05 ALCAR Approach

Alcar Approach
About Alcar group

Founded in 1979 by two Professors from Northwestern
Universitys Kellogg School of Management, Al Rappaport and
Carl Noble Jr.
Al Rappaport authored Creating Shareholder Value
Years of Development has Resulted in a User-Friendly Tool
with Vast Reporting Capabilities and Flexibility.
Proof of Products Success Evident in Customer Base of Over
2,000 Corporate clients across every Industry and Sector.
Current Clients (e.g.,Mead/Westvaco, Deutsche Bank, SBC
Communications,Baxter, Macromedia, Humana) have helped
shape the Alcar Solution
Alcar Approach
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
In this framework, the emphasis is not on

annual performance but on valuing
expected performance.
The implied value measure is akin to
valuing the firm based on its future cash
flows and is the method most closely
related to the DCF/NPV framework.
With this approach, one estimates future

cash flows of the firm over a reasonable
horizon,
assigns a continuing (terminal) value at the
end of the horizon,
estimates the cost of capital, and
then estimates the value of the firm by
calculating the present value of these
estimated cash flows.
This method of valuing the firm is identical to that

followed in calculating NPV in a capital-budgeting
context.
Since the computation arrives at the value of the
firm, the implied value of the firm's equity can be
determined by subtracting the value of the
current debt from the estimated value of the firm.
This value is the implied value of the equity of
the firm.
Alcar approach - 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 represent 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
Shareholder value creation network
Corporate
Objective
Valuation
Components
Value
Drivers
Cash flow from

operations
Value Growth
duration
Shareholder return
1.Dividends
2.Capital gains
Creating shareholder
value
1.Sales growth
2.Operating
Profit margin
3. Income tax
rate
Discount
rate
1.Working capital
investment
2. Fixed capital
investment
Management
decisions
operating
investment
Debt
Cost of capital
financing
Assessment of the shareholder value impact of the business unit

(strategy)
Procedure suggested by Alcar approach for assessing shareholder impact of a
strategy
Steps
Elaboration
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]
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)
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)
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
5. Establish the pre-strategy value
The pre-strategy value is; [(cash

flow before new investment ) /
(cost of capital)] market value of
the debt
6. Infer the value created by the

strategy
The value created by the strategy

is: (total shareholder value prestrategy value)
Problem - Illustration
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?
Determination of the value created

by a new strategy
Current
values
Income
statem
ent pr oject ions
Residual
value
(year 0)
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
99
109
120
132 145 145
Net profit 90
Balance sheet projections

Current
values
Residual
value
(year 0)
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
Cash flow projections

Current
values
(year 0)
Residual
value
1
5+
Profit after tax
99
109
120
132
145
145
Depreciation
30
33
36
40
44
48
Capital expenditure*
60
66
73
80
88
48
Increase in current
assets
20
22
24
27
29
Operating cash flow
49
54
59
65
72
145
Present value factor

(@16% discount)
0.862
0.743
0.641
0.552
0.476
Present value of the

operating cash flow
42
40
38
36
34
Total pv
=190
*= (depreciation=30)+(rise in fixed asset =30)=60

In addition to Increase in current asset= 20
Present value of the operating cash flow stream=
190
Residual value= 145/0.16 =906
Present value of the residual value= (0.476)906=
431
Total shareholder value= 190+431-0=621
Pre-strategy value=90/0.16 = 563
Value of strategy= 621-563= 58
Prob
The income statement for the year 0 (just
ended) and the balance sheet at the end of
year for Futura Ltd are as follows:
Income statement
balance sheet
Sales
10,000 equity
fixed assets
Gross margin(20%)
2,000
4000
Selling, gen.adm (10%) 1000
PBT
1000
6000
Current assets
Tax
300
2000
PAT
700 Total 6000
6000
Futura ltd. Is debating whether it should maintain

the status quo or adopt a new strategy. If it
maintains the status quo:
The sales will remain constant at 10,000
The gross margin will remain at 20%and the
selling , general and admn. expenses 10% of
sales
Depreciation charges will be equal to new
investments
The asset turnover ratios will remain constant
The discount rate will be 15%
The income tax rate will be 30%
If Futura Ltd adopts a new strategy its sales will

grow at a rate of 20% per year for three years.
The margins, the turnover ratios, the capital
structure, the income tax rate and the discount
rate, 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?
soln
Current
values
(year 0)
Income statm
1
2
ent
3
sales
10,000 12,000
14,400 17,280 17,280
Gross margin (20%)
2,000
2,400
2,880
3,456
3,456
Selling and gen adm. (10%)
1,000
1,200
1,440
1,728
1,728
PBT
1,000
1,200
1,440
1,728
1,728
Tax
300
360
432
518.4
518.4
PAT
700
840
1008
1209.6 1209.6
Balance sheet & cash flow projections

Current
values
(year 0)
Fixed assets
4,000
4,800
5,760
6,912
6,912
Current assets
2,000
2,400
2,880
3,456
3,456
Total assets
6,000
7,200
8,640
10,368 10,368
Equity
6,000
7,200
8,640
10,368 10,368
Profit after tax (a)
840
1008
1209.6 1209.6
Depreciation (b)
400
480
576
691.2
Capital expenditure(c)
1200
1440
1728
691.2
Increase in current and

operating cash flow (d)
400
480
576
(360)
(432)
(518.4) 1209.6
a+b-c-d
PVIF=
0.870
(313.2)
0.756
(326.59)
0.658
(341.11)
Present value of the operating cash flow stream=

(980.90)
Residual value=1209.6/0.15= 8064
Present value of residual value= 8064/(1.15) 3
Total shareholder value=5302.21980.90=4321.31
Pre-strategy value= 70/0.15= 4667.67
Value of the strategy= 4321.31-4667.67=
= -346.36
Advantages of Alcar Approach

The Alcar approach has been well
received by financial analysts for two main
reasons:
* It is conceptually sound as it employs the
discounted cash flow framework
* Alcar have made available computer
software to popularize their approach
Shortcomings of Alcar Approach

(1) In the Alcar approach, profitability is
measured in terms of profit margin on
sales.
It is generally recognized that this is not a
good index for comparative purposes.
(2) Essentially a verbal model, it is
needlessly cumbersome. Hence it requires
a fairly involved computer programme

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Alcar Approach

About Alcar group

In this framework, the emphasis is not on

With this approach, one estimates future

This method of valuing the firm is identical to that

Alcar approach - value drivers affect

1. Rate of sales growth

While first six value drivers are self explanatory,

Shareholder value creation network

Cash flow from

Assessment of the shareholder value impact of the business unit

1. Forecast the operating cash flow

The annual operating cash flow is

2.Discount the forecasted operating

The weighted average cost of capital

3. Estimate the residual value of the

The residual value is : (perpetuity

4. Determine the total shareholder

The total shareholder value is :

5. Establish the pre-strategy value

The pre-strategy value is; [(cash

6. Infer the value created by the

The value created by the strategy

4. the asset turnover ratios will remain constant

Determination of the value created

ent pr oject ions

132 145 145

Balance sheet projections

Cash flow projections

Profit after tax

Operating cash flow

Present value factor

Present value of the

*= (depreciation=30)+(rise in fixed asset =30)=60

Futura ltd. Is debating whether it should maintain

If Futura Ltd adopts a new strategy its sales will

14,400 17,280 17,280

Gross margin (20%)

Selling and gen adm. (10%)

Balance sheet & cash flow projections

Profit after tax (a)

Increase in current and

Present value of the operating cash flow stream=

Advantages of Alcar Approach

Shortcomings of Alcar Approach

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