VBM – Solution sketch WS 2012/ 2013: Note: This is a solution sketch , not a complete solution. Distr ibution of points is not binding for the corrector. 1 EVA, free cash f low (30) 1.1 EVA without adjustments (14)

NOPAT 2011 2012

Operating income 740.00 670.00

- Provision for income taxes 255.85 229.95 [1 P] each

- Tax shield 3.15 4.55 [1 P] each

( = Tax rate * Interest expenses)

= NOPAT 481.00 435.50

Invested Capital 2010 2011 2012

Total assets 5,000 5,300 5,100 [1 P] each

- Non-interest bearing liabilities 460 390 440 [1 P] each

( = Current liab. - s.-t. debt)

= Invested Capital 4,540 4,910 4,660

Average Inv. Cap. 2010/2011 4,725 [1 P]

Average Inv. Cap. 2011/2012

4,785 [1 P]

EVA 2011 2012

NOPAT 481.00 435.50

- Capital charges 472.50 478.50

( = WACC * Invested Capital)

= EVA 8.50 -43.00 [1 P] each

1.2 Free cash f low (9)

2009 2010 2011

Current assets 1,600 1,800 2,050

- (Current liabilities - s.t. debt) 460 390 440

Working Capital Requirement 1,140 1,410 1,610 [1 P] each

Change in WCR 270 200

Free cash f low 2010 2011

Operating income 740.00 670.00

- Taxes (= Tax rate * operating income) 259.00 234.50

NOPAT 481.00 435.50

+ Depreciation and amortization 1000 1200 [1 P] each

- Capital expenditures 700 800 [1 P] each

- Changes in WCR 270 200 [1 P] each

= Free cash f low 511.00 635.50

1.3 Link between EVA and free cash f low (7) See lecture 3, slide 15:

¨ A project creates value if NPV > 0. [2 P] ¨ The present value of future EVAs plus the value of the invested capital is equal to the

present value of future free cash flows (Preinreich-Lücke): [3 P]

¨ Consequently, using EVA for investment decisions arrives at the same investment decision as using free cash flows. [2 P]

2 Ratio analysis

Operating margin 0.120 0.107 [0.5 P] each

Profit margin 0.077 0.068 [0.5 P] each

ROA (Op. Inc./ Av. total assets) 0.144 0.129 [0.5 P] each

Total asset turnover (sales/ Av.t.a.) 1.200 1.200

* Operating margin 0.120 0.107

ROE pre tax (Op. income/ Av.sh.eq.) 0.232 0.210 [0.5 P] each

Average total assets 2010/2011 5,150 Average total assets 2011/2012

5,200

Average sh's equity 2010/2011 3,190 Average sh's equity 2011/2012

3,190

2.1 EBIT = Operating Income [2 P] 2.2 Op. margin = Op. income/ Sales [1 P] Profit margin = Net profit/ Sales [1 P] Both ratios decrease from 2011 to 2012 [2 P] 2.3 ROA = EBIT / Av. total assets [1 P] ROE = EBIT / Av. shareholder’s equity [1 P]

( ) ( )∑∑==

=+

=++

T

1tt

tT

1t0tt

t

WACC1FCFCapital Invested

WACC1EVA

ROA * (av. total assets/ av. shareholder’s equity) = ROE [2 P] 2.4 ROA = (EBIT/ Sales) * (Sales/ Av. total assets)

= operating margin * total assets turnover [2 P] The decrease in ROA is not due to an activity problem, but solely to a profitability

problem. Recommendation: Improve/ watch profitability; example welcome. [2 P] 2.5 Manager has incentives to underinvest:

Each new project with a Return on Investment (ROI) smaller than the current ROI of the company would decrease the whole company’s ROI, even if the project had a positive NPV and thus should be undertaken. [4 P]

Example: [6 P] A company’s current projects will result in an estimated ROI of about 20 % in the next periods because of a constant estimated EBIT of 200 € and average invested capital (assets) of 1,000 € (which also is relatively constant because investments in replacements are made almost continuously). The company’s cost of capital is 10 %. There exists another project with a positive NPV. Thus, it would be advantageous for the company’s shareholders to implement the project. The implementation of the project requires an investment in working capital of 500 € and will presumably result in an increase of the company’s EBIT of 80 €. This new project thus has a ROI of 16 %. The whole company’s ROI therefore will fall from 20 % to 18.67 % (=280/1,500). If the manager’s performance is measured by the whole company’s ROI, he thus won’t have an incentive to implement the new project. Another but similar reasoning: Assume that four projects are available and that there are enough means to finance all of them. Even if all of them had a positive NPV and thus should be implemented the manager would only undertake one of them: the most profitable one. Otherwise, his overall ROI would be only the weighted average of the most profitable project and the other projects, the latter being less profitable.

3 Management Compensation 3.1 Structure of compensation schedule and design of bonus bank (16)

(i) Structure of compensation schedule: Al ignment: [2 P] + Bonus based on EVA (weak goal congruent) + Stock Options Retention: [2 P] + high fixed salary & high target bonus – Bonus and particularly the stock options (controllability). Wealth leverage: [2 P] + Bonus and stock options. – Fixed salary. Shareholder costs: [2 P] - fixed salary too high compared to peer group – Variable compensation must be higher in expectation than a totally fixed salary because managers are generally risk averse; this is particularly relevant for stock options.

(ii) Design of bonus bank

Alignment of manager and shareholders -> long-term value creation: short-term profits out of a project are not pocketed immediately and can be offset by losses out of the project in later periods (for ex. no short-term “milking assets” induced). [2 P] Retention -> if bonus bank value is forfeited when the manager leaves the company. But: Negative bonus bank: retention problem. -> Is there a chance for the manager to get positive bonus payments in the next period(s)? If not: No incentives to work hard but incentives to leave. Furthermore: first year problems [2 P] Wealth leverage: [2 P] Loss participation is possible to a certain degree (negative bonus payments not possible) because the losses of one period are charged against the profits of previous periods Shareholder costs: [2 P] No statement possible

3.2 Bonus bank (9) Base salary = 200,000 Target bonus = 60% * base salary = 0.6 * 200,000 = 120,000

Year 2010 2011 2012

EVA 2,500,000 - 2,000,000 3,000,000

Target EVA 2,000,000 2,000,000 2,000,000

Percentage of target

achievement (PoTA) 125% -100% 150%

Bonus earned =

PoTA* Target bonus

([1 P] each column)

1.25*120,000

= 150,000

-1*120,000

= - 120,000

1.5*120,000

= 180,000

Bonus 2010 50,000 50,000 50,000

Bonus 2011 - 40,000 - 40,000

Bonus 2012 60,000

Calculated bonus

([0.5 P] each column) 50,000

=50,000 – 40,000

=10,000

= 50,000

– 40,000

+ 60,000

= 70,000

Bonus paid

([0.5 P] each column) 50,000 10,000 70,000

Beginning bonus bank

([0.5 P] each column) 150,000

= 100,000

– 120,000

= -20,000

= - 30,000

+180,000

= 150,000

End bonus bank

([0.5 P] each column) 100,000 -30,000 80,000

3.3 Consistency (5)

In order to be consistent with the NPV rule, interests on bonus bank had to be considered [2 P] according to the WACC / discount factor [1 P]. NPV consistency is important because it makes the manager indifferent about the timing of the bonus payout. Otherwise, a manager might want to leave the company early [2 P].

4 Option to Wait 4.1 Decision of the f irm (10)

𝑉! 𝑐! =664,41,1

− 484 = 120

[2 P.]

𝑉! 𝑐! =9681,1

− 484 = 396 > 0    if    c2=968 à invest

[2 P.]

𝑉! 𝑐! =3741,1

− 484 = −144 < 0    if    c2=374 à not invest

[2 P.] Value of option to wait:

𝐸 𝑉! 𝑐! =11,1

∙ 396 ∙ 𝑝 = 360 ∙ 𝑝

[2 P.]

Wait, if 360 ∙ 𝑝 > 120 or 13

p > . [2 P.]

4.2 Residual income without capital iz ing option to wait (14)

𝑅𝐼! = 664,4 − 484 ∙ 1,1 = 132 [2 P.]

𝐸 𝑅𝐼! = 𝑝 ∙ 968 − 484 ∙ 1,1 = 435,6 ∙ 𝑝 [3 P.]

Wait if  435,6 ∙ 𝑝1 + 𝑟!

> 132    à    𝑝 >132435,6

∙ 1 + 𝑟!

[3 P.]

Same decision as firm only if right hand side of the equation equals 13

:

13=

132435,6

∙ 1 + 𝑟!    à 𝑟! = 0,1 = 𝑟

[3 P.] If rM > r: The manager tends to invest too early (the probability p of a good state in the future must be bigger for the manager to postpone the project than it would be optimal for the firm). [3 P.] 4.3 Capital iz ing the option value to wait (6) You have to take into account the value of the option to wait by capital iz ing it (in each case) and therefore treating it as part of the invested capital which causes capital charges. Depreciate this option value the year after it has become worthless. By this modification the manager has to take into account this option.