HOW IS MfVA USED?
The actual use of the MfVA model is quite simple once the information is collected. It is the identification and definition of the needed data and its collection that are the more difficult tasks. The primary tasks are
1. Calculating the Operating Cash Flow Demand (OCFD)
• Identification of the strategic investments to be included
• The expected useful life of the equipment
• The cost of capital
2. Calculating the Operating Cash Flow (OCF)
Once the data has been collected, the relationship illustrated in figure 2 is created and the MfVA index can be calculated.
Operating Cash Flow Demand (OCFD) is the cash flow needed to meet an investor's financial requirements. For strategic investments, it is the cash flow that is needed in order to end up with an investment value of zero when the investment has reached its economic life.
Developing the strategic investment data is a straightforward task. The three categories of investment are strategic, strategic marginal, and nonstrategic. Of the three, both strategic and strategic marginal investments are included in the data. Nonstrategic, while used in accounting calculations, is considered a cost. The values used are the acquisition costs of the investments.
The useful life of the equipment actually includes three pieces of information. First is the acquisition date. Second is the date when the equipment actually went into use. It is very possible that an investment was made in equipment that for some reason was not used until a later date. Lastly is the expected economic life of the equipment. This is not the depreciation life of the equipment, but the period of time that the equipment is expected to be used. It may differ significantly from the accounting depreciation life. To make MfVA useful, the more accurate the predicted useful life, the more accurate will be the calculations.
The third primary data element is the cost of capital. Typically most companies use a percentage that represents something between the company's actual cost of money adjusted by some accounting factor. The better method is to use what is known as the Weighted Average Cost of Capital (WACC). While more complex, the data is relatively easy to obtain and the calculations are quite easy. Known as C* (C Star), the WACC is the blended cost of the firm's debt and equity capital. It is blended based on the proportional relationships between the actual company debt and capital ratios. The WACC consists of the
1. inflation factor—expected inflation factor over the planning horizon
2. long-term government bond rate—actual at the time the model is
run and performance is calculated
3. corporate marginal income tax rate—calculated based on the last 3
years' actuals (preferably)
4. company capital—calculated based on the last 3 years' actuals
5. company debt—calculated based on the last 3 years' actuals (pref
6. total capital—calculated
7. solvency ratio (equity ratio)—company capital/company debt
8. market risk premium—historical average excess return of S&P 500
compared to bonds. Six percent is the accepted MRP and should
9. risk beta—factor or actual if available
10. permanent capital debt rate—current borrowing rate or replacement
cost of debt.
Once the WACC is known, the cash flow each investment must produce in each period can be calculated. The sum of the different investment cash flow requirements per period is that period's OCFD.
Operating Cash Flow (OCF) consists of, simply, the amount of cash used. Using accounting's verbiage, it is earnings before interest and tax (EBDIT), working capital movements, and nonstrategic investments. While these numbers are easy to obtain at the company of P&L level, they can be difficult to develop when working at the unit or manufacturing cell level. As long as the same process or cost allocation is followed for each manufacturing unit evaluated, the indexes developed will be usable.
Once the OCFD and OCF are known, the difference between them is the Cash Value Added. A positive number represents the value that had been added to the company during that period. A negative number would indicate that value was reduced during that period.
Because different units or manufacturing cells have different OCFs and OCFDs, it is not possible to make direct comparisons to determine the relative value of different operations. To allow unit operations comparisons, a MfVA index should be used. This creates an index number that can be used for comparing similarly calculated value numbers for internal operating units. The index is calculated as the OCF divided by the OCFD. The index makes it possible to compare different units' profitability in a manner consistent with financial theory. An MfVA index above one indicates that the strategic investment produces sufficient OCF. Less than one and value is being lost. Greater than one and value is being added.
Once the results are known, management can better understand what components of OCF and OCFD are creating or hindering value creation. When understood, these components can be changed to better match future strategies. Management will then have a powerful tool for analyzing the value and profitability of each unit's operation
To Be Continued