THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 1March 2, 1998 2:01 PM- 1 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBCGS VALUE MANAGEMENT FRAMEWORKAN OVERVIEW FOR MBA STUDENTSByRawley ThomasDirector of ResearchThe Boston Consulting Group200 South Wacker DriveChicago, Illinois 60606312-627-2618Thomas.1THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 2March 2, 1998 2:01 PM- 2 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedWHAT GETS MEASURED GETS DONE2THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 3March 2, 1998 2:01 PM- 3 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedTraditional Valuation Techniques Versus BCGs Valuation FrameworkTraditional Valuation TechniquesForecast nominal cash flows by estimating P&L line items and changes to the balance sheetEstimate terminal value with a perpetuity of the forecasted last years net cash flowDetermine cost of capital by weighting equity CAPM cost with debt costDiscount the cash flows and terminal value to present value with the weighted average cost of capitalObservations on Missing Elements 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 downNo fade in performance to determine likely cash flows in a competitive environmentDiscount rates determined by past price changes, not future likely cash flowsNo extensive empirical testingBCGs Valuation FrameworkTranslate accounting statements to gross cash flows and gross cash investments in constant dollars to produce cash on cash returnsTranslate cash on cash returns to economic performance measures (CFROIs) by adjusting for asset life and mix of depreciating versus non-depreciating assetsDetermine sustainable asset growth ratesFade CFROIs and asset growth rates toward corporate averages consistent with life cycle theory and empirical evidence to estimate future cash flows (replaces terminal valuation)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 equityApply the market derived discount rate to the cash flows derived from fading economic performance to determine market valuation; subtract debt to determine equity valuationTest model values against actual stock prices for thousands of firms for 10-40 years across many countries; refine, refine, refine3THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 4March 2, 1998 2:01 PM- 4 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedMANY ASSETS FOLLOW THE SAMEUSEFUL OUTPUT PATTERN AS A CAR .ConstantDollarLevelAnnuityEconomicLifeLikelyActualOutputOutput Declinewith StraightLine Depreciation4THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 5March 2, 1998 2:01 PM- 5 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedISSUES WITH TRADITIONAL RETURN MEASURES(*) Economic depreciation = amount of annual sinking-fund payment earning COC required to replace assets ($357 = 0.1/1.114 - 1)(12,000 - 2,000)Investment pro a new plantSubsequent annual measurementYr 1Yr 6Yr 12Income843843843Depreciation714714714Cash flow1,557 1,5571,557Cash invested12,000 12,000 12,000Book capital11,286 7,7163,432ROCE (%)7.510.924.6ROGI (%)131313CFROI (%)101010ROCE = Income/book capitalROGI = Cash flow/ cash investedCFROI= (Cash flow - economic depreciation(*)/cash invested$12,000$1,557$2,000IRR = 10%5THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 6March 2, 1998 2:01 PM- 6 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedYr 1Yr 6Yr 12NOPAT(1)843843843Book capital(2)11,2867,7163,432Cost of capital(3)x10%x10%x10%Capital charge(4)1,129772343EVA(1-4)(286)71500Cash flow(6)1,5571,5571,557Cash invested(7)12,000 12,000 12,000Cost of capital(8)x10%x10%x10%Capital charge(9)1,2001,2001,200Economic dep.(*)(10)357357357CVA(6-9-10)000VALUE-ADDED MEASURES REFLECT RETURN,COST OF CAPITAL AND SIZEReturn on New PlantMeasured Over Time(*) Economic depreciation = amount of annual sinking fund payment earning COC required to replace assets ($357 = 0.1/(1.114 - 1)(12,000 - 2,000)Investment pro a new plant$12,000$1,557$2,000IRR = 10%6THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 7March 2, 1998 2:01 PM- 7 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedTracking the Sampleof 1970 Companiesthrough timeTracking the Sampleof 1980 Companiesthrough timeTracking the Sampleof 1987 Companiesthrough timeNote the averages &dispersions have risenbetween 1970-1987,hypothesized to berelated to supply-sidepolicy changes7THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 8March 2, 1998 2:01 PM- 8 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedTHE MARKET EXPECTS THE PERFORMANCEOF MERCK TO FADE .(REGRESS TOWARD MEAN PERFORMANCE)Fade = 0%Fade = 10%Illustrates PerpetuityTrap:Overvalues HighReturn FirmsDramatically8THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 9March 2, 1998 2:01 PM- 9 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedR2=0.13N=750R2=0.40N=750R2=0.25N=750R2=0.25N=7509THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 10March 2, 1998 2:01 PM- 10 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedOn the 24 groups of 25 firms, Stewartclaims a 44% R2. This higher correlationrelates to the elimination of 300 companiesinstead of 31 extreme outliers and the grouping of companies that serves toeliminate the intra-group variance.N=861R2=0.27R2 = 0.21R2 = 0.67R2 = 0.1010THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 11March 2, 1998 2:01 PM- 11 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedAPPROACH TO IMPLEMENTATIONWhat Full Effort Might Look LikeModule 1Analytical diagnostic: “value audit”Module 2Measure selection and tailoringModule 3Value Driver analysis of BUsModule 4Install in planning, budgeting & reportingModule 5Install in compensationModule 6Apply to portfolio managementValue analysis of company and business unitsIdentify priorities and issuesReview options against applica-tionsTailor as requiredTransfer approach to BUsLink to operating decisionsRe-examine processes and linkagesProvide training and document-ationStructureMeasuresTargetingResourceallocationPortfolio balancingExternal reporting11THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 12March 2, 1998 2:01 PM- 12 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCOMPARISON OF COST OF CAPITAL MEASUREMENT METHODSCAPMMarket DerivedAssumes 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. BondInterestRatesDividendDiscountModelsBCGMarket DerivedCost of Capital12THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 13March 2, 1998 2:01 PM- 13 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedSTUDIES USING MARKET DERIVED METHODSBlanchard, 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, v41 (6), pp. 16-19, 22-25.Fuller, Russell J., “Programming the Three-Phase Dividend Discount Model,” Journal of Portfolio Management, 1979, v5(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 Nations Capital Needs: Three Studies, Committee for Economic Development, New York, pp. 103-188.Rozeff, Michael S., “The Three-Phase Dividend Discount Model the ROPE Model,” Journal of Portfolio Management, 1990, v16(2), pp. 36-42.Williams, J.B., The Theory of Investment Value, Harvard University Press, Cambridge, Mass., 1938.13THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 14March 2, 1998 2:01 PM- 14 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBCG/HOLT RESEARCH USING MARKET DERIVED METHODSby Rawley ThomasHOLTs Discount Rate, April 25, 1986, 122 pagesCovers cash estimation, market derived methodology, tax premiums, leverage, comparison to other academic research, and CAPMNew Electric Utility Discount Rate, September 6, 1987, 40 pagesShows 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 pagesCovers leverage researchNew System Adjustments, May 3, 1989, 4 pagesCovers revised leverage adjustmentsReal Equity Rates, October 1, 1989, 21 pagesUpdates cost of capital research on tax premiums and leverageReal Equity Discount Rates - Data, October 2, 1989, 23 pagesDisplays IRS, Federal Reserve, and HOLT data underlying discount rate research 1950-1988.Effect of Proposed Change on Stock Prices, October 3, 1989, 38 pagesAccounts for 200 point drop in market by analyzing effect of capital gains indexation versus lower capital gains tax ratesResponses to Equity Discount Rate Research, November 2, 1989, 4 pagesCongressional response to HOLT researchAnother Response to Discount Rate Research, December 4, 1989, 10 pagesDepartment of Treasury response to HOLT researchVolatility “Risk” Versus Inflation Risk, July 25, 1990, 11 pagesCompares CAPM volatility risk to inflation riskInvestors Discount Rate for Oil Companies, March 22, 1991, 63 pagesCorrelates oil industry market derived equity discount rates to government ownership and leverage14THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 15March 2, 1998 2:01 PM- 15 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedMARKET DERIVED DISCOUNT RATEPrice = Discounted Present Value of Expected Future Net Cash FlowsCorporate Sector Cash Flowsvary with the structuralcharacteristics of an economyInvestors Discount Rateis volatileS&P 400DJIA 30etc.15THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 16March 2, 1998 2:01 PM- 16 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBCGS METHOD FOR DERIVING INVESTOR DISCOUNT RATES (WACCs) 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.Sample of CompaniesCaculate CFROI for SampleCalculate Growth rates for Country EconomyEmploy Present Value Valuation ModelDetermine Market Derived Investor Discount Rate (WACC)Cost of DebtMarket LeverageMarket Derived Real Equity RateInflationary ExpectationsMarket Derived Equity Risk PremiumGovernment Bond Rates16THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 17March 2, 1998 2:01 PM- 17 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCFROIS CORRELATE HIGHLY WITH THE FUNDAMENTALS OF INFLATION, AND CORPORATE TAXES1996 DISCOUNT RATE SAMPLE10.8596 Actual11.4197 Forecast“Best Fit Line”Fundamental CFROI = 14.65 - 0.438 * GDP Deflator Inflation - 0.122 * Corporate Tax Ratet-Statistics: -9.54 on GDP Deflator Inflation; -7.00 on Corporate Tax RateCorrelation between Inflation and Tax Rates: 0.00%CFROI ActualR2 = 0.7617THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 18March 2, 1998 2:01 PM- 18 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedTO SMOOTH ECONOMIC CYCLES, BUT INCORPORATE STRUCTURAL SHIFTS, BCGS VALUATION MODEL ASSUMES CURRENT CFROI LEVELS FADE TOWARD THE 5-YEAR PAST MEDIAN OF THE DISCOUNT RATE SAMPLE AT A 10% RATEAnnual CFROIs5-Year Past Median CFROIs18THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 19March 2, 1998 2:01 PM- 19 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBCGS VALUATION MODEL ANTICIPATES THAT THE GROSS ASSET GROWTH RATE OF ALL COMPANIES IN THE USA FADE TOWARD THE LONG TERM ECONOMY AVERAGEAnnual GDP Growth Rates3.2 % Compounded Annual Growth Rate in GDP from 1950-1996Unlike CFROIs, 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.19THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 20March 2, 1998 2:01 PM- 20 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedPrice = Discounted Present Value of Expected Future Net Cash FlowsTHE INVESTORS DISCOUNT RATE IS THAT RATE WHICH EQUATES THE PRESENT VALUE OF CASH FLOWS FROM BCGS VALUATION MODEL TO THE MARKET VALUE OF DEBT AND EQUITYMarket Value of Debt andEquity of S&P 400 Sample$3,474 Billion$1,903 Billion of AssetsReturning 11.1% and Growingat 3.2% per yearFading 10% toward10.8% CFROISolve for the Rate at WhichPresent Value of Cash FlowsEquals PriceSeptember = 5.77%(Weighted Averaged Real After-Corporate-TaxCost of Capital)Answer tells us what the Marketis presently requiring as aRate of Return20THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 21March 2, 1998 2:01 PM- 21 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCALCULATION OF FUTURE CASH FLOWS AND PRESENT VALUES1996 DISCOUNT RATE SAMPLE21THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 22March 2, 1998 2:01 PM- 22 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights Reserved22THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 23March 2, 1998 2:01 PM- 23 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedPAST RESOURCES COMMITTED1996 DISCOUNT RATE SAMPLE23THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 24March 2, 1998 2:01 PM- 24 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCALCULATION OF ASSET ADDITIONS1996 DISCOUNT RATE SAMPLE24THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 25March 2, 1998 2:01 PM- 25 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights Reserved25THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 26March 2, 1998 2:01 PM- 26 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights Reserved26THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 27March 2, 1998 2:01 PM- 27 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBCG DECOMPOSES THE WEIGHTED AVERAGE REAL COSTS OF CAPITAL INTO THEIR DEBT AND EQUITY COMPONENTS USING MARKET WEIGHTS1.765.776.53Real Debt RateAfter Corporate TaxReal Equity RateReal Weighted Average27THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 28March 2, 1998 2:01 PM- 28 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedMARKET % DEBT/TOTAL CAPITAL HAS DECLINED SIGNIFICANTLY SINCE 1990Variations inMarket Leverage and InvestorTax Premiums Help to ExplainMarket Derived Real Equity Discount RatesSee Next Slide . 15.928THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 29March 2, 1998 2:01 PM- 29 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedReal Equity Discount Rates Decompose into the Fundamentals of Tax Premiums, Leverage Risk Premiums, CFROIs & Sub-Par ReturnsUSA - 1950-1997Dividend Tax PremiumsCapital GainsTax PremiumsLeverage RiskPremiumsMarket DerivedReal EquityDiscount RateFundamental Equity Discount Rate=-3.36+DivTaxPrem+CapGainTaxPrem+0.207*Debt/Total Capital+0.408* CFROI-1972/78 Sub-Par Returns1972/78 Sub-Par Returns; MayRepresent a Proxy for Other EffectsDiscount Rates Based on 1996 Discount Rate Sampleof 279 S&P IndustrialsR2 = 0.91CFROIEffects29THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 30March 2, 1998 2:01 PM- 30 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCFROIS NORMALLY EXCEEDTHE MARKET DERIVED DISCOUNT RATES1996 DISCOUNT RATE SAMPLECFROIsMarket DerivedDiscount RatesDifferencesPolitics/Policies Change30THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 31March 2, 1998 2:01 PM- 31 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCFROIS NORMALLY EXCEEDTHE MARKET DERIVED DISCOUNT RATESEven though many economists believe that all returns must converge, in a healthy capitalist economy, CFROIs on hard assets will exceed investor required returns on financial assets most of the time, because:Continuous new entrepreneurial innovations prevent CFROIs from converging completely to promised financial returns (imperfect arbitrage) andEntrepreneurs must be rewarded with greater returns to assume the greater dispersion and higher risk of loss associated with CFROIs on illiquid hard assets compared to financial returns on marketable, liquid financial assets31THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 32March 2, 1998 2:01 PM- 32 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedProducer Price Index % ChangeGNP/GDP Deflator % ChangeInflationary Expectations0.0% Base Rate 1950-19802.6% Base Rate 1981-1996Inflationary Expectations based on0-2.6 base rates follow actual inflationmore closely, but avoid the sharp volatilityof actual PPI and GNP/GDP annual inflation.2.48Note: the base rate is definedas the after-investor tax, afterinflation required return on Government long term bonds.BCG CALCULATES INFLATIONARY EXPECTATIONS BY SUBTRACTING TAX PREMIUMS AND A BASE RATE FROM LONG TERM GOVERNMENT BOND YIELDSUSA - 1950-199732THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 33March 2, 1998 2:01 PM- 33 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedMARKET DERIVED NOMINAL EQUITY RATES COME FROM MARKET DERIVED REAL EQUITY RATES PLUS THE COMPOUNDED EFFECT OF INFLATIONARY EXPECTATIONS Market Derived Nominal Equity Rate9.176.532.48Market Derived Real Equity RateInflationary Expectations33THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 34March 2, 1998 2:01 PM- 34 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedTHE EQUITY RISK PREMIUM HAS DECLINED TO THE 2-3% RANGERisk Premium DifferencesMarket Derived Nominal Equity RateNominal Long Term Government Bond Rate2.6634THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 35March 2, 1998 2:01 PM- 35 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedRISK CONCEPTS AND MEASUREMENTCAPMMarket DerivedInvestors seek to avoid price volatility relative to the market.Investors seek to avoid losses from unanticipated major events.Major EventsBankruptcy (Leverage)Unanticipated InflationGovernment InterventionGovernment OwnershipVoting Rights on Key ChangesAsset AgeArbitrage Pricing Theory (APT)postulates other risk factors:Interest RatesOil PricesPrice/Equity BookSize35THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 36March 2, 1998 2:01 PM- 36 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedNAIVE BELIEFS INCORRECTLY ASSUME COSTS OF DEBT AND EQUITY DO NOT VARY WITH CAPITAL STRUCTURE .Cost of EquityCost of Debt, After-Corporate-TaxWeighted AverageCost of CapitalAfter-Corporate-TaxNote: NOTBased onValid TheoryorEmpiricalEvidence36THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 37March 2, 1998 2:01 PM- 37 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBCG EMPIRICAL WORK CONFIRMS INCREASING REAL COSTS OF DEBT AND EQUITY, ACCORDING TO TRADITIONAL THEORYEquityWeightedAverageDebtAfter-TaxSource: BCG Database andEmpirical Research on 63Value Line Industries - 1995To 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.Rawley Thomas - Director of Research Line of best fit based on minimizingabsolute deviations of a power curve(to reduce influence of outliers) andconstrained to pass through resultsfor Sample F6.03+35.14(D/C)2.422.38+2.69(D/C)1.8637THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 38March 2, 1998 2:01 PM- 38 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedPRELIMINARY HOLT DISCOUNT RATE RESEARCHMARKET DERIVED REAL COST OF EQUITYCORRELATION COEFFICIENTS1990, 220 Companies, 15% Fade of Cash Flows to Corporate AverageNote: Random sample of 220 nonfinancial industrial companies, drawn from over 6,000Plant age and life (inflation adjustment factor)Plant lifeDividend yieldSize (LN-current dollar gross investment)Debt/total capital at marketIndustry risk (government intervention?)Company Beta (value line)Unlevered BetaNote the small correlation with Beta. This small 1% R2 with Beta suggests re-evaluation of traditional risk concepts.38THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 39March 2, 1998 2:01 PM- 39 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedBOTH CFROI AND TSR FOLLOW STABLE PARETIAN DISTRIBUTIONSWITH INFINITE VARIANCES AND SIMILAR PEAKEDNESS .Peakedness =1.4912.1 standard errorsaway from 2 (Gaussian)Peakedness =1.458.8 standard errorsaway from 2 (Gaussian)Competitivepressuresforce returnsdownNumberofFirmsInvestorpressuresforce returnsupKEY CONCLUSIONSThe 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 CAPMmeasures 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.39THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 40March 2, 1998 2:01 PM- 40 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedCONFLICTING PERFORMANCE SIGNALSCAN 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 performance40THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 41March 2, 1998 2:01 PM- 41 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedFOCUS ON CFROI REMOVED REINVESTMENT BIAS, ENCOURAGED ECONOMIC BEHAVIOR AND INCREASED VALUEPercentageCampbell Soup Co.YearROCECFROITSR/index100838612713515116716715822723926925241THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 42March 2, 1998 2:01 PM- 42 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedAGING PLANT TRAPPercentageper yearYearNominal RONA hurdle rateForecast RONAReal discount rateForecast CFROI42THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 43March 2, 1998 2:01 PM- 43 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedNEW PLANT TRAPPercentageper yearYearOld plantRONAReal discount rateCFROINew plantNominal RONA hurdle rate43THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 44March 2, 1998 2:01 PM- 44 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedINTANGIBLE TRAPPercentageper yearYearBeforepurchaseAfter purchaseReal discount rateNominal hurdle rateRONACFROI (pooling accounting)44THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 45March 2, 1998 2:01 PM- 45 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedACCOUNTING RETURN MEASURES PROVIDEMISLEADING SIGNALSBusiness Unit RONA and CFROI Vs. Hurdle RatesPercentageper yearBusiness unitNominal RONAhurdle rateReal CFROIhurdle rateFortune 100 manufacturerOld assetsInflationLeasesLow depreciationNew assetsGoodwillHigh depreciationDeferred taxes45THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 46March 2, 1998 2:01 PM- 46 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedESTIMATING THE PAST CAPITAL EXPENDITUREREAL GROWTH RATE FROM LIFE, ACCUMULATED DEPRECIATION, AND INFLATION46THE BOSTON CONSULTING GROUPP:MasterDkBCGs Value Management Framework -An Overview for MBA Students.PPTRt rt (Ppt) Slide 47March 2, 1998 2:01 PM- 47 -Copyright 1996BCG/HOLT Planning AssociatesAll Rights ReservedDERIVATION OF THE RELATIONSHIP OF THECAPITAL EXPENDITURE REAL GROWTH RATE (g) TOTHE RATIO OF ACCUMULATED DEPRECIATION TO GROSS PLANTAssumptions:(1) Depreciation begins the year the firm places the asset in service(2) The plant retires the year after the project Life yearNumerical iterative techniquesemploying the Newton-RaphsonMethod and calculus can solvethis formula for g.47