[MUSIC] The other very important use of the cost of capital is to allow us to measure performance. We can now try to answer this question. How do we measure whether a company, or a division of a company is generating sufficient profits? Think about the following. Suppose you have invested, you have already invested a million dollars in a project, in a certain investment. How large would annual profits have to be for this project to be creating value. So, remember the idea that for a project to create value, the rate of return has to be greater than the discount rate. And now we have an estimate for a discount rate that comes from our cost of capital. So the answer has to be that the minimum profit that the project has to generate is the WACC times a million dollars. The WACC is a percentage return. If you multiply that by a million, you're gonna get a dollar value. This dollar value should be a benchmark for the company. So if it's PepsiCo, we just figured out that the WACC, it should be lower than 6%. 6% is a conservative estimate. So what you would do is you would multiply 6% times 1 million to have to figure out what is the minimum amount of annual profit that a PepsiCo project would generate. The general concept that we're going to introduce here is this notion of EVA, which we call economic value added. So economic value added is just going to be profit minus WACC times the amount of capital that is invested either in a company, or a decision, or a project. And now we're gonna go back to module one, where we talked about how to measure profits and how to measure assets. A very important notion that we discussed in module one is that, if you want to measure profits for the company as a whole, you cannot use net income. You have to use operating income. You have to use a measure of profits that is before interest payments. In this course, the measure we are using is called OPAT, which is operating profits minus taxes. The same measure that we're going to use here to estimate EVA. What EVA is going to give you, is the difference between OPAT and the WACC, which as we learned is the minimum percentage returned times the operating assets, which are going to be an estimate for how much capital is invested in that company. So the EVA in the end is going to measure whether the company is generating real economic profits after accounting for the required return. After accounting for the minimum profits that the company should generate. So, why are we using this notion of operating assets. First of all, the definition. What we mean by operating assets is the difference between book value of assets and cash. Going back to model one, think about the following. Why are we using book? We already saw the answer. In this type of applications, when we are measuring current profitability, what you want to do is you want to measure the capital that is invested in the company right now. You don't want to include future profits in your measure of assets, so you definitely do not want to use market values here. If you're using market values, really what you're doing is comparing current profits to future profits, we do that when we compute valuation ratios, not when we're trying to measure performance. Why are we excluding cash? We are excluding cash because cash is clearly not invested in the business for most cases. Cash is invested in there's a financial asset, that is invested, typically in treasury bonds, bank deposits. This is not money that is directly invested in the business. So when computing EVA it's good practice to remove cash and short-term investments. There's the word generally there, because in some cases, the cash might be an operating asset. In some cases the cash is required to run the business. You can think of a supermarket, for example, that needs some cash to give change to consumers who come to buy their goods. In that case, cash is part of the business. It is invested in the business but as this example shows, for most real world companies, cash is going to be invested in financial assets so it should not be included in operating assets. So let's go back to PepsiCo and try to figure out whether PepsiCo is generating sufficient profits to cover its cost of capital. That's the notion of EVA. We estimated the WACC at 5%, we have a reasonable range of 4.5 to 6. So we can use these percentage required returns now to measure EVA. All we need to do is to measure OPAT and operating assets. And you should know how to do this already we did this a lot in module one. OPAT is just the difference between operating income, EBIT minus taxes, so OPAT for PepsiCo in 2014 was $7.8 billion. Operating assets, very easy, just take the total assets and deduct cash. Our estimate here would be $62 billion. And then our assumption when we do this calculation is that all the other current assets are invested in the business. And if we go over the list here for most of them is reasonable. Receivables, we learned in module two that receivables is an investment in the business. Net PPE, goodwill, which, if you know some accounting, you will know that goodwill comes from the effect of previous acquisitions on the balance sheet, intangibles. So, it looks like most of these assets are actually invested in the business except for cash. Cash is definitely, most likely to be invested in financial assets like bank deposits and treasury bonds. So that's why we came up with this number. That's why we're using 62 billion instead of 70 billion to estimate operating assets for Pepsi. Given this analysis, we can do the EVA, which is reported here in this table. So you have, for each data, remember we are working with this range for cost of capital. For each data, we have a certain required return on equity. We have a WACC and that gives you the EVA. So even if you take our most conservative estimate, which is a WACC of 6%, what we find out is that PepsiCo is generating approximately $4 billion of pure economic profit in 2014. So that's the difference between OPACC and the WACC multiplied by the operating assets.