BCGS VALUE MANAGEMENT FRAMEWORK AN OVERVIEW FOR MBA
BCG’S VALUE MANAGEMENT FRAMEWORK AN OVERVIEW FOR MBA STUDENTS By Rawley Thomas Director of Research The Boston Consulting Group 200 South Wacker Drive Chicago, Illinois 60606 312 -627 -2618 Thomas. Rawley@BCG. com P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 1 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 1 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
WHAT GETS MEASURED GETS DONE P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 2 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 2 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
Traditional Valuation Techniques Versus BCG’s Valuation Framework Traditional Valuation Techniques BCG’s Valuation Framework Forecast nominal cash flows by estimating P&L line items and changes to the balance sheet Translate accounting statements to gross cash flows and gross cash investments in constant dollars to produce cash on cash returns Estimate terminal value with a perpetuity of the forecasted last year’s net cash flow Determine cost of capital by weighting equity CAPM cost with debt cost Discount the cash flows and terminal value to present value with the weighted average cost of capital Translate cash on cash returns to economic performance measures (CFROIs) by adjusting for asset life and mix of depreciating versus nondepreciating assets Determine sustainable asset growth rates Observations on Missing Elements Fade CFROIs and asset growth rates toward corporate averages consistent with life cycle theory and empirical evidence to estimate future cash flows (replaces terminal valuation) No performance measure to determine if the business is achieving returns above or below the cost of capital or if the trend in those returns is up or down Estimate market derived real discount rate by equating the present value of the cash flows for a large aggregate to the sum of the prices of debt and equity No fade in performance to determine likely cash flows in a competitive environment Apply the market derived discount rate to the cash flows derived from fading economic performance to determine market valuation; subtract debt to determine equity valuation Discount rates determined by past price changes, not future likely cash flows No extensive empirical testing P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 3 March 2, 1998 2: 01 PM Test model values against actual stock prices for thousands of firms for 10 -40 years across many countries; refine, refine THE BOSTON CONSULTING GROUP - 3 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
MANY ASSETS FOLLOW THE SAME USEFUL OUTPUT PATTERN AS A CAR. . . Constant Dollar Level Annuity Likely Actual Output Decline with Straight Line Depreciation Economic Life P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 4 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 4 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
ISSUES WITH TRADITIONAL RETURN MEASURES Investment profile of a new plant $2, 000 $1, 557 Subsequent annual measurement Yr 1 Yr 6 Yr 12 Income 843 843 Depreciation 714 714 1, 557 Cash flow $12, 000 Cash invested 12, 000 IRR = 10% Book capital ROCE = Income/book capital ROGI = Cash flow/ cash invested CFROI = (Cash flow - economic depreciation(*))/cash invested 11, 286 7, 716 3, 432 ROCE (%) 7. 5 10. 9 24. 6 ROGI (%) 13 13 13 CFROI (%) 10 10 10 (*) Economic depreciation = amount of annual sinking-fund payment earning COC required to replace assets ($357 = {0. 1/[1. 114 - 1)](12, 000 - 2, 000)}) P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 5 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 5 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
VALUE-ADDED MEASURES REFLECT RETURN, COST OF CAPITAL AND SIZE Return on New Plant—Measured Over Time Yr 1 Yr 6 Yr 12 843 11, 286 7, 716 3, 432 Cost of capital(3) x 10% NOPAT(1) Investment profile of a new plant Book capital(2) 843 Capital charge(4) 1, 129 $2, 000 $1, 557 772 343 EVA(1 -4) (286) 71 500 Cash flow(6) 1, 557 Cash invested(7) 12, 000 $12, 000 IRR = 10% Cost of capital(8) x 10% Capital charge(9) 1, 200 Economic dep. (*)(10) 357 CVA(6 -9 -10) 0 357 0 0 (*) Economic depreciation = amount of annual sinking fund payment earning COC required to replace assets ($357 = {[0. 1/(1. 114 - 1)](12, 000 - 2, 000)}) P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 6 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 6 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 7 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 7 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 8 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 8 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
Note the averages & dispersions have risen between 1970 -1987, hypothesized to be related to supply-side policy changes Tracking the Sample of 1970 Companies through time P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 9 March 2, 1998 2: 01 PM Tracking the Sample of 1980 Companies through time THE BOSTON CONSULTING GROUP Tracking the Sample of 1987 Companies through time - 9 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
THE MARKET EXPECTS THE PERFORMANCE OF MERCK TO FADE. . . (REGRESS TOWARD MEAN PERFORMANCE) Fade = 0% Illustrates Perpetuity Trap: Overvalues High Return Firms Dramatically P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 10 March 2, 1998 2: 01 PM Fade = 10% THE BOSTON CONSULTING GROUP - 10 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
R 2=0. 13 N=750 R 2=0. 25 N=750 P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 11 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP R 2=0. 25 N=750 R 2=0. 40 N=750 - 11 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
On the 24 groups of 25 firms, Stewart claims a 44% R 2. This higher correlation relates to the elimination of 300 companies instead of 31 extreme outliers and the grouping of companies that serves to eliminate the intra-group variance. N=861 R 2=0. 27 R 2 = 0. 67 P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 12 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP R 2 = 0. 21 R 2 = 0. 10 - 12 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
APPROACH TO IMPLEMENTATION What Full Effort Might Look Like Module 1 Analytical diagnostic: “value audit” • Value analysis of company and business units • Identify priorities and issues Module 2 Measure selection and tailoring • Review options against applications • Tailor as required P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 13 March 2, 1998 2: 01 PM Module 3 Value Driver analysis of BU’s • Transfer approach to BUs • Link to operating decisions Module 4 Module 5 Module 6 Install in Apply to planning, compensation portfolio budgeting management & reporting • Reexamine processes and linkages • Provide training and documentation THE BOSTON CONSULTING GROUP • Structure • Measures • Targeting • Resource allocation • Portfolio balancing • External reporting - 13 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
COMPARISON OF COST OF CAPITAL MEASUREMENT METHODS CAPM Market Derived Assumes investor discount rate risk premiums did not change during the past measurement period. Therefore, future risk premiums equal past risk premiums. Assumes future cash flows can be estimated so that the discount rate equates the present value of those cash flows to the price. Bond Interest Rates P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 14 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP Dividend Discount Models BCG Market Derived Cost of Capital - 14 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
STUDIES USING MARKET DERIVED METHODS Blanchard, Oliver J. , “Movements in the Equity Premium”, Brookings Paper on Economic Activity, 2: 1993, pp. 75 -138. Corcoran, Patrick J. and Leonard G. Sahling, “The Cost of Capital: How High is It? ”, The Federal Reserve Bank of New York: Quarterly Review, Summer 1982, p. 23 -31. Farrell, James L. , “The Dividend Discount Model: A Primer, ” Financial Analysts Journal, 1985, v 41 (6), pp. 16 -19, 22 -25. Fuller, Russell J. , “Programming the Three-Phase Dividend Discount Model, ” Journal of Portfolio Management, 1979, v 5(4), 28 -32. Gordon, Myron J. and E. Shapiro, “Capital Equipment Analysis: The Required Return of Profit, ” Management Science, 3 pp. 102 -110 (October 1956). Holland, Daniel M. and Stewart C. Myers, “Trends in Corporate Profitability and Capital Costs” in Robert Lindsay, ed. The Nation’s Capital Needs: Three Studies, Committee for Economic Development, New York, pp. 103188. Rozeff, Michael S. , “The Three-Phase Dividend Discount Model the ROPE Model, ” Journal of Portfolio Management, 1990, v 16(2), pp. 36 -42. Williams, J. B. , Theory of Investment Value, Harvard University Press, Cambridge, Mass. , 1938. P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 15 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 15 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BCG/HOLT RESEARCH USING MARKET DERIVED METHODS by Rawley Thomas HOLT’s Discount Rate, April 25, 1986, 122 pages • Covers cash estimation, market derived methodology, tax premiums, leverage, comparison to other academic research, and CAPM New Electric Utility Discount Rate, September 6, 1987, 40 pages • Shows discount rates for utilities that are higher than industrials. Postulates government regulation and the risk of unanticipated inflation may cause the higher risk. Valuation Model Improvements, March 3, 1989, 5 pages • Covers leverage research New System Adjustments, May 3, 1989, 4 pages • Covers revised leverage adjustments Real Equity Rates, October 1, 1989, 21 pages • Updates cost of capital research on tax premiums and leverage Real Equity Discount Rates - Data, October 2, 1989, 23 pages • Displays IRS, Federal Reserve, and HOLT data underlying discount rate research 1950 -1988. Effect of Proposed Change on Stock Prices, October 3, 1989, 38 pages • Accounts for 200 point drop in market by analyzing effect of capital gains indexation versus lower capital gains tax rates Responses to Equity Discount Rate Research, November 2, 1989, 4 pages • Congressional response to HOLT research Another Response to Discount Rate Research, December 4, 1989, 10 pages • Department of Treasury response to HOLT research Volatility “Risk” Versus Inflation Risk, July 25, 1990, 11 pages • Compares CAPM volatility risk to inflation risk Investor’s Discount Rate for Oil Companies, March 22, 1991, 63 pages • P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 16 March 2, 1998 2: 01 PM Correlates oil industry market derived equity discount rates to government ownership and leverage THE BOSTON CONSULTING GROUP - 16 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
MARKET DERIVED DISCOUNT RATE Corporate Sector Cash Flows vary with the structural characteristics of an economy Price = Discounted Present Value of Expected Future Net Cash Flows S&P 400 DJIA 30 etc. Investors Discount Rate is volatile P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 17 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 17 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BCG’S METHOD FOR DERIVING INVESTOR DISCOUNT RATES (WACC’s) DIFFERS FROM TRADTIONAL CAPM METHODS. WE START WITH A SAMPLE AND A VALUATION MODEL TO DERIVE A WACC. THEN WE SPLIT THE WACC INTO ITS DEBT AND EQUITY COMPONENTS. FROM THE EQUITY RATE, WE CALCULATE THE RISK PREMIUM OVER GOVERNMENT BOND RATES. Caculate CFROI for Sample Determine Market Derived Investor Discount Rate (WACC) Sample of Companies Market Derived Real Equity Rate Market Derived Equity Risk Premium Calculate Growth rates for Country Economy Cost of Debt Employ Present Value Valuation Model Market Leverage Inflationary Expectations P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 18 March 2, 1998 2: 01 PM Government Bond Rates THE BOSTON CONSULTING GROUP - 18 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
CFROI’S CORRELATE HIGHLY WITH THE FUNDAMENTALS OF INFLATION, AND CORPORATE TAXES 1996 DISCOUNT RATE SAMPLE 11. 41 ‘ 97 Forecast R 2 = 0. 76 CFROI Actual 10. 85 ‘ 96 Actual “Best Fit Line” Fundamental CFROI = 14. 65 - 0. 438 * GDP Deflator Inflation - 0. 122 * Corporate Tax Rate t-Statistics: -9. 54 on GDP Deflator Inflation; -7. 00 on Corporate Tax Rate Correlation between Inflation and Tax Rates: 0. 00% P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 19 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 19 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
TO SMOOTH ECONOMIC CYCLES, BUT INCORPORATE STRUCTURAL SHIFTS, BCG’S VALUATION MODEL ASSUMES CURRENT CFROI LEVELS FADE TOWARD THE 5 -YEAR PAST MEDIAN OF THE DISCOUNT RATE SAMPLE AT A 10% RATE Annual CFROI’s 5 -Year Past Median CFROI’s P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 20 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 20 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BCG’S VALUATION MODEL ANTICIPATES THAT THE GROSS ASSET GROWTH RATE OF ALL COMPANIES IN THE USA FADE TOWARD THE LONG TERM ECONOMY AVERAGE Annual GDP Growth Rates 3. 2 % Compounded Annual Growth Rate in GDP from 19501996 Unlike CFROI’s, where clear trends are evident, there does not appear to be a clear trend in growth rates for the economy. Consequently, a long term average smooths out the annual fluctuations with no loss in investor anticipated trend. P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 21 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 21 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
THE INVESTORS’ DISCOUNT RATE IS THAT RATE WHICH EQUATES THE PRESENT VALUE OF CASH FLOWS FROM BCG’S VALUATION MODEL TO THE MARKET VALUE OF DEBT AND EQUITY $1, 903 Billion of Assets Returning 11. 1% and Growing at 3. 2% per year Fading @ 10% toward 10. 8% CFROI Market Value of Debt and Equity of S&P 400 Sample $3, 474 Billion Price = Discounted Present Value of Expected Future Net Cash Flows Solve for the Rate at Which Present Value of Cash Flows Equals Price September = 5. 77% (Weighted Averaged Real After-Corporate-Tax Cost of Capital) P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 22 March 2, 1998 2: 01 PM Answer tells us what the Market is presently requiring as a Rate of Return THE BOSTON CONSULTING GROUP - 22 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
CALCULATION OF FUTURE CASH FLOWS AND PRESENT VALUES 1996 DISCOUNT RATE SAMPLE P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 23 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 23 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 24 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 24 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
PAST RESOURCES COMMITTED 1996 DISCOUNT RATE SAMPLE P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 25 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 25 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
CALCULATION OF ASSET ADDITIONS 1996 DISCOUNT RATE SAMPLE P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 26 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 26 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 27 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 27 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 28 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 28 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BCG DECOMPOSES THE WEIGHTED AVERAGE REAL COSTS OF CAPITAL INTO THEIR DEBT AND EQUITY COMPONENTS USING MARKET WEIGHTS Real Equity Rate 6. 53 5. 77 Real Weighted Average 1. 76 Real Debt Rate After Corporate Tax P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 29 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 29 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
MARKET % DEBT/TOTAL CAPITAL HAS DECLINED SIGNIFICANTLY SINCE 1990 15. 9 Variations in Market Leverage and Investor Tax Premiums Help to Explain Market Derived Real Equity Discount Rates See Next Slide. . . P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 30 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 30 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
Real Equity Discount Rates Decompose into the Fundamentals of Tax Premiums, Leverage Risk Premiums, CFROI’s & Sub-Par Returns USA - 1950 -1997 Fundamental Equity Discount Rate =-3. 36+Div. Tax. Prem+Cap. Gain. Tax. Prem +0. 207*Debt/Total Capital +0. 408* CFROI -1972/78 Sub-Par Returns R 2 = 0. 91 Market Derived Real Equity Discount Rate CFROI Effects Leverage Risk Premiums Capital Gains Tax Premiums Discount Rates Based on 1996 Discount Rate Sample of 279 S&P Industrials Dividend Tax Premiums P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 31 March 2, 1998 2: 01 PM 1972/78 Sub-Par Returns; May Represent a Proxy for Other Effects THE BOSTON CONSULTING GROUP - 31 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
CFROI’S NORMALLY EXCEED THE MARKET DERIVED DISCOUNT RATES 1996 DISCOUNT RATE SAMPLE CFROI’s Market Derived Discount Rates Differences Politics/Policies Change P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 32 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 32 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
CFROI’S NORMALLY EXCEED THE MARKET DERIVED DISCOUNT RATES Even though many economists believe that all returns must converge, in a healthy capitalist economy, CFROI’s on hard assets will exceed investor required returns on financial assets most of the time, because: • Continuous new entrepreneurial innovations prevent CFROI’s from converging completely to promised financial returns (imperfect arbitrage) and • Entrepreneurs must be rewarded with greater returns to assume the greater dispersion and higher risk of loss associated with CFROI’s on illiquid hard assets compared to financial returns on marketable, liquid financial assets P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 33 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 33 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BCG CALCULATES INFLATIONARY EXPECTATIONS BY SUBTRACTING TAX PREMIUMS AND A BASE RATE FROM LONG TERM GOVERNMENT BOND YIELDS USA - 1950 -1997 Producer Price Index % Change Inflationary Expectations based on 0 -2. 6 base rates follow actual inflation more closely, but avoid the sharp volatility of actual PPI and GNP/GDP annual inflation. Inflationary Expectations 0. 0% Base Rate 1950 -1980 2. 6% Base Rate 1981 -1996 GNP/GDP Deflator % Change 2. 48 P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 34 March 2, 1998 2: 01 PM Note: the base rate is defined as the after-investor tax, after inflation required return on Government long term bonds. THE BOSTON CONSULTING GROUP - 34 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
MARKET DERIVED NOMINAL EQUITY RATES COME FROM MARKET DERIVED REAL EQUITY RATES PLUS THE COMPOUNDED EFFECT OF INFLATIONARY EXPECTATIONS Market Derived Nominal Equity Rate 9. 17 6. 53 Market Derived Real Equity Rate Inflationary Expectations P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 35 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP 2. 48 - 35 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
THE EQUITY RISK PREMIUM HAS DECLINED TO THE 2 -3% RANGE Market Derived Nominal Equity Rate Nominal Long Term Government Bond Rate 2. 66 Risk Premium Differences P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 36 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 36 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
RISK CONCEPTS AND MEASUREMENT CAPM Market Derived Investors seek to avoid price volatility relative to the market. Arbitrage Pricing Theory (APT) postulates other risk factors: Interest Rates Oil Prices Price/Equity Book Size P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 37 March 2, 1998 2: 01 PM Investors seek to avoid losses from unanticipated major events. Major Events Bankruptcy (Leverage) Unanticipated Inflation Government Intervention Government Ownership Voting Rights on Key Changes Asset Age THE BOSTON CONSULTING GROUP - 37 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
NAIVE BELIEFS INCORRECTLY ASSUME COSTS OF DEBT AND EQUITY DO NOT VARY WITH CAPITAL STRUCTURE. . . Cost of Equity Note: NOT Based on Valid Theory or Empirical Evidence Weighted Average Cost of Capital After-Corporate-Tax Cost of Debt, After-Corporate-Tax P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 38 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 38 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BCG EMPIRICAL WORK CONFIRMS INCREASING REAL COSTS OF DEBT AND EQUITY, ACCORDING TO TRADITIONAL THEORY To our knowledge, no one has published empirical results like these because of the significant inaccuracies in the traditional estimation procedures typically used. BCG eliminates much of these inaccuracies through our fading CFROI valuation model. Even with these inaccuracies eliminated, these cost of capital curves are probably not accurate enough for precise optimum capital structure work on individual firms. This is due to remaining noise in the data and no size, entrenchment, and asset restructuring functions built into our current valuation model. However, these empirical results can be employed to avoid the misperception that costs of equity and total capital do not change significantly with changes in leverage. Equity 6. 03+35. 14(D/C) 2. 42 Rawley Thomas - Director of Research Weighted Average Debt After-Tax 2. 38+2. 69(D/C) 1. 86 Source: BCG Database and Empirical Research on 63 Value Line Industries - 1995 P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 39 March 2, 1998 2: 01 PM Line of best fit based on minimizing absolute deviations of a power curve (to reduce influence of outliers) and constrained to pass through results for Sample F THE BOSTON CONSULTING GROUP - 39 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
PRELIMINARY HOLT DISCOUNT RATE RESEARCH MARKET DERIVED REAL COST OF EQUITY CORRELATION COEFFICIENTS 1990, 220 Companies, 15% Fade of Cash Flows to Corporate Average Plant age and life (inflation adjustment factor) Plant life Dividend yield Size (LN-current dollar gross investment) Debt/total capital at market Industry risk (government intervention? ) Note the small correlation with Beta. This small 1% R 2 with Beta suggests reevaluation of traditional risk concepts. Company Beta (value line) Unlevered Beta Note: Random sample of 220 nonfinancial industrial companies, drawn from over 6, 000 P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 40 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 40 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
BOTH CFROI AND TSR FOLLOW STABLE PARETIAN DISTRIBUTIONS WITH INFINITE VARIANCES AND SIMILAR PEAKEDNESS. . . Number of Firms Peakedness =1. 49 12. 1 standard errors away from 2 (Gaussian) Investor pressures force returns up P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 41 March 2, 1998 2: 01 PM Competitive pressures force returns down THE BOSTON CONSULTING GROUP KEY CONCLUSIONS The distributions here are 8. 8 to 12. 1 standard errors away from Gaussian Normal. For these distributions, variance does not exist. Variance is infinite. Therefore, traditional CAPM measures of risk do not exist. These results suggest risk theory should be revised to reflect actual distributions and the possibility that investors seek to avoid the risk of loss in the fat tails of the distributions, not dispersion risk. Peakedness =1. 45 8. 8 standard errors away from 2 (Gaussian) - 41 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
CONFLICTING PERFORMANCE SIGNALS CAN CAUSE PROBLEMS Most managements use IRR or NPV for new projects and plans Most managements use accounting ratios (ROE, ROCE, RONA) or earnings growth for existing businesses The two types of measures are fundamentally inconsistent and can lead to poor management decisions For consistency and economic validity, use a measure like total shareholder return to evaluate project and overall company performance P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 42 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 42 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
FOCUS ON CFROI REMOVED REINVESTMENT BIAS, ENCOURAGED ECONOMIC BEHAVIOR AND INCREASED VALUE Campbell Soup Co. Percentage ROCE CFROI TSR/index P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 43 March 2, 1998 2: 01 PM 100 83 86 Year 127 135 151 167 158 227 239 269 252 THE BOSTON CONSULTING GROUP - 43 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
AGING PLANT TRAP Percentage per year Nominal RONA hurdle rate Forecast RONA Real discount rate Forecast CFROI Year P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 44 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 44 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
NEW PLANT TRAP Percentage per year Old plant New plant RONA CFROI Nominal RONA hurdle rate Real discount rate Year P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 45 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 45 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
INTANGIBLE TRAP Percentage per year Before RON A After purchase CFROI (pooling accounting) Nominal hurdle rate Real discount rate Year P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 46 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 46 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
ACCOUNTING RETURN MEASURES PROVIDE MISLEADING SIGNALS Business Unit RONA and CFROI Vs. Hurdle Rates Percentage per year Fortune 100 manufacturer • • Old assets Inflation Leases Low depreciation • • New assets Goodwill High depreciation Deferred taxes Nominal RONA hurdle rate Real CFROI hurdle rate Business unit P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 47 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 47 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
ESTIMATING THE PAST CAPITAL EXPENDITURE REAL GROWTH RATE FROM LIFE, ACCUMULATED DEPRECIATION, AND INFLATION P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 48 March 2, 1998 2: 01 PM THE BOSTON CONSULTING GROUP - 48 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
DERIVATION OF THE RELATIONSHIP OF THE CAPITAL EXPENDITURE REAL GROWTH RATE (g) TO THE RATIO OF ACCUMULATED DEPRECIATION TO GROSS PLANT Numerical iterative techniques employing the Newton-Raphson Method and calculus can solve this formula for g. Assumptions: P: Master. Dk BCG’s Value Management Framework An Overview for MBA Students. PPT Rt rt (Ppt) Slide 49 March 2, 1998 2: 01 PM (1) Depreciation begins the year the firm places the asset in service (2) The plant retires the year after the project Life year THE BOSTON CONSULTING GROUP - 49 Copyright 1996 BCG/HOLT Planning Associates All Rights Reserved
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