Insight
Middle market business owners and operators frequently confront strategic capital decisions, often with scant time and limited tools to assist in picking a path. However, the wrong capital investment decision can reverberate through a business for years by destroying value and depriving more deserving initiatives of scarce resources.
Economic Value Added (EVA) analysis can assist in making decisions, reducing risk and increasing enterprise value over the long term.
Evaluating strategic alternatives challenges the owner or entrepreneur’s sense of direction. “Which way do we go?” The forks in the road at these alternative junctions encompass a myriad of capital allocation decisions: new products, new equipment, sales strategies, strategic partnerships, capitalization, or even mergers and acquisitions. The effects of these choices can manifest immediately or over many years, but the ultimate sum of these decisions adds to or subtracts from the value of the business. Additionally, in a process to sell the business, demonstrating an established methodology for evaluating opportunities that require the commitment of resources reduces the perceived risk to future cash flows and supports a higher valuation. With the value of the enterprise in the balance, augmenting the decision-making process with evaluation tools seems prudent.
All businesses have some method for evaluating alternatives, whether explicit or not. In middle market companies, the gut feel of the entrepreneur frequently dominates the process. Most often, the owner’s personal capital and wealth, as well as a bank guarantee, can be at stake when major decisions are on the line. From a founder’s perspective, abdominal navigation (gut feel) guided the company to its current success, so why change? Don’t fix what isn’t broken. However, the risk of choosing the wrong course increases as a business gains scale and the number of decisions multiplies. EVA offers a dispassionate and objective compass reading to assist the entrepreneur.
EVA analysis fundamentally measures whether shareholder value has been created or destroyed by measuring economic operating profits after subtracting the cost of the capital invested in the assets used to generate those profits. Capital has a cost, whether or not expressed in an interest rate, and ignoring it obfuscates economic reality.
The Example Problem – New Product Launch?
The success of horizontal drilling in the Bakken shale of North Dakota and the Marcellus shale of Pennsylvania has created demand for a new pressure transducer for oil and gas production. As a leading manufacturer of transducers for the energy industry, Halliburton has come to a company to produce the new product. Because of the high cost of development and production equipment, Halliburton has agreed to source this product solely from this company for a minimum of 5 years. Based on minimum order requirements, the project should generate annual operating cash flow of $15MM. The project requires an investment in new machining equipment and plant capacity that will cost approximately $50MM. The company can comfortably use existing borrowing capacity to fund the investment.
The investment can be paid back in just over three years and the bank is willing to fund it. It looks good to the entrepreneur. The inclination is to sign the contract and order the equipment. THE
Analysis
The first step in an analysis is to get the nomenclature correct. A few observations:
1. Cash flow doesn’t take into account the “expense of the equipment” or the tax charge on profits. Operating cash flow needs to be converted to Net Operating Profit After Tax (NOPAT). In our example, the equipment would have limited or no value after the contract term and therefore the cash flows need to be burdened by the economic cost of replacing the equipment at the end of its useful life. Tax laws allow this cost as a tax deduction, resulting in the $15MM of annual cash flow turning into $3.25MM of NOPAT.
2. The bank will fund the investment without a personal guarantee, but not without the full credit support of the business. As a result, the full blended cost of all the capital employed by the business must be considered, not just the loan rate. In addition, although the bank will offer the loan at a floating rate of interest, the debt must be borrowed over a five-year term. The cost of debt for five years adds an additional 175 BP, pushing the cost of debt to approximately 4.5%, and the after-tax cost to approximately 3%.
3. Determining the cost of equity requires a more complicated analysis, but we will assume an 18% cost of equity for this prudently leveraged business.
4. The mix of debt and equity capital in this business after making the investment is approximately 40% and 60%, respectively.
An annual EVA analysis of this opportunity yields the following:
As the graph above shows, over five years $13.75MM of economic value would be destroyed in contrast to the misleading positive measures of operating profit and NOPAT. How can the owner take advantage of this new opportunity without damaging the economic value of the business? Careful examination of the starting conditions and assumptions may lead to the answer. Armed with knowledge of EVA, negotiating with the customer (Halliburton) may yield a higher initial selling price for the new pressure transducer and correspondingly higher NOPAT. As manufacturing efficiencies increase over time, savings could be passed on to the customer in the form of lower prices while operating profits are maintained, thus creating positive EVA. Perhaps a reexamination of the capital expenditure required could lead to lower cost alternatives and a correspondingly decreased budget. If the capital employed in the project were reduced, the economic profit realized may exceed the capital charge hurdle.
The Conclusion
The simple example above highlights the importance of using the EVA tool in the assessment of opportunities and initiatives. Without an objective structure, the unsuspecting (however confident) business owner may inadvertently make decisions that destroy shareholder value. Asking whether an initiative is profitable is not enough. Rather, the question should be whether the return exceeds the weighted average cost of capital employed? In the long term, the discipline of using EVA in the process of evaluating strategic alternatives will guide the entrepreneur in allocating capital resources and, over time, to increase the value of the business.