Downstream and Economic value added: Difference between pages

From ACT Wiki
(Difference between pages)
Jump to navigationJump to search
imported>Doug Williamson
(Add link.)
 
imported>Doug Williamson
(Add TOC.)
 
Line 1: Line 1:
1.
(EVA).  


In relation to guarantees, a ''downstream guarantee'' is one given by a parent company in relation to the obligations of one of its subsidiary companies.


The periodic addition to shareholder value resulting from the efficient management and allocation of resources.


2.
The important insight from EVA analysis is that a whole firm, a project or a division will be <u>destructive</u> of [[shareholder value]] in the following circumstances:


A ''downstream loan'' is a loan made by a parent company to one of its subsidiary companies.
(1) Whenever its returns are inferior to the relevant economic [[cost of capital]].


(2) Even if it appears to be profitable when measured on an accounting basis (for example on an [[Earnings per share]] basis).


3.


In the oil and gas industry the ''downstream business'' refers to distributing and selling refined and synthetic oil and gas products, together with the refining of crude oil.
EVA can be considered at the whole-firm level or in relation to smaller business units or projects.
 
 
__TOC__
 
 
== EVA at the whole-firm level ==
 
 
The periodic addition to total shareholder value from the efficient management and allocation of the whole firm's resources.
 
 
EVA can be quantified at a whole-firm level as:
 
EVA = [Return on book capital LESS Market cost of capital] x Book capital.
 
 
<span style="color:#4B0082">'''Example 1: EVA calculation'''</span>
 
Taking a simplified example, take an all-equity financed firm with:
 
(1) A market capitalisation (P<sub>0</sub>) of $130m.
 
(2) Book value of equity $100m.
 
(3) Annual after tax returns of $13m.
 
 
''To keep this illustration simple, we will assume no growth.''
 
''In other words the whole of the annual after tax returns of $13m are paid out as dividends (D<sub>1</sub>).''
 
 
Return on book capital = 13/100
= 13%.
 
Market cost of capital = 13/130
= 10%
 
(Using Ke = D<sub>1</sub>/P<sub>0</sub>).
 
EVA = [13% - 10% = 3%] x $100m
 
= '''$3m'''.
 
 
''In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA.''
 
''So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.''
 
 
<span style="color:#4B0082">'''Example 2: MVA calculation'''</span>
 
Turning back for now to our simple example, EVA is also closely related to Market value added (MVA). 
 
MVA is the total present value of the expected EVA in the current and future periods.
 
 
For example in this case the EVA is a simple fixed perpetuity of $3m.
 
The total present value of the fixed perpetuity of $3m is evaluated using:
 
(1) The simple fixed perpetuity formula 1/r.
 
(2) The market cost of capital 10%.
 
 
MVA = $3m/0.10
 
= '''$30m'''.
 
 
 
== EVA at the individual project level ==
 
 
It is also possible to calculate and analyse EVA at the individual project level.
 
In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) [[Weighted average cost of capital]].
 
 
A simple decision rule when using EVA at the project level is:
 
(1) Reject all negative EVA projects.
 
(2) Positive EVA projects will be considered further.




== See also ==
== See also ==
* [[Guarantee]]
* [[Net present value]]
* [[OPEC]]
* [[Internal rate of return]]
* [[Upstream]]
* [[Book value]]
* [[Legal implications of cash pooling structures]]
* [[Cost of capital]]
* [[Earnings per share]]
* [[Excess Return]]
* [[Market value added]]
* [[Return on capital employed]]
* [[Shareholder value]]
* [[Wealth Added Index]]
 
[[Category:Corporate_finance]]

Revision as of 15:15, 4 December 2015

(EVA).


The periodic addition to shareholder value resulting from the efficient management and allocation of resources.

The important insight from EVA analysis is that a whole firm, a project or a division will be destructive of shareholder value in the following circumstances:

(1) Whenever its returns are inferior to the relevant economic cost of capital.

(2) Even if it appears to be profitable when measured on an accounting basis (for example on an Earnings per share basis).


EVA can be considered at the whole-firm level or in relation to smaller business units or projects.



EVA at the whole-firm level

The periodic addition to total shareholder value from the efficient management and allocation of the whole firm's resources.


EVA can be quantified at a whole-firm level as:

EVA = [Return on book capital LESS Market cost of capital] x Book capital.


Example 1: EVA calculation

Taking a simplified example, take an all-equity financed firm with:

(1) A market capitalisation (P0) of $130m.

(2) Book value of equity $100m.

(3) Annual after tax returns of $13m.


To keep this illustration simple, we will assume no growth.

In other words the whole of the annual after tax returns of $13m are paid out as dividends (D1).


Return on book capital = 13/100 = 13%.

Market cost of capital = 13/130 = 10%

(Using Ke = D1/P0).

EVA = [13% - 10% = 3%] x $100m

= $3m.


In practice a number of adjustments would be made both to the market values and to the book values used in the calculation of the EVA.

So the application of EVA analysis is both more complicated, and arguably more subjective, than the simple calculation illustrated above.


Example 2: MVA calculation

Turning back for now to our simple example, EVA is also closely related to Market value added (MVA).

MVA is the total present value of the expected EVA in the current and future periods.


For example in this case the EVA is a simple fixed perpetuity of $3m.

The total present value of the fixed perpetuity of $3m is evaluated using:

(1) The simple fixed perpetuity formula 1/r.

(2) The market cost of capital 10%.


MVA = $3m/0.10

= $30m.


EVA at the individual project level

It is also possible to calculate and analyse EVA at the individual project level.

In simple terms, EVA is positive when the project Internal rate of return exceeds the (appropriately risk-adjusted) Weighted average cost of capital.


A simple decision rule when using EVA at the project level is:

(1) Reject all negative EVA projects.

(2) Positive EVA projects will be considered further.


See also