Mva, Eva, Fcf Assignment

Mva, Eva, Fcf Assignment Words: 2288

1. 0BACKGROUND In assignment 2, I was assigned to find the relationship between Free Cash Flow (from now on refer as FCF), Economic Value Added (from now on refer as EVA) and Market Value Added (from now on refer as MVA), specifically whether a company with high FCF also have high EVA and MVA. Explanation using empirical evidence is also needed to support my reasoning and arguments. Therefore, in order to complete this assignment, I have used a few types of references which are financial management reference books, journals, articles from Fortune magazine and set-up an interview with Mr.

Amiruddin b. Abdul Shukor which is the Chief Financial Officer (CFO) for Nationwide Express Courier Services Berhad. Throughout his career, he had worked in Permodalan Nasional Berhad (PNB), Permodalan Terengganu Berhad (PTB), Securities Comission Malaysia (SC) and Malaysian Industrial Development Finance Berhad (MIDF). An interview session was set with him on 2/12/2011 at his office in the headquarters of Nationwide Express Courier Services Berhad in Shah Alam, Selangor. 2. 0FINDINGS 2. 1Free Cash Flow

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In definition, FCF is the cash flow actually available for distribution for investors after the company has made all the investment in fixed assets and working capital necessary to sustain ongoing operations (Brigham & Ehrhardt, 2005). Basically, the formula for FCF is as follows: In the investors’ perspective, positive value of FCF is more favorable than negative value because it means that the company has high expectancy of generating available cash in the future. As for the managers’ of a company, positive FCF reflect their ability in managing cash within the firm (Amiruddin, 2011).

However, in some cases, negative FCF is not always bad. FCF value can be negative due to the reason that the NOPAT value is high. This situation occurs when the company is experiencing rapid growth which means that there is a significant increment in the operating expenses which caused the NOPAT value to be significantly high and result in negative FCF. This scenario usually happens in startup companies or companies that are incurring significant current expenses to launch new product line (Brigham & Houston, 1999).

However, this situation usually lasted for a short-term and the FCF value will eventually produce a positive value in the future. Therefore, it is good to have profitable growth although it contributes to negative FCF (Brigham & Houston, 1999). 2. 2Market Value Added For MVA, it is defined as the difference between the market value of the firm’s stock and the amount of equity capital that was supplied by the shareholders. This will result in maximizing of shareholders’ wealth (Brigham & Ehrhardt, 2005). The formulas for MVA are as follows:

Basically, the goal of MVA is to maximize the shareholders’ wealth and this can be achieved through maximizing the value of MVA. The higher the MVA value is, the better the job management is doing for the firm’s shareholders (Brigham & Ehrhardt, 2005). This is due to the reason that, with high MVA, shareholders can trade their share at a higher price and obtain more profit. Therefore, in the investors’ point of view, it is the job of the management team to create value in the market to ensure higher stock price is being traded.

For the firms’ point of view, higher MVA can ensure higher stock price which also means higher capital being invested in the company (Amiruddin, 2011). 2. 3Economic Value Added EVA is defined as the managerial effectiveness in a given year (Brigham & Ehrhardt, 2005) or a measure of how much the management has added to shareholders’ wealth during the year (Brigham, Houston, Yao, Hon & Bany, 2010). EVA can be calculated using the following formula: EVA is an estimate of the true economic profit of the year and it represents residual income that remains after the cost of all capital including equity apital has been deducted (Brigham & Ehrhardt, 2005). EVA can also be used as a troubleshooting tool in managing resources in a firm. Examples can be seen from article titled “THE REAL KEY TO CREATING WEALTH: Rewarded by knockout results, managers and investors are peering into the heart of what makes businesses valuable by using a tool called Economic Value Added” written by Shawn Tully, where it discussed the case of CSX – a train freight services company that facing a breakeven issue which eventually manage to overcome it by implementing EVA.

This article also discussed the case of Quaker Oats in managing their capital to become more profitable and how EVA had helped them achieving this. Positive value of EVA shows that the managers had successfully manage the operation this company and vice versa. In the investors’ point of view, positive EVA means that the firm is adding more values on what they have invested. Therefore, positive and higher EVA is much favorable for both investors and managers perspective. 3. 0ANALYSIS 3. 1 The Relationship

Based on the findings above, FCF can be concluded as the measurement of how well the firm in managing their cash, MVA is the measurement of how well the firm in creating value in the market and EVA is the measurement of how well the firm is managing its operations. In a glance, there is definitely a relationship between all these variables either directly or indirectly because value can be easily created when there is cash and cash is obtain through optimizing resources in the company. From the formula discussed in findings, FCF and EVA are directly related through the use of NOPAT in their formulas.

NOPAT which stands for Net Operating Profit after Tax is the amount of profit a company would generate if it had no debt and held no financial assets (Brigham & Ehrhardt, 2005). Therefore, when the NOPAT value increases, FCF and EVA value will increase as well and vice versa. As for MVA, it has indirect relationship with FCF and EVA which is in creating market value of a firm, elements of cash and resources are very much needed and measured. Therefore, MVA has positive relationship as well with FCF and EVA. In theory, high FCF does contribute to high MVA and EVA.

However, in the industry, there are cases where companies can have high FCF and EVA but low MVA. This happens when the company tries to manipulate their data by adjusting their operating expenses which will lead to higher NOPAT where in reality it isn’t. There are also cases when companies with high MVA has low FCF and EVA and this happens when the company is disseminating news on positive development of the company for example new mega-projects, mergers or acquisition that might take place in the near future.

Since MVA is created in the market, the variables of the value created is very much influenced by both internal and external factor of a company including political condition, rumors, financial stability, company’s public figure and much more (Amiruddin, 2011). 3. 2Benefits to Firm Managers Previous studies have shown that there are strong correlation between EVA and MVA. However, when this hypothesis being tested on various samples all over the world such as India (automobile industry), United States of America and South Africa, it shows varies results (Sharma & Kumar, 2010).

There are also studies shows that FCF and EVA are equivalent important in decision-making of a company. The FCF approach focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow, whereas the EVA approach requires defining the periodic total investment in the firm. Each approach practices the method of modifying the accounting information available publicly for most companies (Shrieves & Wachowicz, 2000). The primary goal of a firm is to maximize the shareholders’ wealth.

In order to achieve this, FCF, EVA and MVA play a big role for managers to ensure that this objective can be achieved. It is the managers’ task to maintain a positive and high of all three variables which are FCF, MVA and EVA in compared to the industry and competitors in order to attract new investors and ensure satisfaction of current shareholders. FCF enquire managers to have significant skills in managing company’s available cash because this value could determine the future available cash of the company. Managers can achieve this through effective management of operating expenses and cash flows.

FCF has several uses in a firm such as paying debt and dividends, repurchase stock from shareholders and buy marketable securities or other non-operating assets (Brigham & Ehrhardt, 2005). Managers are able to maximize shareholders through this activities which requires not only positive value of FCF, but also a significant value of FCF. As for MVA, this can be achieved through periodical updates in financial-based media in order to create the firm’s value in the market. News on firm’s new mega-projects, success, mergers and acquisition always attract new investors which contribute to higher stock price.

Higher stock price can maximize the shareholders’ wealth since they’re able to trade their share at a better profit. However, news or rumors that contribute to bad corporate image such as firm’s involvement in environmental pollution, bad-debt or even death of the corporate public figure could lead to drop of stock price. Therefore, it is the managers task to control the information that been disseminated in the media (Amiruddin, 2011). EVA is an internal measure of performance that determines MVA. The EVA value of a company plays an important role in determining and influencing the value of MVA.

EVA measures the surplus value created by a firm in its existing environment. Managers are able to use EVA to track firm’s financial position and to guide management decisions regarding resource allocation, capital budgeting and acquisition analysis. The principle in applying EVA is that the firm must earn more on its funds than the cost of those funds or it is not creating value (Paula & Elena, 2011). Managers can increase the EVA value through several ways which are (Moyer, McGuigan, Kretlow, 2003): 1)Increasing efficiency level in utilizing operations. )Investing in firm that shows good return of investment. 3)Re-allocate resources in current projects that do not contribute much profit to more profitable projects. 4)Optimizing the use of the tax benefits of debt financing to create value while considering risk. Based on the article written by G. Bennett Stewart III, titled “EVA WORKS – but not if you make these common mistakes”, there are several guidelines that should be followed by the managers when implementing EVA in a firm: 1)Adopt EVA in all aspect of the company from top to the lowest level of management. )EVA should be implemented slowly or phase by phase. The larger the firm is, the longer should it take to fully implement EVA. 3)High commitment from the top-level management in implementing EVA. 4)Approach the stakeholders in a manner that can benefit them as well besides the shareholders. 5)Provide stakeholders from all levels with EVA knowledge to ensure all aspect of the company is evaluate and implemented based on EVA. 3. 3Ethical Issues Based on my discussion with Mr. Amiruddin, he had rise the ethical issue of firm managers who manipulate FCF, EVA and MVA value for personal gain.

In order to raise the stock price to maximize shareholders’ wealth, sometimes managers will choose to manipulate their firms’ operating expenses in order to gain higher value of FCF and EVA. The value of MVA can also be manipulated by spreading rumors on company’s positive development and financial news as well as political issue in order to raise the stock price. In order to tackle this problem, investors can measure firms’ FCF, MVA and EVA value by comparing to the industry value and competitors’ value.

If there’s a significant difference between the industry and competitors, there could be some inaccuracy in information that been published. 4. 0CONCLUSION High value of FCF does provide a high value of MVA and EVA but this could differ if the firms’ managers choose to manipulate the data for personal gain. In conclusion, FCF, EVA and MVA are best use together as a performance measurement tool and troubleshooting tool for a company. These variables are able to provide in-depth overview of the firm’s cash, market value and operations. However, there are still a lot of rooms for research on this subject especially in developing countries.

REFERENCES 1. Eugene F. Brigham, Michael C. Ehrhardt, Financial Management: Theory & Practice, 11th Edition, Thomson South-Western, 2005. 2. Eugene F. Brigham, Joel F. Houston, Fundamentals of Financial Management, 9th Edition, Thomson South-Western, 1999. 3. Eugene F. Brigham, Joel F. Houston, Yao-Min Chiang, Hon-Sing Lee, Bany Ariffin, Essentials of Financial Management, 2nd Edition, Cengage Learning Asia, 2010. 4. R. Charles Moyer, James R. McGuigan, William J. Kretlow, Contemporary Financial Management, 9th Edition, Thomson South-Western, 2003. 5.

Shawn Tully with associate reporter Ani Hadjian & Jane Furth, “THE REAL KEY TO CREATING WEALTH: Rewarded by knockout results, managers and investors are peering into the heart of what makes businesses valuable by using a tool called Economic Value Added”, Fortune Magazine, 20th September 1993. 6. G. Bennett Stewart III, “EVA WORKS – but not if you make these common mistake”, Fortune Magazine, 1st May 1995. 7. Dr. Anil K. Sharma, Satish Kumar, “Economic Value Added (EVA) – A Literature Review and Relevant Issues”, International Journal of Economics and Finance, www. ccsenet. org/ijef, 2010. 8. Ronald E.

Shrieves, John M. Wachowicz, “Free Cash Flow (FCF), Economic Value Added (EVA) and Net Present Value (NPV): A Reconciliation of Variations of Discounted Cash Flow (DCF) Valuations”, Business Library, http://www. classle. net/sites/default/files/text/41/NPV_EVA. pdf, 2000. 9. Dumitru Cristina Elena, Dumitru Andreea Paula, “EVA versus Tradicional Accounting Measures of Performance as Drivers of Shareholder Value – A Comparative Analysis”, http://www. upm. ro/proiecte/EEE/Conferences/papers/S309. pdf, 2011. 10. Amiruddinb. Abdul Shukor, Chief Financial Officer, Nationwide Express Courier Services Berhad, 2011. .

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