International Business and Management Antonio Majocchi antonio majocchiunipv

International Business and Management Antonio Majocchi antonio. majocchi@unipv. it Associate Professor in international business

Teaching Faculty q Roger Strange, Professor of international business, Sussex University (18 hours) q David Needle of Professor of management, King's College London (4 hours) q A business case will be discuss under the supervision of an external business consultant (Dr. Ucci from Oliver Wyman) q Attendance even if not compulsory is highly recommended Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Assessment q The course will be assessed by a final exam and assignments q The final exam will cover mainly theoretical arguments of the course and will count 50% of the final mark (this year the exam will be realised in 2 parts) q The assignment is a group projects that count for 40% of the final mark q The class discussion of the business case (compulsory) will count for the remaining 10% Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Class assignment q The goal of the class assignment is to present the international strategy of a MNCs q Group should be formed by no more then 3 students q A lecture (18 of March? ) will be devoted to discuss and present the main criteria to be followed in the presentation (sources, aim of the presentation, methodology etc. ) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Assignment q The assignment should be completed for the end of the course and presented discussed in the last week of the lecturing period (exact dates to be defined) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Reading materials q There is no single recommended text. Readings will be assigned to students at every group of thematic lectures q The reference book for Professor Strange's seminars is: § Bartlett, C. A. , Ghoshal, S. and Beamish, P. W. (2008). Transnational management: text, cases, and readings in cross-border management. London: Mc. Graw-Hill (available in the faculty library) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Course brief Contents: part I q Market selection and Market Entry q What is “globalisation”: data and trends q The Strategy and Structure of MNCs q Control in MNCs § The balance scorecard § EVA principles and application Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Course brief Contents: part II q Financial management in MNCs § International pricing policy § foreign exchange risk § foreign exchange management q Market forecast § Methodology to forecast market potential § Elasticity and pricing Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

To sum up Antonio Majocchi Lectures Written exam (25%). To be held in the planned exam dates Group Assignments Group presentation (31 st May, 1 st June) (40%) Business case 15 March (tentative date) (10%) Roger Strange Written exam (25%). 27 th May Final Mark q if either the Business case or the Group assignment are missed then the student will have to sustain the full exam based on the Bartlett, Ghoshal, and Beamish (2008) book Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Market selection and market entry Compulsory Readings: § Ghauri & Cateora, International marketing, Mc Graw Hill (2° ed), Chapter 7 and Chapter 11 (530 781)

Barriers to international business 1. Tariffs 2. Non Tariff Barriers 1. Specific limitations on trade (Quotas, local content requirements. . ) 2. Customs and administrative entry procedures 3. Standards 4. Government participation in trade 3. Risk (political and economic risk) 4. Knowledge (business, market, consumers, cultural…. ) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Political Risk q The likelihood that a government or society will undergo political changes that negatively affect local business activity q Political risk arises from a variety of sources: § Corrupt or political leadership § An unstable political system § Conflict between races, religions, or ethnic groups § Economic problems Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Examples of political risk q Confiscation (take a piece of equipment ) q Expropriation (take the whole company ) q Nationalization (all the companies in a business sector) q Political sanctions q Violence q Political reprisals q Corruption… Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Economic Risk q Any economic events that negatively affect local business activity q As usual economic risk is measured with the volatility of economic variables q Political and Economic risk define overall “country risk” Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

ICRG Rating Systemof country risk An The assesment Financial Political % Loan default or unnfavourable loan Economic expectations versus reality 6% restructuring Economic planning failures 6% Delayed payment of suppliers’ credits Political leadership 6% Repudiation of contracts by government External conflict 5% Losses from exchange controls Corruption in government 3% Expropriation of private investments Military in politics 3% Total Financial Points Organized religion in politics 3% Law and order tradition 3% Economic 3% Racial and nationality tensions Inflation Political terrorism 3% Debt service as a % of exports of goods and services Civil war 3% International liquidity ratios Political party development 3% Foreign trade collection experience Quality of bureaucracy 3% Current account balance as % of goods and services Total Political Points 50% Parallel foreign exchange rate market indicators Total Economic Points Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 5% 5% 5% 25% 5% 5% 3% 3% 8% 3% 25 %

Country risk agency q http: //www. prsgroup. com/ Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 16

www. aon. com/ Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 17

Factors Influencing Market Entry Strategy International environment: • economic • cultural • legal • Firm’s overall strategy Global market opportunity assessment: • country screening • industry potential • • company sales potential • Entry strategy choices: • export • licensing • joint ventures • • manufactures • Market entry planning Positioning Product adaptation Pricing Channel selection Customer service Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Market selection q The market selection process depends on the kind of investment § § resource seeking market seeking efficiency seeking strategic assets seeking Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Market choice Economic factors Resources Market choice Firms’ costs Infrastructure Cultural factors Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 20

Resources (example) HUMAN CAPITAL SCHOOL-LEAVING EXAMINATION + GRADUATED JOB FORCE STRUCTURES FOR INSTRUCTION PER CAPITAL INCOME ROSOURCE ASSETS MARKET SIZE GDP GROWTH TOTAL POPULATION Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 21

Resources (example) BANKING PRODUCTION RESOURCES BUSINESS COSTS Agglomeration of FF Industrial districts Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 22

Infrastructure ICT TELEMATICS AIR TRANPORT FREIGHT INFRASTRUCTURE BASIC INFRASTRUCTURE ELECTRICITY TRANSMISSION AND DISTRIBUTION LOSSES ROADS NETWORK RAILWAY FREIGHT Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 23

Alternative. Market. Entry. Strategies Alternative q Exporting q Licensing q Low risk. . . low control q Franchising q Joint ventures q Foreign Direct Investments q High risk. . . high control Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 24

Entry Mode Financial Capital 0% 100% Control/flexibility Control Licensing Franchising Minority holdings JV Flexibility Export Agreements Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 FDI

FDI q There are 2 different kind of FDI § Greenfield investments § Mergers & Acquisition (M&A) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Data and trends q FDI general trends Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Source: www. unctad. org Regional trends Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

M&A activity Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 Source: www. unctad. org

Newcomers Source: www. unctad. org Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Strategy and Structure Compulsory Readings: § Bartlett, Goshal and Beamish, (2008), (510 2368), • Chapter 1; (pp. 1 - 13) • Chapter 3; (pp. 197 – 209) • Reading 3 -2, G. S. Yip, Global strategy…in a world of Nations? (pp. 291 – 304) • Chapter 4; (p. 333 - 349) and Case 4 - 1 (p. 350 – 365) • Chapter 7 (p. 648 – 660)

Organizational Designs q Types of structures used by companies to manage foreign activities: Little/No Formal Organization International Division Global Organizations Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

No formal organisation q Domestic operations assume responsibility for international activities in the early stages q The organizational structure reflects the increased demands from the international marketplace q The export department structure becomes obsolete as the firm becomes more involved in foreign markets Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

International division q Centralizes in one entity all of the responsibility for international activities q Best serve firms with few products that do not vary significantly Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Degree of product diversification The Stopford & Wells Model Product Division Int division Grid/Matrix structure Improved cost efficiency is a major benefit Follows the marketing concept most closely Area Divisions Foreign sales/Total sales Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The international division Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

International strategies Local Adaptation Standardization low high low Global high Transnation al Multidomestic Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 37

Strategy implementation q Multidomestic (Decentralized) systems have loose and simple controls. Subsidiary operates as a profit center q Global (Centralized) systems have tight controls. Strategic decision making is at headquarters. q Transnational (Coordinated decentralization) calls for overall strategy to come from headquarters q Subsidiaries are free to implement within agreed upon range Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

A typical area division q Telefónica has a regional structure q The different operations of the Telefónica Group in 25 countries are organised into three geographical regions: Spain, Latin America and Europe. q The Corporate Centre is in charge of global strategy and corporate policies, Telefónica O 2 UK, Argentina, Brazil, Chile, Colombia, Telefónica O 2 Germany, management of common activities and Ecuador, El Salvador, United States, Telefónica O 2 Ireland, Guatemala, Mexico, Nicaragua, Telefónica O 2 Czech Republic coordination of the activity of business Panama, Peru, Puerto Rico, Uruguay Telefónica O 2 Slovakia and Venezuela units. Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

A global company Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Multidomestic q Subsidiaries are managed as a portfolio of international assets q Coordination is very limited q Control is mainly financial q Subsidiaries have an high level of autonomy and are focused on localisation issues Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Global q All value added activities are concentrated in the MNCs headquarter q There is no adaptation and the world market is considered as an homogeneous market q The role of subsidiaries is very limited Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The transnational model q geographic dispersion q economies of scale q interdependence: intense relationships among units characterised by an high of cooperation and competition (both horizontal and vertical) q formal and informal methods of control q diversified role for the subsidiaries Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The complexity of the model Source: Bartlett & Goshal, 1987 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The new role of subisdiaries Relevance of the local market Subsidiary Competences low Country organization CONTRIBUTOR high with a distinctive competence Most entities hold this role. It provides EXECUTOR low critical mass high A competent national subsidiary that may be STRATEGIC serving as a partner in developing and LEADER implementing strategy The international company has a low BLACK HOLE competence country organization, or none at all Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 45

The transnational model q The model try to avoid problems of effort duplication and inefficiency q Subsidiaries are able to make local business development decisions within the global framework q Subsidiaries can take a leading role with regard to specific functions/business or areas Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Control in transnationals q Control evolves in transational corporation and became a very complex function q i. e. R&D not only has short-term objectives (product development) but also medium and long term ones (patents/research projects) q Even aspects which cannot be expressed strictly in quantitative terms are considered Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Strategic Control in MNCs Compulsory Readings: § The balanced scorecard. Measures that drive Performance, Kaplan R. S. & Norton D. P. 1992 Harvard Business Review, Jan/Feb, pp. 71 -79 § Putting the balanced scorecard to work, Kaplan R. S. & Norton D. P. 1993 Harvard Business Review, Sept/Oct, p. 71 -79 § Balanced scorecard for multinationals, S. P. Landry, W. Y. Canri Chan, T. Jalbert, Journal of Corporate Accounting & Finance, 2002, 13(6), p. 31 -40

Control q Control refers to the general function of overseeing business unit performance q Typically the corporate development function oversees strategy and the controllers (financial function) budget and measure short-term financial performance Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Control q Different categories of control Personal/Cultural Direct/ explicit Indirect/ implicit Impersonal/Burocratic Personal centralised control Burocratic formalised control Control by Socialisation and Network Output Control Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Socialisation and Network q It combines a lot of relatively diverse mechanisms. § Socialisation – instrument to ensure that employees share organisational values and goals § Informal, lateral exchange of information – mutual adjustment, informal communication § Formalised cross-departmental relations – temporarily formalised devices such as task forces, cross-functional teams… Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Performance measurement q The organisation’s measurement system strongly affects the behaviours of managers and employees q However, as the experience of Multidomestic firms showed, relying only on financial performance measurements is a too limited approach Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Balanced Scorecard (BSC) q “The BSC is a strategic planning and management system that is used to align business activities to the strategy of the organization, improve internal and external communications, and monitor organization performance against strategic goals”* q The BSC includes financial measures but also operational measures on customer satisfaction, internal processes and the firm’s innovation activities * Kaplan & Norton, 1996 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

BSC and strategy q The BSC is not just a list of performance indicators but provides executives with a comprehensive framework that translate company’s vision and strategy into a coherent set of performance measures q Therefore, managers should first define the company’s goal and then define the measurement and the goals Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Strategy process q Given the firm’s strategy for each perspectives firm defines Goals § Measures § Targets § Actions § Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

BSC the implementation q BSC Metrics allow the managers to know how well their business is running § The financial perspective indicates whether or not the firm’s strategy and implementation is contributing to bottom-line improvement § In the customer perspective managers define the segments in which the business units will compete § In the internal perspective executives identify the internal process in which the firm must excel § The learning and growth process identify the processes that the organisation must develop to create long-term growth and improvement Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Strategy process Mission Strategy 4 perspectives Goals Actions Measures (KPI) Measures Goals Actions Measures Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Strategy process q “A scorecard makes sense primarily for business unites and divisions with a well defined strategy” q A corporate-level scorecard can be defined only after a BSC has been defined at a business level q This explain the difficulties in implementing BSC for MNCs and multibusiness firm Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Goals & measures: examples q The customer perspective goal: time to market lead time (existing products) § time to market (new products) § on-time delivery § …… § q The internal business perspective goal: cost saving production time § safety § defect rate § Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Goals & measures: examples q Innovation and learning perspective goal: tech leadership Employee turnover § Job satisfaction § Training/Learning opportunities § q The financial perspective goal: profitability ROE § Shareholders value § Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

How to choose the goals for each perspective q Building a balanced scorecard should encourage managers to define the objectives according to corporate strategy q By this point of view the objectives of the 4 perspectives should be part of a coherent framework Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Financial perspective q Financial goals could differ considerably at each stage of a business’s life cycle q Let’s just consider three stages: § Growth § Sustain § Harvest Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Financial perspective q The growth stage is generally a cash burning phase § Growth rate in sales § Number of new market segments § % of sales from new products introduced within a specific period q The sustain stage is the most common stage and typical profitability measure are used § Operating income (Ebit) § Return on capital employed Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Financial perspective q The harvest phase is the mature stage when firms try to harvest the investments made in the two previous phases q The goal is typically to maximize cash flow back to the corporation § Operating cash flow § Reduction in working capital requirements § Cash-to-cash cycle Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Example: Cash-to-cash cycle q It is the sum of days cost-of-sales in inventory + days sales in account receivables less days purchases in accounts payables Raw materials from suppliers Sell product/services Days inventories Days payables Pay suppliers Days Receivables Cash to cash cycle Collect cash Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Cash-to-cash cycle q The case of a construction company q Cash-to-cash= 89 days Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Customer perspective q The customer perspective of the BSC is aimed at identifying the customer and the market segment in which they have to compete q The core measurement group includes measures of § § § Satisfaction Market share Retention Acquisition Profitability… Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Customer perspective Market share Is the proportion in a given market in terms of sales, customers, unit volume that a business sells Acquisition Measures, in absolute and relative terms, the rate at which a business unit attracts or win new customers or business Retention Tracks, in absolute and relative terms, the rate at which a business unit retains ongoing relationships with customers Satisfaction Assesses the satisfaction level of customers along specific performance criteria Profitability Measures the net profit of a customers after allowing for the unique expenses required to support the customers Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Customer profitability q In order to have measure of customer profitability firms should have implemented an activity-based cost system q Not all clients’ demand can be satisfied in ways that are profitable to an organisation Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The internal business perspective q For the internal business perspective managers identify the process that are most critical for achieving customers and shareholders objectives q Typically firms concentrate on things such as quality, time, productivity Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The internal business perspective q The BSC framework identify three main business processes: § Innovation § Operations § After-sales services Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Innovation q Measures for basic and applied research § % of sales from new products § % of sales from proprietary products § New product introduction vs competitors or vs plan § Time to develop next generation products § Productivity measure Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Operations q Operations start with receipt of a customer order and finish with the delivery q Typical measures are: § § Standard costs Machine efficiency Operating processes’ quality Cycle time Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Post sales q Measures: § Cycle times from customers requests to resolutions of the problems § Costs of after-sales services § Dispute resolution time Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Learning & growth perspective q This perspective develop objectives and measures to drive organisational learning and growth q The previous three perspectives identify where the organisation must excel to achieve breakthrough performance q Forward looking investments are generally treated as period expenses so that cutbacks in these investments are an easy way to produce incremental short-term earnings Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Learning & growth q The BSC identify 3 main categories for this perspective: § Employee capabilities § Information system capabilities § Motivation, empowerment and alignment Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Employee capabilities q Core employee measurement group are: § Employee satisfaction (typically through survey) § Employee retention (key staff turnover measurement) § Employee productivity (ranging from simple measures such as revenue per employee to value-added per employee Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Information system capabilities q The information system is nowday a critical resource q It not only interlink all the activities of the firm worldwide q It supply also rapid, timely and accurate information and feedback on the product just made or the services just delivered Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Motivation empowerment q Measures of motivation § Suggestions made and Suggestions implemented § Implementing a reward structure for implemented suggestions q Measures of improvements § § Late deliveries Number of defects Scraps absenteeism Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Alignment q Alignment focus on whether or not units and individuals have their objectives aligned with the company goals (as articulated in the BSC) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Alignment q In the implementation process a typical initial measure is the percentage of top managers exposed to BSC then the same ratio considering all the staff employees q At a later stage it is considered the degree of accomplishment of the BSC goals introducing incentives to achieving these targets q Incentive can be referred to single employees (pay raise) or to subunit and division (resources, autonomy) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

A tentative strategy map Objective Financial KPI q share value Saherholder value Customer q EVA Targets q share Retention & Satisfaction Premium price Internal Improve service & contact time Learning retention q av. Time < 5 days after 1° contact q % workforce Sales force empowerment comp price stockholders q % trained q Loyalty clients program q targeted sales force q > 90% q Continuos q < 5% of q workforce q standardis. increase larger product program benchmark q positive EVA discrimination q premium p on q > 10% vs competition q complaints Actions q > 90% learning program q Contact centre q % workforce q Stock stockholders ownership plan q training Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

BSC web-service solutions q The BSC is now implemented through web services applications q At http: //www. bscdesigner. com/download you can find a freeware version (BSC Designer Light) of one - among the thousands – available applications Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

A practical example q Tata Tea started building EVA as a key performance indicator in the balanced scorecards, so that the performancemanagement system centres around EVA Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Economic value added (EVA®) Compulsory Readings: § Journal of Applied Corporate Finance • EVA Momentum: The One Ratio That Tells the Whole Story G. Bennett Stewart III, 21(2), pp. 74 -86, (Spring 2009); • How To Fix Accounting—measure And Report Economic Profit, G. Bennett Stewart III, 15 (3), pp. 63 -82 (Spring 2003); • The Eva Revolution, Al Ehrbar, G. Bennett Stewart III, 12 (2), pp 18 – 31, (Summer 1999); • (SUGGESTED) Specific Knowledge and Divisional Performance Measurement, M. C. Jensen, W. H. Meckling, pp. 49 -57, 21(2), (Spring 2009)

Shortcomings of accounting numbers q The classical ratios considered for businesses control such as EPS, ROI or ROE have a series of limitation as standards for measuring business performance q Standard earning numbers are sensitive to accounting methods, do not measure proper cash inflow and ignore the “time value of money” Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Cash flow estimation q Cash flow from operation (CFFO) may be calculated as follows: CFFO = sales-op expenses - tax + Depreciation (& other noncash items) – incremental working capital investments – Capital expenditures Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Incremental Working Cap q Any increments in Net working capital is a cash absorption activity NWC increase = + increase in receivables + increase in inventories - increase in payables - increase in deferred taxes Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

EPS q A Subsidiary is planning a new investments of € 15 M which will generate a 10% increase of sales q Consider that: § Subsidiary has no debt § the cost of equity is 12% § The business is a mature business and the profit could be consider a perpetuity q Remember that the present value of a perpetuity is: Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

EPS q Even if earnings increase the equity value of the investment does not change q EPS fails to measure changes in economics value Sub A with no debt Sub A + 10% Sales € 200 € 220 Op expenses € 170 € 187 Earnings before tax = € 30 = € 33 Income tax (0. 4%) € 12 € 13. 20 Earnings € 18 € 19. 80 Equity value (CF/Co. E) 18/0. 12=150 19. 8/0. 12 -15=150 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Roi q Roi & Roe are popular financial performance indicators. Roi is a frequently used measure of division’s performance q Roi remains a good indicator of business profitability but still is an accrual accounting return and not a full economic measure q This is true even when Roi is compared to an hurdle rate that generally equals the business unit cost of capital Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

ROI q Roi is computed by a wide variety of methods q This is one: EBIT Net Book value of FA + Net Working Capital q In this case the “tax shield” effect is not considered Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

ROI q Moreover, both the numerator and the denominator are affected by arbitrary accounting assumptions q The recent drive towards “fair value” accounting has mitigated the problem q Nonetheless, operating income (EBIT) is not the CF generated by the business Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

ROI q Roi depends on capitalisation and depreciation policies that are strictly accounting decisions q For example, R&D expenses are customarily expensed in the current period and not considered as an investment (thus increasing the Roi rate) q Thus, using Roi to compare R&D intensive and not intensive business can be highly misleading Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

ROI q Overall Roi has 3 main additional shortcomings: § It depends on the investments base of the business unit considered (the larger the investment base the lower the accounting return) § Aggressive strategies (R&D spending, new investments…) typically lower Roi while harvesting strategies increase Roi § Does not take in account the overall risk (i. e the cost of capital) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

ROE q Roe is the ratio of net profit on total shareholder capital q Roe is seldom used at the divisional level where debt is rarely allocated but is more widely used at the corporate level q Roe has all the shortcomings of Roi but in addition it is sensitive to leverage q Roe increases as more then optimal debt is issued Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Time value of money q Earning calculations ignore the time value of money i. e. the risk free rate, the cost of risk compensation and the expected rate of inflation q This is not the case with NPV calculation (CF= cash flow; r=interest rate) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The risk/return relationship Expected return Risk free rate (Rf) Return Risk Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

EVA® q EVA (Economic Value added) is a methodology aimed at measuring shareholder value creation q EVA is increasingly becoming the global standard for measuring business performance q Shareholder value is created only if a business earns a rate of return on investments greater than the rate investors can expect to earn by investing in alternative, equally risky, securities Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

EVA® q Eva take in account both the real cash flow generated by the business divisions and the overall risk of the business q By this point of view Eva is an “economic” profit measure as opposed to the typical accounting measures q Eva can be calculated for any entity including divisions departments, products lines… Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Eva balance sheet Regular Balance Sheet Cash Short term Debt EVA Balance Sheet Cash Short term Debt NWC Short term Receivables Not Interest+ Inventories + Prepayments bearing liabilities Long term Debt Fixed Assets SH Equity Net Assets Invested Capital Nopat Wacc Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The EVA® approach Eva = NOPAT – (WACC Invested Capital) Net operating profit after tax Weighted average cost of capital Net Fixed asset + net working capital Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The EVA® q The return on net assets is defined as the ratio of Nopat on Net Assets (RONA) q Eva will be positive if : RONA>WACC q Eva can be also be expressed as: Eva=(RONA-WACC) Invested Capital Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

NOPAT q Nopat is the firm’s profit assuming that the firm has no debt q The term “net” means that Nopat is net of amortization (which is a real economic cost) q The idea is that Nopat captures the profit that accrue to all capital holders (both lenders and shareholders) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

NOPAT adjustments q The main adjustment is the reclassification of some expenses as investments (typically R&D) and the subtraction of provision and extraordinary expenses i. e. all non-monetary costs such as provisions (except amortization!) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

NOPAT q Nopat is equal to: Ebit (adjusted)-corporate taxes (without debt)= or more precisely profit(adjusted)+interest expenditures(1 -t) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Nopat: the formulas Ebit (+) 100 Option 1 Interest cost (-) 20 Ebit (+) 100 PTP (=) 80 Interest cost (-) == Tax rate = 50% 40 Tax rate = 50% 50 Profit 40 Nopat 50 Option 2: Profit + IC(1 -t) Option 3: Ebit (1 -t) Profit (+) 40 Interest cost (1 -t) (+) 10 Ebit (+) 100 Nopat 50 (1 -t) (-) 50% Nopat 50 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Income statement (basic) Sales (+) 100 Costs of Goods and Services (-) 20 Labour Costs (-) 10 Earnings before Interests, Taxes & D&A - EBITDA (=) 70 Depreciation & Amortization - D&A (-) 20 Interest costs (-) 10 Pre-tax profit (t=40%) PTP (=) 16 Profit 40 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Adjusted Profit q In order to estimate the adjusted profit exceptional costs (i. e. integration costs) should be deducted and R&D costs should be amortised according to the amortisation period considered Profit 40 Integration costs (+) 5 Research cost capitalised 50 n. of years of capitalisation of R&D costs 10 years Costs to be added and deducted +50 and + 5 Adjusted Profit Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 90

Nopat q Nopat is not affected by the firm’s capital structure choices Unlevered firm (1) levered firm (2) Invested capital 10, 000 Equity 10, 000 5, 000 2, 000 Debt 0 5, 000 8, 000 Sales 16, 667 Cogs 13, 000 Depreciation 2, 000 EBIT 1, 667 Interests (i=5%) 0 250 400 Pre-tax Profit 1, 667 1, 417 1, 267 Tax (0. 4 tax rate) 667 507 Net Profit 1, 000 850 760 Nopat=NP+Int*(1 -t) 1, 000 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

EVA BS at the divisional level q When Eva is measured at the divisional levels, cash is typically excluded from invested capital (cash is typically managed centrally) EVA Balance Sheet Cash Short term Debt EVA BS at the Divisional Level NWC Long term Debt Fixed Assets ST debt Long term Debt Fixed Assets SH Equity Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The Cost of capital q The cost of capital is the rate of return a capital provider would expect to receive if the capital were invested in a project/division of comparable risk q Therefore, the cost of capital is an opportunity cost q Since risk is a crucial element investors require higher returns from equity capital than they do from debt RE>RD Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

WACC q The WACC is calculated as follows: q Where the cost of debt is the pretax rate the company pays to its lenders (since interest payments are – as a rule – tax deductible) q The cost of equity should be estimated and depends on the overall risk of the investment Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

WACC q If the market value of debt is = € 30 M; the market value of equity is = € 50 M, the cost of debt= 9% and the cost of equity is 15% then, geiven a tax rate of 40% the weighted cost of capital is equal to…. . Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

CAPM q The CAPM (Capital Asset Pricing Model) offers is one of the methodologies (among others!) to estimate the cost of equity q The cost of equity is equal to the return on riskless assets plus a risk premium which reflect the price paid by the stock market to all equity investors, adjusted for beta which is a specific risk factor Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Beta q Beta is the volatility of a company stock price with respect to the overall stock market q Therefore Beta is the company-specific risk that the asset adds to a market portfolio q Analytically Beta equals: Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Riskless rate q The only securities that have not default risk are government securities. Nonetheless they bear interest rate risk. The most common rates used are: § T-bill rate § Treasury notes rate § Inflation-indexed Treasury rate Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Equity risk premium q Risk premium should measure what investors on average demand as extra return for investing in the market portfolio relative to a risk free assets q RP is usually estimated looking at the historical premium earned by stocks over Treasury bills and bonds Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

US Equity risk premium Arithm. Av. Stock T bill T bond 1928 -2003 11. 82% 3. 90% 5. 28% 1963 -2003 12. 10% 6. 01% 7. 40% 1993 -2003 12. 63% 4. 20% 7. 76% Stock T bill T bond 1928 -2003 9. 85% 3. 86% 5. 02% 1963 -2003 10. 82% 5. 97% 7. 00% 1993 -2003 10. 87% 4. 19% 7. 30% Geom. Av. Source: www. Damodaran. com Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Some Beta Examples Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Some Beta Examples BETA AD. BE TA MIB 30 0, 96 0, 97 0, 13 M SXXE 1, 24 1, 16 0, 25 31. 1. 97 - 28. 6. 02 M MIB 30 0, 86 0, 92 0, 12 FIAT 31. 1. 97 - 28. 6. 02 M SXXE 0, 98 0, 99 0, 15 FIAT 1. 1. 93 - 26. 12. 97 W MIB 30 0, 93 0, 06 FIAT 1. 1. 93 - 26. 12. 97 W SXXE 1, 08 1, 05 0, 13 FIAT 3. 1. 97 - 26. 7. 02 W MIB 30 0, 93 0, 07 FIAT 31. 1. 97 - 28. 6. 02 W SXXE STOCK PERIODO RETURN FIAT 29. 1. 93 - 28. 11. 97 M FIAT 29. 1. 93 - 28. 11. 97 FIAT INDEX 0, 96 STDE 0, 97 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 0, 09

Some Beta Examples BETA AD. BE TA MIB 30 0, 76 0, 84 0, 06 M SXXE 0, 76 0, 84 0, 16 30. 1. 98 - 28. 6. 02 M MIB 30 0, 61 0, 74 0, 11 GENERALI 30. 1. 98 - 28. 6. 03 M SXXE 0, 68 0, 79 0, 13 GENERALI 29. 1. 93 - 26. 12. 97 W MIB 30 0, 81 0, 87 0, 04 GENERALI 29. 1. 93 - 26. 12. 98 W SXXE 0, 71 0, 80 0, 10 GENERALI 2. 1. 98 - 26. 7. 02 W MIB 30 0, 85 0, 90 0, 05 GENERALI 2. 1. 98 - 26. 7. 03 W SXXE STOCK PERIOD RETURN GENERALI 29. 1. 93 - 31. 12. 97 M GENERALI 29. 1. 93 - 29. 11. 97 GENERALI INDEX 0, 82 0, 88 STDE 0, 06 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Some Beta Examples STOCK PERIOD RETURN INDEX BETA AD. BETA MONDADORI 29. 1. 93 - 28. 11. 97 M MIB 30 0, 56 0, 71 0, 15 MONDADORI 31. 12. 92 - 31. 12. 97 M SXXE 0, 70 0, 80 0, 25 MONDADORI 31. 12. 97 - 31. 7. 02 M MIB 30 1, 55 1, 36 0, 23 MONDADORI 30. 1. 98 - 28. 6. 02 M SXXE 1, 86 1, 57 0, 23 MONDADORI 1. 1. 93 - 26. 12. 97 W MIB 30 0, 41 0, 61 0, 09 MONDADORI 1. 1. 93 - 26. 12. 98 W SXXE 0, 56 0, 71 0, 16 MONDADORI 2. 1. 98 - 26. 7. 02 W MIB 30 0, 94 0, 96 0, 09 MONDADORI 2. 1. 98 - 26. 7. 02 W SXXE 1, 04 1, 03 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010 STDE 0, 11

Beta for divisions q The procedure for estimating betas for operating divisions within firms depends largely on whether the divisions are organized by product line or geography Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Geographical divisions q In this case the cost of equity is set adding to the company cost of capital a risk premium equals to § the rate of return on local bonds if the division is mainly funded in the home currency § A measure of country risk if financing comes mainly from the parent company § Typical measure of country risk are spread on local government bond denominated in foreign currency or DCS Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Product divisions q When division are based on product line betas can be estimated from comparable firms in the same or similar industries q This simple approach assumes that the capital structure of all the firms in the industry is similar (beta increases when the D/E ratio increases) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The levered Beta q If our capital structure is different from the industry average structure then we have to unlevered and then “relevered” the Beta q Since we know that: Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Estimating business Beta q If the average industry beta is 1. 27 and the average industry D/E ratio is 0. 45, assuming t=0. 4, then the unlevered industry beta is: q This means that if the average industry beta is 1. 27, if all the firms had been all-equity firms, with no debt, their average beta would be 1. 00 Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Estimating business Beta Now to derive the beta for our division we just have to take the unlevered beta and then lever it back up again to out capital structure q Let’s assume that our D/E ratio is 0. 25, then q Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Eva guidelines q Given that Eva is: Eva=Nopat-(WACC) Invested Capital q The main indications of EVA methodology to managers is that they should implement action either to increase Nopat or the decrease the invested capital q Wacc depends on overall risk and capital structure (a financial decision) Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

EVA and time value of money q EVA is much better than conventional measures in explaining the market value of a company q The market value of a company depends directly on the future EVA-values: The market value of a company = Book value of equity + present value of future EVA Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

MV and EVA q If the company produces a return that is equal to capital costs then the market value of the company will equal the book value of equity q I. e. when EVA = 0, then company´s market value of equity equals its book value of equity Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

The firm MV Market value premium Market value of the firm Book value of equity Firm’s market value= equity book value + NPV of future EVA Positive EVA builds up a premium to the market value of equity, since investors pay for excess return Antonio Majocchi - International Business and Management, Academic Year 2009 -2010

Marginal EVA and pricing q When EVA is computed at the division level, the computation requires estimation at the divisional level q This will involve allocation mechanisms and allocation of fixed headquarters expenses becomes an issue q The initial estimates of EVA are likely to reflect the allocation mechanisms used and the mistakes made in those allocations q Changes in EVA over time are more useful measures than the initial EVA estimates themselves Antonio Majocchi - International Business and Management, Academic Year 2009 -2010