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Golf course management: An Economic Value Added approach
I can still remember that day in 1998 when I became the grow-in superintendent at a new golf course in northern Virginia. I began work that first day with a golf course shaped entirely of soil; complete with the tee complexes, bunkers, greens and green surrounds, mounds, swales and hollows -- all devoid of grass. That was my job, to grow it in, and in a way I was adding value to this property. I was taking this shaped soil and growing it into an economically viable entity. Even outside of the grow-in perspective, any superintendent can be perceived to be adding value to an existing golf course by efficiently managing the assets at their disposal.
However, in the eyes of investors, bankers, venture capitalists, management firms, creditors and the like, creating value is not about improving green space. They are not concerned so much with disease free turf, fast green speeds, or good fertility programs; they are concerned primarily with numbers. These business people are looking for ROI (return on investment); they are looking at EBITDA (earnings before interest, taxes, depreciation and amortization); they worry about NOPAT (net operating profit after taxes). And at the end of the day, they are mostly interested in one thing -- making a profit.
Let me introduce you to the Economic Value Added (EVA) approach to thinking about golf course management. Whether you are a superintendent, a general manager, an investor or any of the multitude of other stakeholders involved in the business of golf, this approach to thinking about managing golf properties provides actionable alternatives for all levels of staff and management whereby they can contribute directly to the economic value of your property. EVA is accurate in its representation of economic value added or lost, and it's even a bit enlightening in comparison to the generally accepted accounting principles by which we have traditionally measured performance.
The Economic Value Added approach
The basic formula for EVA is:
For example, let’s say that North Fork Golf Club is purchased by a group of investors for $5.5 million. The investors have put up $2 million while borrowing the remaining $3.5 million from Lexicon Financial at 7.5 percent interest. These are some nice sound numbers financially speaking, with the investors acquiring a 36 percent equity interest in the property; I would not call this property highly leveraged, so it might just have a chance to make it in today’s economy. Traditional thinking would tell us that this property has a debt cost associated with it equal to the 7.5 percent interest that’s being charged on the loan. However, in the EVA approach, we think in terms of assigning a cost to both the equity portion of the financing as well as the debt. These two costs are then weighted in order to determine the WACC (Weighted Average Cost of Capital), which in turn is used in solving the EVA equation.
But what should the cost of equity be? After all the investors don’t consider their investment to be a loan; they don’t expect to see their money back in the form of cash, and the only future payment possibly due to investors might be in the form of dividends, maybe. The cost being associated with equity under the EVA approach should be thought of as an opportunity cost. In other words, we assume that the investors originally had a choice of investment options; perhaps they were considering buying North Fork GC, but they were also considering a Kentucky Fried Chicken franchise and a BP gas station franchise. They had other investment opportunities, and they chose golf probably because they like to play golf more than they like to eat chicken or fill up their cars. The chicken franchise would have returned 12 percent annually and the gas station 8 percent annually. Averaged out, the investors could have realistically expected to make about 10 percent in some other investment opportunity. Finally in calculating the cost of equity, we should also consider a beta factor, which is a constant used to account for the risk inherent in certain investment options. Simply put, we would probably consider investing in a golf property slightly more risky than investing in either of the other two options (due to the weather factor, the current slump of the industry, the fickleness of golfers, etc) so the beta factor we will assign to the equity investment in this golf property is 1.15. We are saying that we think investing in North Fork GC is about 15 percent riskier than investing in either of the other opportunities. Therefore the cost of equity in the North Fork GC scenario is calculated as such:
Weighted Cost of Equity = Percentage of Equity * Opportunity ROI * beta
The cost of debt is a bit easier to calculate, in that we already know the interest rate of the loan from Lexicon Financial (7.5 percent). We simply have to make an allowance for the tax break we’ll be getting on the loan, as the interest on our loan payments to Lexicon are going to be a tax deductible business expense.
If we assume that this golf property will be taxed at a 40-percent rate, the effective interest rate we’ll be paying on the loan will only be 4.5 percent.
The effective interest rate is calculated here:
And the weighted cost of debt is calculated here:
Now we can go ahead and calculate our Weighted Average Cost of Capital, taking into account costs for both the investors’ equity and the costs of our debt after taxes.
WACC = 4.18 + 2.86 = 7.04%
This is a critical number, and what it means for our investors is that 7.04 percent is the minimum return on total investment they can accept, and still be able to create economic profit by investing in this property. Had they simply looked at the after tax cost of debt, our investors would have thought that a return on investment of say 6 percent would have been a good deal. While a return on investment of 6 percent would have covered the after tax cost of debt (4.5 percent), a 6 percent return would actually have been lower than their weighted average cost of capital, and therefore this investment would have been a destroyer of wealth rather than a creator of wealth. If economic wealth is not being created with this investment opportunity, then the investors may have been better off investing in either the chicken franchise or the gas station.
So now having calculated the WACC, we can return to the EVA equation and calculate our Economic Value Added.
EVA = NOPAT – (total capital supplied * weighted cost of capital)
We can see in the EVA equation that an annual net operating profit after taxes in excess of $387,200 will add economic value to the firm (North Fork GC), and will create wealth for the investors. By way of example, if North Fork GC had experienced a reasonable good first year in business with net operating profit after taxes of say $350,000, the investors would still have destroyed economic value in the amount of $37,200, as they would have failed to recoup all of the costs of their equity and debt capitalization.
There is a dual importance to the 7.04-percent benchmark which has additional meaning to the firm in the area of capital budgeting. This WACC value is the minimum return on investment that is acceptable for any new investment options the club might be considering. For instance, if the club is considering two capital projects next season, 1) renovating the dining room area of the club house, or 2) installing a new swimming pool, the rate of return for both of these projects must be calculated, and that rate of return must exceed the 7.04-percent threshold in order for funding to be approved. If the return on investment for the clubhouse renovation is estimated at 8.5 percent, and the return on investment for the pool is estimated at 2 percent, then only the dinning room renovation is approved for funding. If the return on investment for both of these capital proposals fails to exceed the 7.04-percent threshold, then neither project will be approved, as they would both be destroyers of the economic wealth of the firm.
Actionable alternatives to create EVA
For each type of asset, firms face a trade-off: current assets (working capital) are necessary to conduct business and the greater the holdings of current assets, the smaller the danger of running out (running out of certain food items in the restaurant, running out of pesticides when you need to spray, running out of a merchandise in the pro shop when demand is high), which in turn lessens the firm’s operating risk. However, holding working capital in inventories or cash or receivables is costly.
Let’s exam inventories in a golf course maintenance operation: In early spring, I’m already worrying about all of the diseases, cut worms and crabgrass I’ll be facing. Then a salesman arrives with his discounted early order programs, and I am happy to order all of the fertilizer and pesticides I’ll need for the coming season, take delivery of it in March, pay for it in May, and store the inventory until I need it; after all I just saved the club a lot of money compared to the in-season prices. Right? Well, maybe not. What I just did was to tie up a lot of the club’s working capital in inventory. This is the same working capital that could have been used to cover early season payrolls, pay food and beverage vendors or pay for pro shop merchandise. To be sure, inventory management is a balancing act, trying hold just enough inventory to have what’s needed for current use, but not too much to tie up precious working capital. The trend these days is toward what we call just in time (JIT) inventory management, which means you are ordering strictly for the short run, and the materials arrive just in time for your use. What JIT inventory management really does for your firm is to shift the cost of holding inventory back to the vendor, as the vendor now pays the transportation, warehousing and financial carrying costs of this inventory until you’re ready to use it. You may pay slightly higher per-unit costs at the time of purchase, but the bulk of your working capital is preserved and can be used more efficiently in alternative uses, and this in turn is increasing the economic profits (the EVA) of your firm.
Accounts payable can also come into play at this point to enhance EVA. If vendors are offering a discount for prompt or early payment for your JIT inventories, you may want to take advantage of them, and a simple calculation will tell you whether or not their discounts are worth your while. Otherwise, accounts payable can and should be pushed back to be paid near the end of the due-date cycle, which allows your firm to hold its working capital longer. Once again it’s better for you to hold your cash (your working capital) and apply it more efficiently to alternative uses, than to pay it out earlier than required to a vendor.
Accounts receivable management may not be as much of a concern for some golf properties, as most of our sales are made for cash due at the time of the sale (green fees, cart fees, food amd beverage income, merchandise, etc.). However, if your property is in the habit of extending credit to large golf outings, corporate customers or members, then accounts receivable management is important. Obviously, the shorter the days sales outstanding (the average collection period it takes to actually get paid for your receivables), the better your working capital position will be, and this enhances your economic profits.
Cash is the final component of working capital, but too much cash is not necessarily a good thing. Cash is basically a non-interest bearing entity. Cash that is being used efficiently in a variety of working capital management programs is working in your favor and creating economic profits for your golf course, but cash lying around in a non-interest bearing checking account is not being made to work for you and is not contributing to the EVA equation of your firm.
Free cash flow and EVA
FCF = Operating Cash Flow – Gross Capital Expenditures
Free cash flow is a good indicator of financial performance, without having to guess at some of the harder to quantify variables such as the cost of equity in the weighted average cost of capital value. Free cash flow simply says; here is the cash that’s left over after expenses, taxes and re-investing in the property to ensure continued success. It is money that the investors can take in the form of a dividend, or a stock buy-back, it can be used in repaying debt holders or putting it aside as retained earnings.
Generally speaking, golf course construction and operation requires a fairly high initial capital investment, coupled with a relatively low return on that investment. Someone once told me that golf courses are a lot like coffee shops, in that you have to sell a lot of cups of coffee in order to make a profit. I agree that driving revenues through increased rounds of golf will always do wonders for the bottom line. However, good solid judgment with regard to the acquisition and replacement of capital assets along with some smart current asset management can also go a long way to attaining profitability in the golf industry.