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CHAPTER 9

Financial Statements, Cash Flow, and Taxes

As noted earlier, a negative current FCF is not necessarily bad, provided it is due
to high growth. For example, Home Depot has negative FCF due to its rapid growth,
but it also has a very high ROIC, and this high ROIC results in a high market value for
the stock.
MicroDrive had an ROIC in 2002 of 9.46 percent ($170.3/$1,800  0.0946). Is
this enough to cover its cost of capital? Well answer that question in the next section.
What is net operating working capital? Why does it exclude most short-term investments and also notes payable?
What is total operating capital, or, equivalently, total operating assets? Why is it
important for managers to calculate a companys capital requirements?
What is NOPAT? Why might it be a better performance measure than net income?
What is free cash ow? Why is free cash ow the most important determinant of
a rms value?

MVA and EVA

Neither traditional accounting data nor the modied data discussed in the preceding
section bring in stock prices, even though the primary goal of management is to maximize the rms stock price. Financial analysts have therefore developed two new performance measures, MVA, or Market Value Added, and EVA, or Economic Value
Added. These concepts are discussed in this section.8

Market Value Added (MVA)

The primary goal of most rms is to maximize shareholders wealth. This goal obviously benets shareholders, but it also helps to ensure that scarce resources are allocated efciently, which benets the economy. Shareholder wealth is maximized by
maximizing the difference between the market value of the rms stock and the amount
of equity capital that was supplied by shareholders. This difference is called the Market Value Added (MVA):
MVA  Market value of stock
Equity capital supplied by shareholders
 (Shares outstanding)(Stock price)
Total common equity.
(9-9)
To illustrate, consider Coca-Cola. In late 2001, its total market equity value was
$123.5 billion, while its balance sheet showed that stockholders had put up only $10.4
billion. Thus, Coca-Colas MVA was $123.5
$10.4  $113.1 billion. This $113.1
For an updated estimate of
billion represents the difference between the money that Coca-Colas stockholders
Coca-Colas MVA, go to
have invested in the corporation since its foundingincluding retained earnings
http://nance.yahoo.com,
versus the cash they could get if they sold the business. The higher its MVA, the betenter KO, pick Detailed for
ter the job management is doing for the rms shareholders.
the quote, and click Get.
Sometimes MVA is dened as the total market value of the company minus the toThis shows the market value
of equity, called Mkt Cap. To tal amount of investor-supplied capital:
get the book value of equity,
select Research, then Financials, and then Balance
Sheet.

MVA  Total market value
Total capital

 (Market value of stock  Market value of debt)
Total Capital. (9-9a)

The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of the
consulting rm Stern Stewart & Company. Stern Stewart copyrighted the terms EVA and MVA, so
other consulting rms have given other names to these values. Still, EVA and MVA are the terms most commonly used in practice.

351

Financial Statements, Cash Flow, and Taxes

MVA and EVA

355

For most companies, the total amount of investor-supplied capital is the sum of equity,
debt, and preferred stock. We can calculate the total amount of investor-supplied
capital directly from their reported values in the nancial statements. The total market value of a company is the sum of the market values of common equity, debt, and
preferred stock. It is easy to nd the market value of equity, since stock prices are readily available, but it is not always easy to nd the market value of debt. Hence, many analysts use the value of debt that is reported in the nancial statements, or the debts
book value, as an estimate of its market value.
For Coca-Cola, the total amount of reported debt was $6.9 billion, and Coca-Cola
had no preferred stock. Using this as an estimate of the market value of debt, Cokes
total market value was $123.5  $6.9  $130.4 billion. The total amount of investorsupplied funds was $10.4  $6.9  $17.3 billion. Using these total values, the MVA
was $130.4
$17.3  $113.1 billion. Note that this is the same answer that we got using the previous denition of MVA. Both methods will give the same results if the
market value of debt is approximately equal to its book value.

Economic Value Added (EVA)

If you want to read more
about EVA and MVA, surf
over to http://www.
sternstewart.com and learn
about it from the people
who invented it, Stern Stewart & Co.

Whereas MVA measures the effects of managerial actions since the very inception of a
company, Economic Value Added (EVA) focuses on managerial effectiveness in a
given year. The EVA basic formula is as follows:
EVA  Net operating prot after taxes (NOPAT)

After-tax dollar cost of capital used to support operations

(9-10)

 EBIT(1
Corporate tax rate)
(Operating capital)(WACC).

Operating capital is the sum of the interest-bearing debt, preferred stock, and common equity used to acquire the companys net operating assets, that is, its net operating working capital plus net plant and equipment. Operating assets by denition
equals the capital used to buy operating assets.
We can also calculate EVA in terms of ROIC:
EVA  (Operating capital)(ROIC
WACC).

(9-10a)

As this equation shows, a rm adds valuethat is, has a positive EVAif its ROIC is
greater than its WACC. If WACC exceeds ROIC, then new investments in operating
capital will reduce the rms value.
EVA is an estimate of a businesss true economic prot for the year, and it differs
sharply from accounting prot.9 EVA represents the residual income that remains after the cost of all capital, including equity capital, has been deducted, whereas accounting prot is determined without imposing a charge for equity capital. As we discussed in Chapter 6, equity capital has a cost, because funds provided by shareholders
could have been invested elsewhere, where they would have earned a return. Shareholders give up the opportunity to invest elsewhere when they provide capital to the
rm. The return they could earn elsewhere in investments of equal risk represents the
cost of equity capital. This cost is an opportunity cost rather than an accounting cost, but
it is quite real nevertheless.
Note that when calculating EVA we do not add back depreciation. Although it is not
a cash expense, depreciation is a cost, and it is therefore deducted when determining
9

The most important reason EVA differs from accounting prot is that the cost of equity capital is deducted
when EVA is calculated. Other factors that could lead to differences include adjustments that might be
made to depreciation, to research and development costs, to inventory valuations, and so on. These other
adjustments also can affect the calculation of investor supplied capital, which affects both EVA and MVA.
See Stewart, The Quest for Value, listed in the Selected Additional References at the end of the chapter.

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CHAPTER 9

Financial Statements, Cash Flow, and Taxes

both net income and EVA. Our calculation of EVA assumes that the true economic depreciation of the companys xed assets exactly equals the depreciation used for accounting and tax purposes. If this were not the case, adjustments would have to be made
to obtain a more accurate measure of EVA.
EVA measures the extent to which the rm has added to shareholder value. Therefore, if managers focus on EVA, this will help to ensure that they operate in a manner
that is consistent with maximizing shareholder wealth. Note too that EVA can be determined for divisions as well as for the company as a whole, so it provides a useful basis for determining managerial performance at all levels. Consequently, EVA is being
used by an increasing number of rms as the primary basis for determining managerial compensation.
Table 9-5 shows how MicroDrives MVA and EVA are calculated. The stock price
was $23 per share at year-end 2002, down from $26 per share at the end of 2001. Its
WACC, which is the percentage after-tax cost of capital, was 10.8 percent in 2001 and
11.0 percent in 2002, and its tax rate was 40 percent. Other data in Table 9-5 were
given in the basic nancial statements provided earlier in the chapter.
Note rst that the lower stock price and the higher book value of equity (due to retaining earnings during 2002) combined to reduce the MVA. The 2002 MVA is still
positive, but $460
$254  $206 million of stockholders value was lost during 2002.
EVA for 2001 was just barely positive, and in 2002 it was negative. Operating income (NOPAT) rose, but EVA still declined, primarily because the amount of capital
rose more sharply than NOPATby about 26 percent versus 8 percentand the cost
of this increased capital pulled EVA down.
Recall also that net income fell somewhat from 2001 to 2002, but not nearly so
dramatically as the decline in EVA. Net income does not reect the amount of equity
TABLE 9-5

MVA and EVA for MicroDrive (Millions of Dollars)

2002

See Ch 09 Tool Kit.xls

for details.

2001

MVA Calculation
Price per share
Number of shares (millions)
Market value of equity
Book value of equity
MVA  Market value
Book value

23.0
50.0
$1,150.0
$ 896.0
$ 254.0

26.0
50.0
$1,300.0
$ 840.0
$ 460.0

$ 283.8
40%
$ 170.3
$1,800.0
11.0%
$ 198.0
($27.7)
9.46%
(1.54%)
($27.7)

$ 263.0
40%
$ 157.8
$1,455.0
10.8%
$ 157.1
$ 0.70
10.85%
0.05%
$
0.7

EVA Calculation
EBIT
Tax rate
NOPAT  EBIT(1
T)
Total investor-supplied operating capitala
After-tax cost of capital, WACC (%)
Dollar cost of capital  Capital (WACC)
EVA  NOPAT
Capital cost
ROIC  NOPAT/Operating capital
ROIC
Cost of capital  ROIC
WACC
EVA  (Operating capital)(ROIC
WACC)

a
Investor-supplied operating capital equals the sum of notes payable, long-term debt, preferred stock, and common equity, less short-term investments. It could also be calculated as total liabilities and equity minus accounts
payable, accruals, and short-term investments. It is also equal to net operating working capital plus operating longterm assets.

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The Federal Income Tax System

357

capital employed, but EVA does. Because of this omission, net income is not as useful
as EVA for setting corporate goals and measuring managerial performance.
We will have more to say about both MVA and EVA later in the book, but we can
close this section with two observations. First, there is a relationship between MVA
and EVA, but it is not a direct one. If a company has a history of negative EVAs, then
its MVA will probably be negative, and vice versa if it has a history of positive EVAs.
However, the stock price, which is the key ingredient in the MVA calculation, depends
more on expected future performance than on historical performance. Therefore, a
company with a history of negative EVAs could have a positive MVA, provided investors expect a turnaround in the future.
The second observation is that when EVAs or MVAs are used to evaluate managerial performance as part of an incentive compensation program, EVA is the measure
that is typically used. The reasons are (1) EVA shows the value added during a given
year, whereas MVA reects performance over the companys entire life, perhaps even
including times before the current managers were born, and (2) EVA can be applied to
individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation.
Dene the terms Market Value Added (MVA) and Economic Value Added
(EVA).
How does EVA differ from accounting prot?

The Federal Income Tax System

The value of any nancial asset (including stocks, bonds, and mortgages), as well as
most real assets such as plants or even entire rms, depends on the stream of cash
ows produced by the asset. Cash ows from an asset consist of usable income plus depreciation, and usable income means income after taxes.
Our tax laws can be changed by Congress, and in recent years changes have occurred frequently. Indeed, a major change has occurred, on average, every three to
four years since 1913, when our federal income tax system began. Further, certain
A web site explaining fedparts of our tax system are tied to the ination rate, so changes occur automatically
eral tax law is http://www.
each year, depending on the rate of ination during the previous year. Therefore, altaxsites.com. From this
though this section will give you a good background on the basic nature of our tax syshome page one can visit
tem, you should consult current rate schedules and other data published by the Interother sites that provide
summaries of recent tax leg- nal Revenue Service (available in U.S. post ofces and on the Web) before you le
islation or current informayour personal or business tax returns.
tion on corporate and indiCurrently (early 2002), federal income tax rates for individuals go up to 39.6 pervidual tax rates. The ofcial
cent,
and, when Social Security, Medicare, and state and city income taxes are ingovernment site is http://
cluded,
the marginal tax rate on an individuals income can easily exceed 50 percent.
www.irs.gov.
Business income is also taxed heavily. The income from partnerships and proprietorships is reported by the individual owners as personal income and, consequently, is
taxed at federal-plus-state rates going up to 50 percent or more. Corporate prots are
subject to federal income tax rates of up to 39 percent, plus state income taxes. Furthermore, corporations pay taxes and then distribute after-tax income to their stockholders as dividends, which are also taxed. So, corporate income is really subject to
double taxation. Because of the magnitude of the tax bite, taxes play a critical role in many
nancial decisions.
As this text is being written, Congress and the administration are debating the
merits of different changes in the tax laws. Even in the unlikely event that no explicit
changes are made in the tax laws, changes will still occur because certain aspects of the
tax calculation are tied to the ination rate. Thus, by the time you read this chapter,