Alcar Approach

Topics: Depreciation, Net present value, Generally Accepted Accounting Principles Pages: 10 (3686 words) Published: July 23, 2013

ALCAR approach: the Alcar Group Inc. a management education and software company, developed an approach to VBM which is based on discounted cash flow analysis Determinants of shareholder value: according to Alfred Rappaport author of creating share holder value; a guide to managers and investors, who is regarded as father of share holder value, the following seven factors called “value drivers” affect shareholder value 1. Rate of sales growth

2. Operating profit margin
3. Income tax rate
4. Investment in working capital
5. Fixed capital investment
6. Cost of capital
7. Value growth duration
While first six “value drivers” are self explanatory, last one value growth duration represents the period over which investments are expected to earn rates of return in excess of cost of capital. It is an estimate reflecting the belief of management that competitive advantage will exist for a finite period Thereafter competitive edge would be lost causing the rate of return to regress to the cost of capital Assessment of the shareholder value impact of the business unit (strategy) Procedure suggested by Alcar approach for assessing shareholder impact of a strategy Step 1: Forecast the operating cash flow stream for the business unit (strategy) over the planning period The annual operating cash flow is defined as: cash inflow [(sales)(operating profit margin)(1-effective tax rate)] –cash outflow [fixed capital investment + working capital investment] Step 2: Discount the forecasted operating cash flow stream using the weighted average cost of capital The weighted average cost of capital is: (post-tax cost of debt) (market value weight of debt) + (post-tax cost of equity) (market value weight of equity) Step 3: Estimate the residual value of the business unit (strategy) at the end of the planning period and find its present value The residual value is: (perpetuity cash flow)/ (cost of capital) Step 4: Determine the total shareholder value

The total shareholder value is: present value of the operating cash flow stream + present value of the residual income – market value of the debt Step 5: Establish the pre-strategy value
The pre-strategy value is; [(cash flow before new investment) / (cost of capital)] – market value of the debt Step 6: Infer the value created by the strategy
The value created by the strategy is: (total shareholder value – pre-strategy value) Problem: The income statement for year 0 (the year which has just ended) and the balance sheet at the end of year 0 for Ventura Limited are given below ( in blue colour); Ventura ltd is debating whether it should maintain the status quo or adopt a new strategy. If it maintains the status quo: 1. the sales will remain constant at 1,000 2. the gross margin and selling, general, and admin. Expenses will remain unchanged at 25 and 10 percent respectively 3. depreciation charges will be equal to new investments 4. the asset turnover ratios will remain constant 5. the discount rate is 16% 6. the income tax rate is 40% If Ventura ltd adopts a new strategy its sales will grow at a rate of 10% per year for five years The margins, the turnover ratios, the capital structure, the income tax rate, and the discount rate, however will remain unchanged Depreciation charges will be equal to 10% of the net fixed assets at the beginning of the year What value will the new strategy create? • 40. Determination of the value created by a new strategy Current values Income statem ent pr oject ions Residual value (year 0) 1 2 3 4 5 5+ Sales 1000 1100 1210 1331 1464 1611 1611 Gross margin (25%) 250 275 303 333 366 403 403 S &G.A (10%) 100 110 121 133 146 161 161 PBT 150 165 182 200 220 242 242 Tax 60 66 73 80 88 97 97 Net profit 90 99 109 120 132 145 145 • 41. Balance sheet projections Current values Residual value (year 0) 1 2 3 4 5 5+ Fixed assets 300 330 363 399 439 483 483 Current assets 200 220 242 266 293 322 322 Total assets 500 550 605 667 732 805 805 Equity 500 550 605 667 732 805 805...
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