “Movements in the Equity Premium”, Brookings Paper on Economic Activity, 2:1993, pp. 75-138.

Corcoran, Patrick J. and Leonard G. Sahling, “The Cost of Capital: How High is It?”, The Federal Reserve Bank of New York: Quarterly Review, Summer 1982, p. 23-31.

Farrell, James L., “The Dividend Discount Model: A Primer,” Financial Analysts Journal, 1985, v41 (6), pp. 16-19, 22-25.

Fuller, Russell J., “Programming the Three-Phase Dividend Discount Model,” Journal of Portfolio Management, 1979, v5(4), 28-32.

Gordon, Myron J. and E. Shapiro, “Capital Equipment Analysis: The Required Return of Profit,” Management Science, 3 pp. 102-110 (October 1956).

Holland, Daniel M. and Stewart C. Myers, “Trends in Corporate Profitability and Capital Costs” in Robert Lindsay, ed. The Nation’s Capital Needs: Three Studies, Committee for Economic Development, New York, pp. 103-188.

Rozeff, Michael S., “The Three-Phase Dividend Discount Model the ROPE Model,” Journal of Portfolio Management, 1990, v16(2), pp. 36-42.

Williams, J.B., The Theory of Investment Value, Harvard University Press, Cambridge, Mass., 1938.





BCG/HOLT RESEARCH USING MARKET DERIVED METHODS

by Rawley Thomas

HOLT’s Discount Rate, April 25, 1986, 122 pages

• Covers cash estimation, market derived methodology, tax premiums, leverage, comparison to other academic research, and CAPM

New Electric Utility Discount Rate, September 6, 1987, 40 pages

• Shows discount rates for utilities that are higher than industrials. Postulates government regulation and the risk of unanticipated inflation may cause the higher risk.

Valuation Model Improvements, March 3, 1989, 5 pages

• Covers leverage research

New System Adjustments, May 3, 1989, 4 pages

• Covers revised leverage adjustments

Real Equity Rates, October 1, 1989, 21 pages

• Updates cost of capital research on tax premiums and leverage

Real Equity Discount Rates - Data, October 2, 1989, 23 pages

• Displays IRS, Federal Reserve, and HOLT data underlying discount rate research 1950-1988.

Effect of Proposed Change on Stock Prices, October 3, 1989, 38 pages

• Accounts for 200 point drop in market by analyzing effect of capital gains indexation versus lower capital gains tax rates

Responses to Equity Discount Rate Research, November 2, 1989, 4 pages

• Congressional response to HOLT research

Another Response to Discount Rate Research, December 4, 1989, 10 pages

• Department of Treasury response to HOLT research

Volatility “Risk” Versus Inflation Risk, July 25, 1990, 11 pages

• Compares CAPM volatility risk to inflation risk

Investor’s Discount Rate for Oil Companies, March 22, 1991, 63 pages

• Correlates oil industry market derived equity discount rates to government ownership and leverage





MARKET DERIVED DISCOUNT RATE

Price = Discounted Present Value of Expected Future Net Cash Flows

Corporate Sector Cash Flowsvary with the structural

characteristics of an economy

Investors Discount Rateis volatile

S&P 400DJIA 30

etc.





BCG’S METHOD FOR DERIVING INVESTOR DISCOUNT RATES (WACC’s) DIFFERS FROM TRADTIONAL CAPM METHODS.

WE START WITH A SAMPLE AND A VALUATION MODEL TO DERIVE A WACC. THEN WE SPLIT THE WACC INTO ITS DEBT AND EQUITY

COMPONENTS. FROM THE EQUITY RATE, WE CALCULATE THE RISK PREMIUM OVER GOVERNMENT BOND RATES.

Sample of Companies

Caculate CFROI for Sample

Calculate Growth rates for Country

Economy

Employ Present Value Valuation Model

Determine Market Derived Investor

Discount Rate (WACC)

Cost of Debt

Market Leverage

Market Derived Real Equity Rate

Inflationary Expectations

Market Derived Equity Risk

Premium

Government Bond Rates





CFROI’S CORRELATE HIGHLY WITH THE FUNDAMENTALS OF INFLATION, AND CORPORATE TAXES

1996 DISCOUNT RATE SAMPLE

0123456789

101112

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

10.85‘96 Actual

11.41‘97 Forecast

“Best Fit Line”

Fundamental CFROI = 14.65 - 0.438 * GDP Deflator Inflation - 0.122 * Corporate Tax Rate

t-Statistics: -9.54 on GDP Deflator Inflation; -7.00 on Corporate Tax Rate

Correlation between Inflation and Tax Rates: 0.00%

CFROI Actual

R2 = 0.76





TO SMOOTH ECONOMIC CYCLES, BUT INCORPORATE STRUCTURAL SHIFTS, BCG’S VALUATION MODEL

ASSUMES CURRENT CFROI LEVELS FADE TOWARD THE 5-YEAR PAST MEDIAN OF THE DISCOUNT RATE

SAMPLE AT A 10% RATE

0123456789

101112

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

Annual CFROI’s

5-Year Past Median CFROI’s





BCG’S VALUATION MODEL ANTICIPATES THAT THE GROSS ASSET GROWTH RATE OF ALL COMPANIES IN THE USA FADE

TOWARD THE LONG TERM ECONOMY AVERAGE

-3-2-10123456789

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

Annual GDP Growth Rates

3.2 % Compounded Annual Growth Rate in GDP from 1950-1996

Unlike CFROI’s, where clear trends are evident, there does not appear to be a clear trend in growth rates for the economy. Consequently, a long term average smooths out the annual fluctuations with no loss in investor anticipated trend.





Price = Discounted Present Value of Expected Future Net Cash Flows

THE INVESTORS’ DISCOUNT RATE IS THAT RATE WHICH EQUATES THE PRESENT VALUE OF CASH FLOWS FROM BCG’S VALUATION

MODEL TO THE MARKET VALUE OF DEBT AND EQUITY

Market Value of Debt andEquity of S&P 400 Sample

$3,474 Billion

$1,903 Billion of AssetsReturning 11.1% and Growing

at 3.2% per yearFading @ 10% toward

10.8% CFROI

Solve for the Rate at WhichPresent Value of Cash Flows

Equals PriceSeptember = 5.77%

(Weighted Averaged Real After-Corporate-Tax

Cost of Capital)

Answer tells us what the Marketis presently requiring as a

Rate of Return





CALCULATION OF FUTURE CASH FLOWS AND PRESENT VALUES1996 DISCOUNT RATE SAMPLE





PAST RESOURCES COMMITTED1996 DISCOUNT RATE SAMPLE





CALCULATION OF ASSET ADDITIONS1996 DISCOUNT RATE SAMPLE





BCG DECOMPOSES THE WEIGHTED AVERAGE REAL COSTS OF CAPITAL INTO THEIR DEBT AND EQUITY

COMPONENTS USING MARKET WEIGHTS

-2

0

2

4

6

8

10

12

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

1.76

5.77

6.53

Real Debt RateAfter Corporate Tax

Real Equity Rate

Real Weighted Average





MARKET % DEBT/TOTAL CAPITAL HAS DECLINED SIGNIFICANTLY SINCE 1990

0

5

10

15

20

25

30

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

Variations inMarket Leverage and InvestorTax Premiums Help to Explain

Market Derived Real Equity Discount Rates

See Next Slide ...

15.9





-2

0

2

4

6

8

10

12

14

16

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

%

Real Equity Discount Rates Decompose into the Fundamentals of Tax Premiums, Leverage Risk Premiums, CFROI’s & Sub-Par Returns

USA - 1950-1997

Dividend Tax Premiums

Capital GainsTax Premiums

Leverage RiskPremiums

Market DerivedReal Equity

Discount Rate

Fundamental Equity Discount Rate=-3.36+DivTaxPrem+CapGainTaxPrem

+0.207*Debt/Total Capital+0.408* CFROI

-1972/78 Sub-Par Returns

1972/78 Sub-Par Returns; MayRepresent a Proxy for Other Effects

Discount Rates

Based on 1996

Discount Rate

Sampleof 279 S&P

Industrials

R2 = 0.91

CFROIEffects





CFROI’S NORMALLY EXCEEDTHE MARKET DERIVED DISCOUNT RATES

1996 DISCOUNT RATE SAMPLE

-2-10123456789

101112

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

CFROI’s

Market DerivedDiscount Rates

Differences

Politics/Policies Change





CFROI’S NORMALLY EXCEEDTHE MARKET DERIVED DISCOUNT RATES

Even though many economists believe that all returns must converge, in a healthy capitalist economy, CFROI’s on hard assets will exceed investor required returns on financial assets most of the time, because:

• Continuous new entrepreneurial innovations prevent CFROI’s from converging completely to promised financial returns (imperfect arbitrage) and

• Entrepreneurs must be rewarded with greater returns to assume the greater dispersion and higher risk of loss associated with CFROI’s on illiquid hard assets compared to financial returns on marketable, liquid financial assets





-5

0

5

10

15

20

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

Producer Price Index % Change

GNP/GDP Deflator % Change


0.0% Base Rate 1950-19802.6% Base Rate 1981-1996

Inflationary Expectations based on0-2.6 base rates follow actual inflationmore closely, but avoid the sharp volatilityof actual PPI and GNP/GDP annual inflation.

2.48

Note: the base rate is definedas the after-investor tax, afterinflation required return on Government long term bonds.

BCG CALCULATES INFLATIONARY EXPECTATIONS BY SUBTRACTING TAX PREMIUMS AND A BASE RATE FROM LONG

TERM GOVERNMENT BOND YIELDSUSA - 1950-1997





MARKET DERIVED NOMINAL EQUITY RATES COME FROM MARKET DERIVED REAL EQUITY RATES PLUS THE COMPOUNDED EFFECT OF

INFLATIONARY EXPECTATIONS

1

3

5

7

9

11

13

15

17

19

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

%

Market Derived Nominal Equity Rate

9.17

6.53

2.48

Market Derived Real Equity Rate






THE EQUITY RISK PREMIUM HAS DECLINED TO THE 2-3% RANGE

0

2

4

6

8

10

12

14

16

18

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Risk Premium Differences

Market Derived Nominal Equity Rate

Nominal Long Term Government Bond Rate

2.66





RISK CONCEPTS AND MEASUREMENT

CAPM Market Derived

Investors seek to avoid price volatility relative to the market.

Investors seek to avoid losses from unanticipated major events.

P = Net Cash Flow

(1 + DR)t

tt=1

n=

Major EventsBankruptcy (Leverage)Unanticipated Inflation

Government InterventionGovernment Ownership

Voting Rights on Key ChangesAsset Age

Arbitrage Pricing Theory (APT)postulates other risk factors:

Interest RatesOil Prices

Price/Equity BookSize





NAIVE BELIEFS INCORRECTLY ASSUME COSTS OF DEBT AND EQUITY DO NOT VARY

WITH CAPITAL STRUCTURE ...

4

5

6

7

8

9

10

0 10 20 30 40 50 60 70 80 90 100

Debt/Total Capital at Market

NominalCosts

ofCapital

Cost of Equity

Cost of Debt, After-Corporate-Tax

Weighted AverageCost of CapitalAfter-Corporate-Tax

Note: NOTBased on

Valid Theoryor

EmpiricalEvidence





BCG EMPIRICAL WORK CONFIRMS INCREASING REAL

COSTS OF DEBT AND EQUITY, ACCORDING TO TRADITIONAL THEORY

0

5

10

15

20

25

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75

Market Debt/Total Capital

%

Equity

WeightedAverage

DebtAfter-Tax

Source: BCG Database andEmpirical Research on 63Value Line Industries - 1995

To our knowledge, no one has published empirical results like these because of the significant inaccuracies in the traditional estimation procedures typically used. BCG eliminates much of these inaccuracies through our fading CFROI valuation model. Even with these inaccuracies eliminated, these cost of capital curves are probably not accurate enough for precise optimum capital structure work on individual firms. This is due to remaining noise in the data and no size, entrenchment, and asset restructuring functions built into our current valuation model. However, these empirical results can be employed to avoid the misperception that costs of equity and total capital do not change significantly with changes in leverage.

Rawley Thomas - Director of Research

Line of best fit based on minimizingabsolute deviations of a power curve(to reduce influence of outliers) andconstrained to pass through resultsfor Sample F

6.03+35.14(D/C)2.42

2.38+2.69(D/C)1.86





PRELIMINARY HOLT DISCOUNT RATE RESEARCHMARKET DERIVED REAL COST OF EQUITY

CORRELATION COEFFICIENTS1990, 220 Companies, 15% Fade of Cash Flows to Corporate Average

Note: Random sample of 220 nonfinancial industrial companies, drawn from over 6,000

(2)

12

15

47

31

34

36

49Plant age and life (inflation adjustment factor)

Plant life

Dividend yield

Size (LN-current dollar gross investment)

Debt/total capital at market

Industry risk (government intervention?)

Company Beta (value line)

Unlevered Beta

Note the small correlation with Beta. This small 1% R2 with Beta suggests re-evaluation of traditional risk concepts.





0

50

100

150

200

250

- 20 - 15 - 10 - 5 0 5 10 15 20 25 30 35 40 45 50

Operating CFROI - 1993

Actual

Gaussian("Normal")

StableParetian

BOTH CFROI AND TSR FOLLOW STABLE PARETIAN DISTRIBUTIONSWITH INFINITE VARIANCES AND SIMILAR PEAKEDNESS ...

0

10

20

30

40

50

60

70

80

90

100

110

120

130

- 80 - 60 - 40 - 20 0 20 40 60 80 100 120 140 160 180

Total Shareholder Return - 1993

Peakedness =1.4912.1 standard errorsaway from 2 (Gaussian)

Peakedness =1.458.8 standard errorsaway from 2 (Gaussian)

Competitivepressuresforce returnsdown

NumberofFirms

Investorpressuresforce returnsup

KEY CONCLUSIONSThe distributions here are 8.8 to 12.1 standard errors away from Gaussian Normal. For these distributions, variance does not exist. Variance is infinite. Therefore, traditional CAPMmeasures of risk do not exist.These results suggest risk theory should be revised to reflect actual distributions and the possibility that investors seek to avoid the risk of loss in the fat tails of the distributions, not dispersion risk.





CONFLICTING PERFORMANCE SIGNALSCAN CAUSE PROBLEMS

Most managements use IRR or NPV for new projects and plans

Most managements use accounting ratios (ROE, ROCE, RONA) or earnings growth for existing businesses

The two types of measures are fundamentally inconsistent and can lead to poor management decisions

For consistency and economic validity, use a measure like total shareholder return to evaluate project and overall company performance





FOCUS ON CFROI REMOVED REINVESTMENT BIAS, ENCOURAGED ECONOMIC BEHAVIOR AND INCREASED VALUE

0

5

10

15

20

80 81 82 83 84 85 86 87 88 89 90 91 92

Percentage

Campbell Soup Co.

Year

ROCE

CFROI

TSR/index 100 83 86 127 135 151 167 167 158 227 239 269 252





AGING PLANT TRAP

0

2

4

6

8

10

12

14

85 86 87 88 89 90

Percentageper year

Year

Nominal RONA hurdle rate

Forecast RONA

Real discount rate

Forecast CFROI





NEW PLANT TRAP

4

9

14

19

24

29

34

75 76 77 78 79 80

Percentageper year

Year

Old plant

RONA

Real discount rate

CFROI

New plant

Nominal RONA hurdle rate





INTANGIBLE TRAP

0

5

10

15

20

25

30

75 76 77 78 79 80 81 82 83 84 85

Percentageper year

Year

Before

purchase

After purchase

Real discount rate

Nominal hurdle rate

RONA

CFROI (pooling accounting)





ACCOUNTING RETURN MEASURES PROVIDEMISLEADING SIGNALS

Business Unit RONA and CFROI Vs. Hurdle Rates

(5)

0

5

10

15

20

25

30

A B C D E F G H I J

RONA

CFROI

Percentageper year

Business unit

Nominal RONAhurdle rate

Real CFROIhurdle rate

Fortune 100 manufacturer

• Old assets• Inflation• Leases• Low

depreciation

• New assets• Goodwill• High

depreciation• Deferred taxes





ESTIMATING THE PAST CAPITAL EXPENDITUREREAL GROWTH RATE FROM LIFE,

ACCUMULATED DEPRECIATION, AND INFLATION

Accumulated DepreciationHistorical Dollar Gross Plant

(L-i+1)(1+g)i-1Dii=1

L

L (1+g)i-1Dii=1

L

where L= Gross Plant Life

g= Past real growth rate in CAPEx

Di

GDP Deflator in Year i





DERIVATION OF THE RELATIONSHIP OF THECAPITAL EXPENDITURE REAL GROWTH RATE (g) TO

THE RATIO OF ACCUMULATED DEPRECIATION TO GROSS PLANT

Year Deflator

ConstantDollar

CapitalExpenditure

HistoricalDollar

CapitalExpenditures

ProjectLife

HistoricalDollar

Depreciation

Num ber ofLayers in

Accum ulatedDepreciation

HistoricalDollar

Accum ulatedDepreciation

1 D 1 C 1 C 1(1+g)0D 1/D 1 L C 1(1+g)

0D 1/(D 1L) 3 3C 1(1+g)

0D 1/(D 1L)

2 D 2 C 1(1+g) C 1(1+g)1D 2/D 1 L C 1(1+g)

1D 2/(D 1L) 2 2C 1(1+g)

1D 2/(D 1L)

3 D 3 C 1(1+g)2

C 1(1+g)2D 3/D 1 L C 1(1+g)

2D 3/(D 1L) 1 1C 1(1+g)

2D 3/(D 1L)

Total C

D1 + g D1

1

i-1L

i1 1 C

D

1 + g D

L1

1

i-1i

L

1 1 C

D LL - i + 1 g D1

1 i=1

Li-1

i 1

A c c u m u l a t e d D e p r e c i a t i o n

G r o s s P l a n t

L - i + 1 g D

L 1 + g D

i - 1i

i = 1

L

i - 1i

i = 1

L

1

Assumptions: (1) Depreciation begins the year the firm places the asset in service(2) The plant retires the year after the project Life year

Numerical iterative techniquesemploying the Newton-RaphsonMethod and calculus can solvethis formula for g.

Bcg Value Management Framework an Overview for Mba Students

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