Residual Income and NPV

The ex-post evaluation of project selection

Two important questions

How do we motivate managers to create shareholder value?

How do we evaluate their performance in terms of value creation.

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:

TSR = %14100

4100110

Issues to be borne in mind when making use of TSR:

1 Relate return to risk class2 It measures in percentage not absolute terms3 TSR is dependant on the time period chosen

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 Returns

20.8%

Holding Period Return

0% 1.06 x 0.6 x 1.5 x 1.04822 = 1.0

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.

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 – CapitalMVA = £40m – £15m = £25mMVA = Ordinary shares market value – Capital

supplied by ordinary shareholders

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

Call in the Accountant

Earnings Per ShareRob the future to pay the presentThe cost of funds is ignoredThe level of investment ignored

Accounting Rate of ReturnSame problems as aboveScale difference can cause problems

The Solution ?

Economic Profit

The Terms

• Economic Profit• Residual Income• Abnormal Earnings• EVA

are more or less synonymous

Residual Income is:

RIt = Xt - rBVt-1

RIt = Residual Income

Xt = Equity Profit

r = Cost of Equity Capital

BVt-1 = Book Value at beginning of period t (end of t-1)

Alternative Formula

1

11

t

tt

tt

BVrROE

BVrBV

XRI

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.

Time 0 1 2 3 4

Cash Flows -1000 400 400 400 400

Depreciation (1000/4) 250 250 250 250

Profit 150 150 150 150

NPV of Cash Flows @ 10% IR£267.95

BVt-1 1000 750 500 250

Residual Income 50 75 100 125

NPV of RI @ 10% IR£267.95

RI computed assuming S.L. Depreciation

RI with Economic Depreciation

Time 0 1 2 3 4

Cash Flows -1000 400 400 400 400

Value of project 995 694.21 363.64 0

Depreciation 5 300.5 330.6 363.6

Profit 395 99 69 36

NPV of Cash Flows @ 10% 267.95

BVt-1 1,000.00 994.741 694.215 363.6 0

Residual Income 294.741 0 0 0

NPV of RI @ 10% 267.95

Illustration of why Profitable Projects 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.

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 0.00

NPV of RI @ 9% 0.00

A profitable profit that destroys value! 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

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 @ 9%-25.91BVt-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 -8.00

NPV of RI @ 9% -25.91

Advantages of RI

It is clearly linked to value creation (NPV) It makes managers aware that capital is

not free

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.

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.