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     EVA Example-1

    Merck Inc.’s EVA for 2003

    note: need NOPAT for 2003, Capital and Cost of Capital for end of 2002.

    I. Cost of Capital (end of 2002)

A. Cost of equity

1. Merck’s ? = 0.95

    source: Value Line Investment Survey from January 3, 2003

    see: pages 9 and 10 of the 10-k handout

    note: the first Value Line Investment Survey for 2003 gives betas at end of 2002

2. Yield to maturity on long-term U.S. Treasuries = 4.91% on December 31, 2002

    source: Wharton Data Research Service

    see: data column “tlb” on page 11 of the 10-k handout

    Accessing Wharton Data Research Service:

    1) http://bearcat.baylor.edu

    2) link to follow: “Other Electronic Sources”

    3) link to follow: “W”

    4) link to follow: “Wharton Research Data Services (WRDS, Compustat,

    CRSP)”

    5) link to follow: “Login Instructions” to the right of “WRDS (online)”

    6) link to follow: “WRDS”

    Accessing Interest Rate data at WRDS:

    1) link to follow: “Federal Reserve Bank Reports” under “Free access data sets”

    2) link to follow: “Data” under “Interest Rates”

    3) Selections:

     Step One: Data Range

    “Daily”;

    Beginning: “Dec”, “2002”;

    Ending: “Jan”, “2003”;

    Step Two: Interest Rates

    “Treasury Long-Term Average: 25 years and above”

    4) “Submit Request”

    note: Stewart wants the return on a 30-year Treasury, but this data is no longer

    published by the Fed (or in the WSJ).

3. Cost of equity = 10.61% = 4.91 + 0.95(6)

    note: use a market risk premium of 6% for EVA calculations.

     Corporate Finance

     EVA Example-2

    B. Cost of debt

    Note: there is no market data on Merck’s debt

    1. Rates on short- and long-term debt

a. Short-term = 2.0%

    source: footnote #8 in Merck’s 10-k

    see: bold sentence on page 5 of the 10-k handout

b. Long-term = 6.09%

    1) Bond rating for Merck in 2002 was Aaa

    source: Wharton Data Research Service

    see: page 12 of the 10-k handout

    Accessing credit ratings at WRDS:

    1) link to follow: “COMPUSTAT North America”

    2) link to follow: “Industrial Annual” under “Annual Updates”

    3) Selections:

    Step One: Data Range

    “Annual”;

    Beginning: “2002” or earlier

    Ending: “2002” or later

    Step Two: Search

    Search by: “SMBL”

    Company Codes = “mrk”

    “Step Three: Variables”

    “Ticker”, “Company Name” (These are not required, but are

    helpful)

    Data Items: DATA280 S&P LT Domestic Issuer Credit Rating

    4) “Submit Request”

    note: A “2” equals a debt rating of AAA.

    source: Compustat User’s Guide

    see: page 15 of the 10-k handout.

    Accessing information on data items in WRDS:

    link to follow: “documentation” on the right side of the WRDS web

    page. You can either search for particular data items or access the

    “data manuals from this documentation page.

     Corporate Finance

     EVA Example-3

    2) Interest rate on "AAA" bonds as of December 31, 2002, was 6.09%

    source: Wharton Data Research Service

    see: data column “aaa” page 11 of the 10-k handout

    Accessing Interest Rate data at WRDS:

    1) link to follow: “Federal Reserve Bank Reports”

    2) link to follow: “Data” under “Interest Rates”

    3) Selections:

     Step One: Data Range

    “Daily”;

    Beginning: “Dec”, “2002”;

    Ending: “Jan”, “2003”;

    Step Two: Interest Rates

    “Corporate Bonds: Aaa”

    4) “Submit Request”

    2. Amount of short- and long-term debt

a. Short-term = 3,669,800,000

    source: “Loans payable and current portion of long-term debt” on Merck’s

    Consolidated Balance Sheet

    see: page 4 of the 10-k handout.

    note: balance sheet numbers are in millions, we need to convert to actual dollars

    to be consistent with stock information (see page 4 of this handout)

b. Long-term = 4,879,000,000

    source: “Long-term debt” on Merck’s Consolidated Balance Sheet

    see: page 4 of the 10-k handout

    note: balance sheet numbers are in millions, convert to actual dollars.

    3. Average rate on debt

Total debt = 8,548,800,000 = 3,669,800,000 + 4,879,000,000

    3,669,800,0004,879,000,000????????????r?4.33%?2.0?6.09?.42932.0?.57076.09????8,548,800,0008,548,800,000????

     Corporate Finance

     EVA Example-4

    4. After-tax cost of debt = 4.33 ( 1 - .35) = 2.82%

    source for tax rate: footnote #15 in Merck’s 10-k see: page 6 of the 10-k handout

note: use “U.S. statutory rate applied to pretax income” rather than effective rate at

    bottom of table

    C. Weights

    1. Market value of equity

a. Market price per share = 56.61 on 12/31/2002

    source: Wharton Data Research Service

    see: page 17 of the 10-k handout

    Accessing stock prices at WRDS:

    1) link to follow: “CRSP”

    2) link to follow: “Daily Stocks” under “Annual Updates”

    3) Selections:

    Step One: Data Range

    “Daily”;

    Beginning: “Dec” “2002”

    Ending: “Jan” “2003”

    Step Two: Search

    Search by: “TICKER”

    Company Codes = “mrk”

    “Step Three: Variables”

    “Ticker”, “Company Name” (These are not required, but are helpful)

    Data Items: “Price” under “Price, Volume, and Returns Information”

    Note: click on the “documentation” link on the right to get information

    about the data items.

    4) “Submit Request”

b. Number of outstanding shares = 2,244,983,250 = 2,976,198,757 731,215,507

    source: “Issued” under Stockholder’s Equity and “Less Treasury Stock” on

    Merck’s Consolidated Balance Sheet

    see: page 4 of 10-k handout

    notes:

    1) need number of shares outstanding as of end of 2002

    2) the balance sheet lists actual number of shares (not millions of shares)

    3) don’t include Treasury Stock as part of outstanding shares

     Corporate Finance

     EVA Example-5

    c. Market value of common stock = 127,088,501,800 = 2,244,983,250 * 56.61

    d. Minority interests = 4,928,300,000

    source: Merck’s Consolidated Balance Sheet

    see: page 4 of 10-k handout

    notes:

    1) minority interest represents ownership claim of those who own stock in

    subsidiaries not 100% owned by Merck

    => should be included in equity

    2) use book value since no market values available

    e. Total equity =132,016,801,800 = 127,088,501,800 + 4,928,300,000

2. Market value of debt

    Total debt = 8,548,800,000

    notes:

    1) see earlier calculation on page 3 (part 3) of this handout

    2) use book values for all debt since no market data available

3. Market weights

    a. Total of market value of equity and debt = 140,565,601,800

    = 132,016,801,800 + 8,548,800,000

    132,016,801,800?.9392?b. Weight of equity 140,565,601,800

    8,548,800,000?.0608?c. Weight of debt 140,565,601,800

    D. Cost of capital = 10.14%?.9392?10.61?.0608?2.82

    notes:

    1) 10.61 is the cost of equity calculated on page 1 (part 3) of this handout

    2) 2.82 is the after-tax cost of debt calculated on page 4 (part 4) of this handout

     Corporate Finance

     EVA Example-6

    II. Basic EVA

A. NOPAT = NI + IE

    => NOPAT = 7,181,800,000

    = 6,830,900,000 + 350,900,000

    sources:

    1) NI: Merck’s Consolidated Statement of Income

    see: page 3 of the 10-k handout

    2) IE: Footnote #14 in Merck’s 10-k

    see: page 6 of the 10-k handout

    notes:

    1) most numbers in Merck’s 10-k are in millions

    2) in footnote #14, income numbers are enclosed in parentheses; expense numbers are

    not.

B. Capital = A - NIBCLs

    => Capital = 38,855,800,000

    = 47,561,200,000 - (12,375,200,000 3,669,800,000)

    = 47,561,200,000 8,705,400,000

    source: Merck’s Consolidated Balance Sheet

    see: page 4 of 10-k handout

    note: the only interest bearing current liability is “Loans payable and current portion of

    long-term debt”

    C. EVA = NOPAT k * Capitalt-1

    = 3,241,821,880

    = 7,181,800,000 - .1014 * 38,855,800,000

    = 7,181,800,000 3,939,978,120

    notes:

    1) NOPAT is calculated above

    2) Capital is calculated above

    3) Merck’s cost of capital is on page 5 (part D) of this handout

    4) Merck’s net income was $6,830,900,000

     Corporate Finance

     EVA Example-7

    D. MVA = Market value - Capital

    = 101,709,801,800

    = 140,565,601,800 38,855,800,000

notes:

    1) the market value of Merck’s stocks and bonds is calculated on page 5 (part 3a) of

    this handout.

    2) Capital is calculated on page 6 (part B) of this handout.

    III. Harnischfeger EVA

    A. NOPAT (2003)

     Operating profit

plus: Interest earned on operating cash

     Goodwill amortization/impairment

     R&D expense

     Change in LIFO provision

less: Cash taxes

     Amortization of capitalized R&D

1. Operating profit = 11,775,700,000

    = 22,485,900,000 4,315,300,000 6,394,900,000

    source: Merck’s Consolidated Statement of Income

    see: page 3 of the 10-k handout

    notes:

    1) Subtract only ongoing, operating expenses from sales

    2) Equity income from affiliates are not added to operating profit (shown as

    negative expense on income statement) since it represents returns from joint

    ventures and partnerships.

    see: page 2 of the 10-k handout.

    3) When calculating Net Income, Merck subtracts minority interest earnings out

    as part of "Other income (expenses)." Since we want to include those earnings,

    no adjustment is needed.

    source: Footnote 14 from Merck’s 10-k

    see: page 6 of the 10-k handout

     Corporate Finance

     EVA Example-8

    2. Interest on cash balances = 56,600,000

    notes:

1) total interest income (2003) = 308,700,000

    source: footnote #14 in Merck’s 10-k

    see: page 6 of the 10-k handout

2) only want to count interest earned on operating cash

    => not given so must estimate

3) key assumption: interest earned on cash as a percentage of all interest earned

    equals cash as a percentage of all assets earning interest.

    => if cash is 20% of assets earning interest, then 20% of all interest is assumed

    to come from cash.

4) Use balances at end of 2002 for interest earning assets

    => better approach: use average of 2002 and 2003

    => but using 2002 numbers will be good enough for an estimate

    => using 2002 numbers is consistent with calculation of capital where use

    2002 numbers from balance sheet

5) Assets earning interest:

    Cash and cash equivalents = 2,243,000,000

    Short-term investments = 2,728,200,000

    Investments = 7,255,100,000

    source: Merck’s Consolidated Balance Sheet

    see: page 4 of the 10-k handout

    note: investments seems to be primarily long-term bonds

    see: “Analysis of Liquidity and Capital Resources” on page 2 of the 10-k

    handout.

6) cash as % of assets earning interest:

    2,243,000,000.1835? 2,243,000,000?2,728,200,000?7,255,100,000

7) Estimated interest on operating cash = 56,600,000

    = (.1835)(308,700,000)

     Corporate Finance

     EVA Example-9

    3. Goodwill amortization/impairment = 0

    note: no information given about impairment of goodwill, current or accumulated.

4. R&D Expense = 0

    note: Merck’s Consolidated Statement of Income states that Merck’s Research and

    development expense in 2003 was $3178.1, however, this was not subtracted from

    sales when calculating operating profit (page 7 of this handout). Since R&D is

    only added back if it was subtracted when calculating operating profit, set to 0.

    see: page 3 of the 10-k handout and page 7 of this handout.

5. Change in LIFO provision = 0

    notes:

    1) Merck calls the LIFO reserve “Reduction to LIFO Cost”.

    2) Merck’s Reduction to LIFO Cost was insignificantly different from zero for

    both 2003 and 2002.

    source: footnote #6 in Merck’s 10-k

    see: page 5 of the 10-k handout

    note: assume that Merck’s "Reduction to LIFO Cost" had been $100,000,000 in 2003

    and $90,000,000 in 2002. Then "Change in LIFO provision" would have been

    10,000,000 [= 100,000,000 90,000,000].

6. Cash taxes = 2,000,000,000

    source: footnote #15 in Merck’s 10-k

    see: bold sentence on page 7 of the 10-k handout

7. Amortization of R&D = 2,273,400,000

    2,677,200,000?2,456,400,000?2,343,800,000?2,068,300,000?1,821,100,000 ?5

    source: “Selected Financial Data” from Merck’s 10-k

    see: page 8 of the 10-k handout

    note: amortization in 2003 = sum of R&D spending from 1998 through 2002 divided

    by 5.

     Corporate Finance

     EVA Example-10

    8. NOPAT

     Operating profit 11,775,700,000 (p. 7)

    plus: Interest on cash balances 56,600,000 (p. 8)

     Goodwill amortization/impairment 0 (p. 9)

     R&D expense 0 (p. 9)

     Change in LIFO provision 0 (p. 9)

    less: Cash taxes (2,000,000,000) (p. 9)

     Amortization of capitalized R&D (2,273,400,000) (p. 9)

    NOPAT 7,558,900,000

    Note: All numbers are from earlier calculations in this handout on the pages listed.

    B. Capital (2002)

     Operating cash

    plus: Receivables

     Inventory (FIFO)

     Other Current Assets

     Plant & Equipment

     Intangible Assets (plus accumulated goodwill amortization/impairment)

     Capitalized R&D

     Other Assets

less: current liabilities (except deferred tax and interest bearing debt)

1. Operating Cash = 2,243,000,000

    source: Merck’s Consolidated Balance Sheet

    see: page 4 of the 10-k handout

    note: don’t include short-term investments since not operating asset

2. Receivables = 5,423,400,000

    source: Merck’s Consolidated Balance Sheet

    see: page 4 of the 10-k handout

     Corporate Finance

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