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