# Why are you destroying the FCF

## Shareholder value

 definitionThe shareholder value concept was first defined in 1986 by the American economist Alfred Rappaport. Thereafter, the value of a company is measured by the market value of its shares.

### 1 This is the purpose of shareholder value

The shareholder value is part of the strategic target planning. With its help, the value of strategies can be determined. Equity represents the most important variable. Its increase means an increase in value for the owners. The shareholder value approach says that this should be the top priority of management, as the owners also bear the risk.

### 2 These data are important for the concept

The following values ​​are considered to be the basic evaluation factors for a successful strategy:

These values ​​must always be included in strategic considerations.

### 3 Calculation of shareholder value

The following formula is used to calculate the shareholder value as the present value of future cash inflows:

The following apply:

 K = Cost of capital rate, discount factor t = 1, ..., T = Planning periods

For the calculation, the free cash flow must first be determined:

 Free cash flow = Operating profit - paid taxes + Depreciation (does not affect expenditure) - Investments in fixed assets (net) - Investments in current assets (net)

The cost of capital is in turn calculated using the following formula:

For the determination of the shareholder value a Planning period from five to 10 years. Ultimately, the period chosen depends on the lifespan of the strategy. When determining the shareholder value, the cash flows of a period of z. If, for example, five years are used, the present value of the cash flows for these five years is the so-called Final value to complete. Based on the consideration that even after the five-year period under consideration there is still an enterprise value that will also lead to a cash flow contribution beyond the five years, this final value must be taken into account.

The final value summarizes the present value of the net cash flow inflows after the planning period. For the sake of simplicity, it is usually assumed that these net cash flow inflows will be achieved continuously at a constant level. For the calculation, this means that the net cash flows beyond the planning period are to be calculated as a "perpetual" annuity.

Practical example

Determination of the shareholder value

As a result of its strategic considerations, a company decides to add a new product to its product range. Development costs for this product have so far been EUR 3.7 million. Production and sales are to be started from 2 year 1.

The following investments are required in year 0:

 KEUR Construction of productionDevelopment of sales organization 7,500 amortization 5 years1,200 amortization 5 years

The following sales are to be achieved with the new product:

 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6ff Turnover kEUR 5.500 11.000 16.500 19.500 21.000 21.000

The product achieves a coverage ratio of 25% in year 1. This is reduced by 1% per year as a result of the cost increases. From 2008, a constant coverage ratio of 20% is assumed.

10% of the increase in sales in each year is assumed to be an investment in current assets.

15% of the increase in sales in each year is invested as a net investment in the fixed assets of the following year. For 2003, 10% of the initial investment is calculated.

From year 6ff, the depreciation corresponds to the investment in fixed assets, so that the net investment is zero.

A profit tax rate of 50% is used.

 period Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6ff sales 5.500 11.000 16.500 19.500 21.000 21.000 Increase in sales 5.500 5.500 5.500 3.000 1.500 0 Coverage ratio 25% 24% 23% 22% 21% 20% contribution margin 1.375 2.640 3.795 4.290 4.410 4.200 Depreciation from initial investment 1.740 1.740 1.740 1.740 1.740 Investments Initial investment 8.700 Net investment AV 870 825 825 825 450 0 Net investment UV 550 550 550 300 150 0 8.700 1.420 1.375 1.375 1.125 600 0 contribution margin 1.375 2.640 3.795 4.290 4.410 4.200 Depreciation 1.740 1.740 1.740 1.740 1.740 0 Profit –365 900 2.055 2.550 2.670 4.200 Taxes –182,5 450 1.027,5 1.275 1.335 2.100 profit after taxes –182,5 450 1.027,5 1.275 1.335 2.100 Cash flow I 1.557,5 2.190 2.767,5 3.015 3.075 2.100 Net investment 8.70 1.420 1.375 1.375 1.125 600 0 Cashflow II (free CF) –8.700 137,5 815 1.392,5 1.890 2.475 2.100 Present value factors 15% 0,869565 0,756143 0,657516 0,571753 0,497176 0,432327 Present value CF II –7.565 104 536 796 940 1.070 Cumulative present value CF II –4.120 Residual value Cash flow in year 0: cost of capital = 14.000 Present value of the residual value 14.000 × 0,432327 = 6.053 Shareholder value 1.933