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Lecture

Chapter 4- Measuring Corporate Performance.docx

8 Pages
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Department
Finance
Course Code
FINE 2000
Professor
Mehdi Beyaghi

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Chapter 4: Measuring Corporate Performance FINE 2000 Measuring Market Value and Market Value Added  Market capitalization: Total market value of equity, equal to share price times number of shares outstanding  The book value of equity is the sum of the funds invested by shareholders when they purchase shares plus earnings reinvested by the company on behalf of the shareholders.  Market value added: market capitalization minus book value of equity o The difference between the market value of the firm’s shares, and the amount of money that shareholders have invested in the firm  Market to book ratio: ratio of market value to book value of equity o How much value has been added for each dollar that shareholders have invested  Drawbacks of market value added and Market to Book Ratio: o Market value of the company’s shares reflects investor’s expectations about future performance o Market values fluctuate because of many risks and events that are outside the financial manager’s control o You can’t look up the market value of privately owned companies whose shares are not publicly traded Economic Value Added and Accounting Rates of Return  to see whether the firm has truly created value, need to measure whether it has earned a profit after deducting all costs, including the cost of capital  cost of capital: minimum acceptable rate of return on capital investment  opportunity cost of capital because it equals the expected rate of return on investment opportunities open to investors in financial markets  the firm creates value only if it can earn more than its cost of capital (more than its investors can earn by investing on their own)  economic value added: operating profit minus charges for the cost of capital employed (residual income) o take into account all of the capital contributed by investors in the corporation o total capitalization: sum of the firm’s debt and shareholder’s equity o deferred tax liabilities are not actual taxes payable but are from income tax expenses on the SCI, they reduce equity but aren’t payable (quasi equity)  EVA: Net Income + after tax net finance expense – (cost of capital x total capitalization) o EVA = NOPAT – (Cost of Capital x total capitalization)  Net operating profit after tax (NOPAT) The after tax profits from operations, as if the firm had no debt. Equals net income (or net earnings or profit) plus after tax net finance (or interest) expense o NOPAT is what the company would earn if it were all equity financed  Variation in cost of capital is due to differences in business risk  Relatively safe companies have low cost of capital, riskier companies have high costs of capital  EVA makes the cost of capital visible to managers  Evaluating performance by EVA pushes managers to flush out and dispose of underutilized assets Accounting Rates of Return  Measures the firm’s profits per dollar of assets  ROC, ROE, ROA  book rates of return Return on Capital Chapter 4: Measuring Corporate Performance FINE 2000  The return that shareholders are giving up by keeping their money in the company is the cost of equity  If the company earns more that the cost of capital, it makes its shareholders better off; it is earning a higher return than they could obtain for themselves  If it earns less than the cost of capital, it makes its investors worse off they could earn a higher return simply by investing on their own in financial markets  Shareholders want the company to invest in projects for which the return on capital is at least as great as the cost of capital Return on Assets  Measures the income available to debt and equity investors per dollar of the firm’s total assets  ROA: net operating profit after taxes (NOPAT) as a percentage of total assets  Some financial analysts take no account for interest payments and measure ROA as net income for shareholders divided by total assets – however this calculation ignores entirely the income the firm’s assets generates for debt investors Return on Equity  Income to shareholders per dollar that they have invested  ROE: Net Income as a percentage of shareholder’s equity  Can be calculated using: o Shareholder’s income can be:  “profit” (net income)  Total comprehensive income (sum of profit and other comprehensive income)  The inclusion of other comprehensive income slightly increases ROE Problems with EVS and Accounting Rates of Return  Rates of return and economic value added have some obvious attractions as measures of performance  Unlike market value based measures, they show current performance and are not affected by all the other things that move stock prices  Also, they can be calculated for an entire company or for a particular plant or division or subsidiary  Drawbacks: o Both EVA and accounting rates of return are based on book values for assets, debt and equity o Accountants do not show every asset on the SFP o It is impossible to include the value of all assets or to judge how rapidly they depreciate o SFP doesn’t show the current market value of all of the firm’s assets o Older assets may be grossly undervalued in today’s market conditions Chapter 4: Measuring Corporate Performance FINE 2000 o High return on assets indicates that the business has performed well by making profitable investments in the past, but it does not necessarily mean that you could buy the same assets today at their reported book values Measuring Efficiency  Factors that contribute to the firm’s overall profitability Asset Turnover Ratio o Shows how much sales are generated by each dollar of total assets, and therefore it measures how hard the firm’s assets are working o Like some profitability ratios, the sales to assets ratio compares a flow measure (sales over the entire year) to a snapshot measure (assets on one day) o The asset turnover ratio measures how efficiently the business is using its entire asset base Inventory Turnover o Efficient firms don’t tie up more capital than they need In raw materials and finished goods o Another way to express this is to look at how many days of output are represented by inventories Receivables Turnover o Sales that have been recorded on the income statement but have not yet been paid are reported on the balance sheet as trade receivables o The receivables turnover ratio measures the firm’s sales as a multiple of its trade receivables o Another way to measure the efficiency of the credit operation is by calculating the average length of time for customers to pay their bills o The faster the firm turns over its receivables, the shorter the collection period Chapter 4: Measuring Corporate Performance FINE 2000 Analyzing the Return on Assets  How profitable sales are Profit Margin o The profit margin measures the proportion of sales that finds its way into profits o When companies are partly financed by debt, a portion of the revenue produced by sales must be paid as interest to the firm’s lenders o So profits from the form’s operations are divided between the debt holders and the shareholders o We would not want to say that a firm is less profitable than its rivals simply because it employs debt finance and pays out part of its income as interest o Alternative measure of profit margin: Du Pont System o Du Pont Formula: ROA equals the product of the asset turnover and operating profit margin o ROA = Asset Turno
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