strategy & Corporate Finance Flashcards
expertise interview
Can you explain the concept of Return on Invested Capital (ROIC) and its importance in value creation?
ROIC is a measure of a company’s efficiency at allocating the capital under its control to profitable investments. It is calculated as after-tax operating profit divided by invested capital. ROIC is crucial because it indicates whether a company is generating returns that exceed its cost of capital. A higher ROIC compared to the cost of capital signifies that the company is creating value for its shareholders.
How do growth and ROIC interact to drive a company’s value?
Growth and ROIC are mathematically linked and together determine a company’s value. High-ROIC companies create more value by focusing on growth, as they can generate higher returns on new investments. Conversely, low-ROIC companies should focus on improving their ROIC before pursuing growth, as growth at lower returns can actually destroy value. Growth (g) is the rate at which the company’s NOPAT and cash flow
grow each year.
What is economic profit, and how does it differ from accounting profit?
Economic profit measures the value created by a company in a single period and is defined as invested capital multiplied by the difference between ROIC and the cost of capital. Unlike accounting profit, which is simply the net income reported on financial statements, economic profit accounts for the opportunity cost of capital, providing a more accurate measure of value creation.
Why might a company with lower growth rates still generate similar shareholder returns as a faster-growing company?
A company with lower growth rates can still generate similar shareholder returns if it has a higher ROIC. For example, General Mills had slower growth compared to Walgreens but generated similar shareholder returns because its ROIC was significantly higher. This higher ROIC compensated for the slower growth, resulting in comparable value creation.
How should managers decide between different investment opportunities to maximize value creation?
Managers should evaluate investment opportunities based on their potential to create value, considering both ROIC and growth. High-ROIC companies should prioritize growth opportunities, while low-ROIC companies should focus on improving their ROIC before pursuing growth. Additionally, managers should consider the type of growth, as different growth strategies yield different returns on capital.
What are the implications of the relationship between growth, ROIC, and cash flow for strategic decision-making?
The relationship between growth, ROIC, and cash flow implies that strategic decisions should be based on a company’s ability to generate returns that exceed its cost of capital. High-ROIC companies should focus on growth to maximize value, while low-ROIC companies should improve their ROIC. Understanding this relationship helps managers prioritize investments and strategies that will create the most value for shareholders.
Why is it important to reorganize traditional financial statements for analysing economic performance?
Traditional financial statements mix operating and nonoperating items, making it difficult to assess a company’s true operating performance and value. Reorganizing these statements into operating items, nonoperating items, and sources of financing provides clearer insights into a company’s economic performance and helps avoid common pitfalls like double-counting and omitting cash flows.
How do you calculate invested capital, and why is it significant?
Invested capital can be calculated using the operating method (operating assets minus operating liabilities) or the financing method (debt plus equity). It represents the total capital required to fund a company’s operations. Understanding invested capital is crucial for calculating Return on Invested Capital (ROIC) and assessing a company’s ability to generate value from its investments.
What is NOPLAT, and how does it differ from net income?
NOPLAT (Net Operating Profit Less Adjusted Taxes) is the after-tax profit generated from core operations, excluding nonoperating income and financing expenses. Unlike net income, which is available only to equity holders, NOPLAT is available to all investors, including debt holders. It provides a clearer picture of a company’s operating performance.
Explain the concept of Free Cash Flow (FCF) and its importance in valuation.
Free Cash Flow (FCF) is the after-tax cash flow available to all investors, independent of financing and nonoperating items. It is calculated as NOPLAT plus noncash operating expenses minus investment in invested capital. FCF is important in valuation because it represents the cash that a company can generate after maintaining or expanding its asset base, which can be used to pay dividends, reduce debt, or reinvest in the business.
How do you adjust financial statements for operating leases, and why is this adjustment necessary?
To adjust for operating leases, you capitalize the lease by multiplying the rental expense by an appropriate capitalization factor based on the cost of debt and average asset life. This adjustment is necessary to compare asset intensity across companies with different leasing policies and to ensure that the company’s ROIC reflects the true cost of using leased assets.
What is the Weighted Average Cost of Capital (WACC) and why is it important in valuation?
The Weighted Average Cost of Capital (WACC) is the blended cost of capital for all investor capital, including equity and debt. It represents the returns that all investors in a company expect to earn for investing their funds in one particular business instead of others with similar risk. WACC is important in valuation because it is used to discount future cash flows to determine the present value of a company.
How do you calculate the cost of equity using the Capital Asset Pricing Model (CAPM)?
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) as follows: E(Ri)=rf+βi[E(Rm)−rf]E(Ri)=rf+βi[E(Rm)−rf] where E(Ri)E(Ri) is the expected return of security ii, rfrf is the risk-free rate, βiβi is the security’s sensitivity to the market, and E(Rm)E(Rm) is the expected return of the market.
What are the key components of WACC and how are they estimated?
The key components of WACC are the cost of equity, the after-tax cost of debt, and the company’s target capital structure. The cost of equity is estimated using models like CAPM, the after-tax cost of debt is estimated using the yield to maturity on the company’s long-term debt, and the target capital structure is determined using market-based values of debt and equity.
How do you estimate the market return for calculating the cost of equity?
The market return can be estimated using two methods:
1. Historical Market Risk Premium: Add a historical market risk premium to today’s interest rate.
2. Market Implied Cost of Equity: Estimate based on current share prices and aggregate fundamental performance (earnings, ROIC, and growth expectations).
What is beta and how is it used in estimating the cost of equity?
Beta is a measure of a stock’s sensitivity to market movements. It is used in the CAPM to adjust the expected return on the market portfolio for the risk of the company being valued. A higher beta indicates higher risk and thus a higher expected return.
How do you estimate the after-tax cost of debt?
The after-tax cost of debt is estimated by multiplying the yield to maturity (YTM) of the company’s long-term, option-free bonds by (1 - T_m), where TmTm is the marginal tax rate.
Why is it important to use market values rather than book values when calculating WACC?
It is important to use market values rather than book values because market values represent the current opportunity cost of capital. Book values are historical costs and do not reflect the current market conditions or the true economic value of the company’s capital structure.
What is the Adjusted Present Value (APV) method and when should it be used?
The Adjusted Present Value (APV) method separates the value of a project or company into two components: the value if financed entirely by equity (unlevered firm value) and the present value of the tax shields and other financing effects. APV should be used in scenarios with changing capital structures, such as leveraged buyouts or major restructurings.
How do you incorporate the interest tax shield into the WACC calculation?
The interest tax shield is incorporated into the WACC calculation by reducing the cost of debt by the marginal tax rate: After-Tax Cost of Debt=Cost of Debt×(1−Tm)
What are nonoperating assets and why should they be valued separately in a DCF analysis?
Nonoperating assets are assets that have value but whose cash flows are not part of the operations of the business. Examples include excess cash, tradable securities, and nonconsolidated subsidiaries. They should be valued separately in a DCF analysis because their cash flows are not included in the free cash flow and can distort the valuation if not accounted for separately.
How does the Economic Profit model differ from the Enterprise DCF model, and what insights does it provide?
The Economic Profit model measures the value created by the company in a single period and is defined as: Economic Profit=Invested Capital×(ROIC−WACC) It highlights how and when the company creates value by focusing on the return on invested capital (ROIC) and the cost of capital (WACC). Unlike the Enterprise DCF model, which focuses on cash flows, the Economic Profit model provides insights into the company’s competitive position and economic performance.
Can you explain the concept of the terminal value in a DCF analysis and how it is calculated?
The terminal value represents the value of a company beyond the forecast period, assuming a perpetual growth rate. It is calculated using the key value driver formula: Continuing Value=NOPLATt+1×(1−g/RONIC)/ WACC−g where NOPLATt+1 is the net operating profit less adjusted taxes in the year following the end of the explicit forecast period, RONIC is the return on new invested capital, WACC is the weighted average cost of capital, and g is the perpetual growth rate.
How do you estimate the growth in perpetuity to calculate the terminal value?
Growth Rate Estimation
Historical Growth Rates: Look at the company’s historical growth rates in revenue, earnings, or cash flows. This can give you a baseline for future growth expectations.
Industry and Economic Outlook: Consider the overall industry growth and the broader economic conditions. This helps in understanding if the company can sustain its historical growth rates.
Competitive Position: Evaluate the company’s competitive position within its industry. Companies with strong competitive advantages might sustain higher growth rates.
