INDIAN INSTITUTE OF MANAGEMENT INDORE POST GRADUATE PROGRAME IN MANAGEMENT AY 2020 — 2021 Term Il FINANCE-I Prof. B Hariprasad Prof. K Kiran Kumar Prof. L V Ramana Prof. Yogesh Maheshwari CREDITS 3 READINGS STRICTLY FOR PRIVATE CIRCULATION; NOT FOR SALEIndian Institute of Management Indore | INO POST GRADUATE PROGRAMME IN MANAGEMENT (PGP) AY: 2020-21, TERM: It TITLE OF THE COURSE: FINANCE CREDITS: 3 Name of the Faculty Faculty Block/ | Email Telephone Room No. Number Prof. 8 Hariprasad A107 kirankumar@iimidracin | 0731-2439519 Prof. K Kiran Kumar 209 hariprasad@iimidr.ac.in | 0731-2439514 Prof. LV Ramana 108 ramana @iimidr.ac.in (0731-2439573 _ Prof. Yoresh Maheshwari | A-109) maheshwari@iimidracin | 0731-2439521 CONSULTATION TIME FOR STUDENTS: Name of the Faculty Timing Prof. B Hariprasad Tuesday & Thursday in between 3:30 to 5:30PM Prof. K Kiran Kumar ‘Thursday in between 3:30 to 5:30PM Prof. LV Ramana ~_| Thursday in between 3:30 to 5:30PM Prof. Yogesh Maheshwari Friday in between 3:00 to 5:00PM ‘COURSE DESCRIPTION: ‘This foundation course in finance introduces the participants to the basics of financial management and its environment. Successful management of businesses requires 3 sound understanding of some of the decision-making tools, which would be introduced as a part of this course. COURSE OBJECTIVES: The course aims at providing the participants with the following: © an understanding of financial planning and analysis, knowledge of working capital decisions, basics of risk, return and valuation, and Underpinnings of financial instruments and markets. PEDAGOGY/TEACHING METHOD The pedagogy would consist of an appropriate mix of lectures, cases and discussions, TEXTBOOK Brigham, Eugene F and Ehrhardt, Michael C., Financial Management: Theory and Practice, 14e, 2014, Cengage Learning, New Delhi (referred to as BE in the course outline}LEARNING OUTCOMES: EXPECTED LEARNING OUTCOMES AND ASSOCIATED MEASURES At the end of the course student is expected to accomplish the following learning outcomes. Alignment of Course Learning Outcomes (CLOs) with the Programme Learning Goals & Objectives and Assessment of the learning outcomes of the course is presented below: Program Learning Goals Learning Objectives Assessment Tool(s) Develop Critical Thinking TT Relate the classrooin learning with problems faced by the ‘organisation or measures taken by the organisation (0 auldress problem/s, 1.2 Identify the decision problem along with sourees. 1.3 Identifies and presents appropriate evidence supporting the analysis of altematives 1.4 Evolves one’s own perspective or takes a position / makes judgement Embedded question(s} in Quizzes and/or ET Develop Competence in ‘Quantitative Analysis 3.3 Understands financial planning and forecasting methods required for making business decisions Embedded question(s) in Quizzes and/or ETEVALUATION: Individual Component [Group Component | Weightage Class Participation 20 Quizzes 40 End Term 40 Total 100% ACADEMIC DISHONESTY: IIM Indore believes in Academic honesty. Academic dishonesty or misconduct is cheating that relates to an academic activity. It isa violation of trust between the Institute and its stakeholders. Plagiarism, fabrication, deception, cheating and sabotage are examples of unacceptable academic conduct. Please consult the Programme manual for the section on academic dishonesty. SCHEDULE OF SESSIONS: Module |: Introduction to Finance Module Objective: To introduce participants to finance through a seamless connect from their first course in accounting, Session Objecti Goals and Functions of Finance To understand the goals of financial management and its constituent decisions Readings: | BE: Ch.1 pp. 3-13 Article: Alfred Rappaport (2006), Ten Ways to Create Shareholder Value, Harvard Business Review, September 2006, 2-13. Financial Statements: From Accounting to Finance To appreciate the use of financial statements for managerial decisions BE: Ch. 2 pp. 51-76 Christopher D. Ittner and David F, Larcker (2003), Coming up Short on Non- financial Performance Measurement, Harvard Business Review, November 2003, 19. Session 3: _| Financial Planning and Forecasting ‘Objective: | To comprehend the process of financial planning and projecting financial statements 1. BE: Ch. 12 pp. 487-511 2. Thomas Piper {2012}, Assessing a Company’ Future Financial Health, HBS No. 9-911-412, Boston, MA: Harvard Business School Publishing Case: Steven Rogers and Kenneth Cooper (2016), Gilbert Lumber Company, HBS No. 9-315-137, Boston, MA: Harvard Business School Publishing ReaModule tl: Working Capital Management Module Objective: To provide a comprehensive understanding of the components of the short term financing policies of a firm Sessions 4: | Working Capital Planning Objective: | To understand the concepts of operating cycle and cash cycle, and to comprehend cash budgeting and cash management techniques Reading: 1. BE: Ch. 16 pp. 631 - 653 2. Andrew R. Jassy, Laurence E. Katz, Kevin Kelly, and Baltej Kochar (1998), Cash Management Practices in Small Companies, HBS No. 9-699:047, Boston, MA: Harvard Business School Publishing Session 5: | Managing the Receivables Objective: | To understand the credit policy variables and their impact on the level of receivables Reading: BE: Ch. 16 pp. 654 ~ 662 Case: Multitech Limited Working Capital Management To introduce the terms of various sources of short term financing and provide a comprehensive view on working capital management BE: Ch. 16 pp, 662 ~ 669 Richard Ruback (2003), Dell’s Working Capital, HBS No. 9-201-029, Boston, MA: Harvard Business School Publishing ‘Module Ill: Introduction to Risk, Return and Valuation Module Objective: To introduce the basic tools that help in valuing financial instruments and to understand the risk-return relationship amongst various classes of financial instruments Sessions Time Value of Money Objective: To familiarise participants with the concepts of discounting and compounding of various kinds of cash flows that will enable computation of value Reading: BE: Ch. 4 pp. 133 - 176 Case: Local Bank (Mini Case, BE: pp. 185-186) Session 8: Bond Valuation Objective: | To be conversant with the process and terms involved in employing time value of money in valuing a fixed income instrument Reading: BE: Ch. 5 pp. 187 - 206, 211 ~ 220 Case Fixed Income Valuation, HBS No. 9-298-080, Boston, MA: Harvard Business. School Publishing (First two exercises only) Session 9: _| Stock Valuation Objective: | To apply the time value of money for valuing a security with variable cash flows | BE: Ch. 7 pp. 289 - 313 Temp Force Company (Mini Case, BE: pp. 322-323) qSession 10; _ Basics of Risk and Return ‘Objective: To understand the concept of risk, its link with the return on an asset and the computations involved BE: Ch. 6 pp. 235 = 250 Introducing Asset Pricing Models To understand the basic tenets of the models that are premised on the risk- return relationship Reading: BE: Ch. 6 pp. 250-265 Module IV: Introduction to Corporate Financing Module Objective: To enable participants understand the framework in which corporates operate and access funds Session 12; _| Financial System Object To understand the different kinds of markets that firms access for short term and long term funds Reading: BE: Ch. 1 pp. 13-27 Session 13: _| Financial Markets ‘Objective: | To understand how corporates undertake issuance of securities, Reading: | 1. BE: Ch. 1 pp. 2728, Ch. 18 pp. 729-735 2. Money and Capital Markets: Another Option for Funding Growth, Harvard Business Press Chapters, Product No. 58326C-PDF-ENG. Case: Kendall H. Backstrand (1997), Netscape’s initial Public Offering, HBS No. 9-295- 088, Boston, MA: Harvard Business School Publising Session 14: _ | Market Efficiency Objective: | To understand the impact of information on the level of efficiency of the market and some tenets of behavioral finance Reading: BE: Ch. 6 pp. 265 ~ 269 “Article: 1. Bruce Stangle (2005), Market Efficiency versus Behavioral Finance, Journalof Applied Corporate Finance, 17(3), 124-134 2, Meir Statman (1999), Behavioral Finance: Past Battles and Future Engagements, Financial Analysts Journal, 18-27 Session 15: _| Integrating the Essentials of Finance with the Financial Environment Objective: | To appreciate the need for aligning the finance function to the financial environment in which the firm operates Reading: | Jose M. Campa (2013), Lessons from the Crisis for Corporate Finance, IESE Insight, 16, 13-18, eePlease indicate the changes made in the course outline based on the measurement of assurance of learning (closing the loop)/student feedback: NIL Please give the details of the book if students need to buy the book: ‘Author Title Publisher [Edition | Remarks, if any Brigham, Eugene F and | Financial Cengage Ide, 2014 | referred to as BE Ebrhardt, Michael | Management: Learning, in the course Theory and Practice_| New Delhi outline Additional Readings: No additional reading is required for the course.Harvard Business Review www hbrreprints.orq, Companies profess devotion Cithiwene Len Ways to Create rarely follow the practices that mateiwerntente Shareholder Value to make your company a level 10 value creator? by Alfred Rappaport Included with this full-text Harvard Business Review article: 1 Article 4 ‘Phe Idea in Brief—the core idea "The Idea in Practice—putting the idea to work 2 ‘Ten Ways to Create Shareholder Value Alist of related mi exploration of the s. with annotations to guide further icles ideas and applications Reprint 0609 “re documest i euhrna lr eon in Prk 8 Hara Pt Kea oman Par LV Ransana Prt Yogoss Maheshwari POPTZHFIN20202¢ atin ate of Maragemant Tare am et 2000 on 202 Fi i a 5 Idea in Brief__ ay firs sactifice sustained growth or sorter financial gan. For example, 2 whopping 60% of executives would inten tionally mit rtiel RED spending justo meet quarcelly etrings benchmaks Re sul They miss opportunites to create en during yluefor thei companies and their shareholders How to cultvate the ftute groath your ‘im needs to succeed? Rappaport ident fies 10 powertl practices Fest among tem: Dov yt sucked into the host term eatrings expectation gamne—it only {tempts you to for90 value-teating invest ments torepor rosy earnings now, Another roctice: Ensure that execucives bear the Same sks of nership that shareholders do —ty requzing them to onnstock hte fron. AceBay.for example, executives Nave toown company shares equivalent thee times their annual base salary eBay aio nae? When exceutves have sigaificant skin inthe game, they tendto make decisions vithong erm value in Ten Ways to Create Shareholder Value The Idea in Practice | oppaport commends thete additional practices to create Yong: term growth for yout compary: Make strategie decisions that maximize ‘expected futuro value—evan at the expense of lower near-term earnings In comparing strategic options ask Which opeating units patent to create long tein giowah vorsants additonal capital in ‘vestments? Which have limited potential and Uheveoreshouie berestiucturedorcivested? what mix of investments sioss operating Units should produce the mast lang term valet Carry assets only if they maximize the long: toem value of your fir, Focus on actives that contibute most to long tm value, such 95 resparch and tate hiring, Outsource lower value activities suchas manufacturing, Consider NetCom puter’ wol chronicled direc 1 consumer {custom PC assembly business model. Deli vests extereivey in marketing and elephone sales while minimizing is investments a lstribution, manutactuing a inventony caring fis, Return excess cash to shareholders when there areno value-cteating opportunities Inwhich to invest Disburse excess cash reserves to shareholders {hvough dividends ancl sate buybacks You't ‘give shareholders chance to ear better {uins elsewhere an prevent management from using the cash co make misguided valus-destying investments, Reward senior executives for delivering superior longterm retums, Standard stock options disinsh long-term mativacon since many executives cash cut ay stead use scoun indeesepsins These options rend executives ony shares utperioum a stack index af the company’s Deets, not simply because che market a 8 hele sng Reward operating unit executives for ‘adding superior muitiyear value Instead of inking baruees to budgets ta proc tice that induces managers to lombal peso mance possi) develop mets that cp tre the shareholder value created by the ‘operating unt And extend the performance ‘evaluation pried toa leastaoling tee- year cle, Reward middie managers and fronting ‘employees for delivering superior performance on key value drivers they Jnfluence directly Focus on thice to five leading value based metrics. suchas time fo market for new prod ‘uct launches, employee tumovey, customer Fetention and umely opening of new sores Provide investors with valve relevant information. Counter short-term eanings obsession an Investor uncertainty by improving the form and conteat of Francia reports Prepare a cor porate performance statement that allows a alps ane shareholders toeadily undewstand the key performance necator that chive your compary’ ong term value, ‘is docuon is oor lr use only in Fro Hara Pot Kran Kor Pa LY Rama Pr ones Maneshwss PGT 20z071 a lan bts of Manager &Companies profess devotion to shareholder value but rarely follow the practices that maximize it. What will it take to make your company a level 10 value creator? Ten Ways to Create Shareholder Value by Alfred Rappaport Ws become fashionable to blame the pursuit of shareholder value forthe ills beseting corpo rate America: manayers and investors obsessed with next quarters tess, flare to invest in Jong term grovth, and even the accounting scare dats that have grabbed headlines. When execu tives destroy the value they ae supposed to be ‘creating, they almost always claim that stock ‘market pressure made them doit. ‘The reality is that the shareholder value principle has not filed management ater, i {is management that has betrayed the princi pile. In the 19905, for example, many compa- nies introduced stock options as a major com ponent of executive compensation. The ides waste align the interests of management with those of shareholders. Bux the generous dist: boution of options largely failed to motivate value friendly behavior because their design al ‘most guarantee that they would produce the ‘opposite result. To start with, relatively sort vesting periods, combined with a belief drat shoreterm earnings fuel stock price, encour ‘aged executives to manage earnings, exercise ARYAN BUSINESS REVIW = SERENE 2006 “This docu ahs er se myn Pl 8 Monga Pt K Xen Kira LY Rahn Yopes Maneshas POPA2IAB2020 21 td tte cf Mangement Ire fan et 20201 san 202% 4 their options early, and cash out opportunist- cally The common practice of accelerating the vesting date for a CEO's options at retirement ‘add yet another incentive to focus on short- term performance, (OF course, these shortcomings were ob- ‘cured dating much ofthat decade, dl eorpor rate governance took a backseat 35 investors watched stock prices rise ata double-digit lip. ‘The climate changed dramatically in the new millennium, however, a accounting scandals, ‘and a steep stock market decline triggered a rash of corporate collapses. The ensuing ex sion of public trust prompted a swift regula- tory respanse-—mest notably the 2002 passage ff the Sarbanes Oxley Act (SOX), which re uizes companies to institute elaborate inter nal controls and makes cosporate executives directly accountable for the accuracy of finan ‘yestor because Lam a businessman I you have the mentality ofboth, it ids youn each fel In Berkshires communications for example, Buffet makes it lear that the company does no “follow the usual practice of giving earnings ‘euidance:” recognizing that"reported earings ‘may reveal relatively ite about our ‘ue economic pesformance” (see Pri | ciple a. Instead the company wawsto be"candi in our reprtina to you, em | phasing the pluses and minuses in portant in appraising business value ‘Our guideline is totel you the business facts that we would want 0 know four Pasitions were reversed. We we yOu | oless"(Prineiple 0) Berkshire’ capital allocation decisions, cxpacialy when earings gronth and value reation conti ae aso consonant with the shareholder value princi | wwrkes ture, Accountingcorsequences dd nat intluence eu operating or api allgaton decisions When aquisition ‘cess are sir, we much pele to pot hase f2of earnings that ae nt report able by ve under standard accounting srinciples thant purchase $1 of earnings tats reportable" (Principles 2nd 3). ‘shareholdervalue companies recog nie the importance of generating lon term cash lows and hence avoid ac- ‘ons designed to boost shorn per formance at the expense af the long view. Berkshire’ 2005 anual report ex plains the company’s position: a ‘management makes bad decisions in ‘order tit shoct-ten earings targets, and consequently gets behind the ight ball, no amountof subsequent brilliance will overcome the darnage ‘hat hos been ited Berkshire also exceptional with ‘ard to its corporate governance and compensation. Theres no doubt that ‘Bult’ weath an that af the com pany's vice chairman, Charlie Munge, ‘ie and all with that ofthe ther share holders: deri stock represents the ‘ost majriy oftheir substantia net worth (Principle 9}. As Buf notes, Chale a I can promise you te sults But we can guarantee that your nancial fortunes wil move inlackstep ‘ith ous for whatever period of time you elec o be our partner? The company’s compensation a> broacsalao consistent withthe share olde vale principle and stands in stark contrast to common US. compensation practices. Buffets $100,000 annual salary aces him in the celia of Fortune 9 CEO py, vhere median compersation exceeds $8 millon. Further, Berkshire therare company that doesnot rant ey ‘employe tock options or restricted stock Buffet snot agai equitybased pay pers, bute does argue that to ew ‘companies propery hn pay and perfor: mance (Principle 6). ‘Buffett uses Clco, Berkshires auto Insurance busines, toiutrate the ‘company's compensation philosooty. “The goals ofthe plan, Bute cepains, “shuld be 1 tailored tothe economics ‘of te specific operating business (2) simple in character sothat the degree totic they are being reaied can be easly measured; ane) rectly related to the daily ativties plan pate pants He states that we shun Totlery Ticket arcangemens. whose vkimate val. totally ut ofthe contol of the person hose behavior we woud ke to affet” (Principles 7 and 8) Sofa Berkshire looks ikea complete level 0 value creation corapany—ane that aplies alten principles, Gutit Hoes clasely adere to Princo « (carry only ase that maximize vale) and bas never acted on Principle 5 (e- turn cash to shareholders) n ash ‘cases, however, Bufett and Munger’s ‘wukngs and comments suggest that erase evalaesits Investments in light ofthese principles even iit oesit directly apply them to itselt. Principe ales Sling operations iF buyer offers a meaningil premium to-stimated value, Gut states aly, * Regardless price, we have no interest at alin selling ary goed businesses that Berlhire ans? noting that this at ‘udehuts our financial performance” ‘And despite sitting on more than f4o billion in excess each at yearend 2005, Berka has not rewrned any cash its shareholders o dae, Honeven the company does apply 2 clear test to de- ‘ermine the vitue of retaining, versus Aisuibuting, cas: Management a ‘esses "whether retention, overtime, deivers shareholders atleast St of mar- et value for each $1 cetained” This test, ‘oF course, sa restatement ofthe core shareholder value concept that alin- vestments should generate a retuen in ‘excess ofthe cost of capital. Consistent ‘with Principle 5, Brett is clea about the consequence af failing this test. He say,"Ifme each the pint tal we cat creat ota value by retaining arte ings, we wil pay them out and let our shareholders depoy the funds! Buf’ fluence extends beyond berkshire to compan for which he thas served asa board member Foro ‘ample the Washington Post and Coca ‘Cola were among thairst companies to voluntarily expense employee stock op- ‘ions in 2002. Companies with which fuser has been involved abo have a history af epurchasing stock ‘ichael J. Mauboussin Is te chien vesmentstotegit ot Legg Mason Capit -Morageorent, based in Bakimore. He isa ‘hordes Berlshive Hathowey. 1, Sows Gr gustan lange Beate they plans pd sori pb “hin dosent nnd or ase ony 8 Pl 8 Horas ro K Kran Kear Pt Ramon, Pol Yea Mohesa's POPITZN 2020-2 at ren ne ef Mergent ii‘The competitive Iandscape, not the shareholder list, should shape business strategies, should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is most likely to create the greatest value? Thivd, for ‘the selected strateuy, how sensitive isthe value ‘of the most likely scenario to potential shifts in competitive dynamics. and. assumptions about technology life cycles, the regulatory environment, and other relevant variables? [At the corporate level, executives must also address three questions: Do any of the operat: {ng units have suficent value creation poten tial to warrant additional capital? Which units hhave limited potential andl therefore should be candidates for restructuring or divestiture? And what mix of investments in operating units is likely to produce the most overall vale? Principle 3: Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings. Companies typically create most oftheir value {rough day-to-day operations, but a major acquisition can create or destroy value Faster ‘han any other corporate activity. With record levels of cash and relatively low debt levels, companies increasingly use mergers and ac. Auisitions to improve their competitive posi. tions: M&A announcements worldwide ex ceeded $2.7 trillion in 2005. Companies (even those that follow Princ ple >in other respects) and their investment bankers usually conser pricefearings muti- ples for comparable acquisitions and the im- mediate impact of earings per share (BPS) 10 asess the attractiveness of a deal. They view pS accretion as good news and its dilution as bad news, When it comes to etchange-of shares mergers, a narrow focus on EPS pases an add ‘tional problem on top oft normal shortcom- Ings of earnings. Whenever the acquiring com- pany’s price/earsings muikiple is greater than the selling company’s multiple, EPS vies. The inverse is also true. IF the actuiting company’s ‘multiple is Tower than the sting company’s smuliple, camings per share decline. ln neither case does EPS tell us anything about the dea’. ‘ongsterm potential to add value, ‘Sound decisions about M&A deals are based ‘on their prospects for creating value, not on their immediate EPS impact, and this is the foundation for the third principle of value cre ation. Management needs to identify clearly "HARYAED ses REVIEW «SEPTEMBER 2006 12 ‘Ten Ways to Create Shareholder Value ‘where, when, and how it can accomplish real performance gains by estimating the present value ofthe reslting inetementaleash flows ane then subtracting the acquisition premium, Value-oriented managements and boards also carefully evalute the risk that anticipated synergles may not materialize, They recognize the challenge of postmenser integtation and the likelihood that competitors will not stand ily by while the acquiring company attempis to generate synergies at thei expense. IF tis Financially feasible, acquiring companies confident of achieving synergies greater than ‘the premium will pay cash so that their share holders will not have to give up any antick pated merger gains to the selling com shareholders, If management is uncertain whether the deal will generate synergies, ican edge its bets by ollering stock. This reduces potential losses for the acquiring company’s shareholders by difuting their ownership terest in the postierger company. Principle 4: Carry only assets that maximize value. ‘The Courth principle takes value creation to a ew level Because It guides the choice of busi ness model that valueconscious companies vill adopt. There are two pars to this principle. Fist, valueoriented companies regularly ‘monitor whether there are buyers willing fo pay ‘meaningful premium over the estimated cash flow value tothe company for its business unis brands real estate, and ather detachable acts ‘Such an analysis i clearly a political minefield for businesses that are performing relatively well against projection: or competitors but are ‘leary more valuable in the hands oF others. Yet failure to exploit such opportunites can seri ‘ously compromise shareholder value. ‘A recent example is Kmart. ESL invest: ments, a hedge fund operated by Edward {Lampert gained control of Kmart for less than $1 billion when it wns under banksuptey pro- tection in 2002 and when its shares were tiad- ing at less than $1. Lampert was able to recoup almost is entire investment by selling stores to Home Depot and Seats, Roebuck. In ald tion, he closed underperforming. stores, fo- cused on profitability by reducing. capital spending and inventory kvels, and eliminated ‘Kmart’ traditional clearance sales. By the end ‘of 2003, shares were trading at about $30; in ‘the following year they surged to $100; ang in race 5 ‘he dour ued ruse on Prot B Harased Pot Kran Kyat POE LV aman. Pok Yeoh Masta: PSPT2W 1202021 at nin nel of Mason4 deal announced in November 2004, they were used to acquire Scars. Former shaye holders of Kyat are justiably asking why the previous management was unable to similarly svigorate the company and whi they had t0 Tiguidate their shaves at distressed pres Second, companies can reduce the capital ‘they employ and increase value in two ways by focusing on high value-added activities (uch as research, design, and marketing) ‘where they enjoy a comparative advantage and Dy outsourcing low value-added activities (ike manufacturing) when these activities can be reliably performed by others at lover cost. Ex “mmples that came te mind include Apple Com putes, whose iPod designed! in Cupertino, California, ane! manufactured in Taiwan, and hotel companies such as Hilton Hospitality ‘and Marriott International, which manage ho tels without owning them. And then there's Des well chronicled directto-customer, cus torn PC assembly business model, which mini snizes the capital the company needs to invest ina sales force and distribution, as well asthe need to carry inventories and invest in manu facturing acltes Principle 5: Return cash to share holders when there are no credible value-creating opportunities to invest in the business. Even companies that base thelr strategic deck sion making on sound vakuc creation principles can slip up when it comes to decisions about ‘ash distribution. The importance of adhering tote ff principk has never been greater: AS ofthe ist quarter of 2006, industrial compa nics inthe S&P S00 were siting on more than ‘$43 ilion in eash—an amount thatisiikelyto tr0W as companies continue to generate post tive free cashflows at record levels Value conscious companies with large amounts of excess cash and ony lied value- ‘creating investment opportunities return the money to sharcholders trough dividends and share buybacks, Not only does this give share hoklers a chance to carn better returns else- where, but it also reduces the risk that mane agement will use the excess cash to make valoe-destroying,investments—In particular, iltadvised, overpriced acquisitions Jost because a company engages in share bnuybacs, however, oesnt mean that it abides by this principle. Many companies buy back ‘iva docunonts ater nua ony Pret B apa aK Kean Ka Prt LV Ramana fo Yopesh Meestwss POPITFFN-12020-21 a Ian toe o Monegenent 13 “Ten viays to Create shareholder Value sinares purely to boost EPS, and, just asin the «ase of mergers and acquisitions, EPS accretion for dilution has nothing to do with whether or not a buyback makes economic sense. When an immediate boost to EPS rather than value creation dictates share buyback decisions, the selling shareholders gain at the expense of the nontendering shareholders if overvalued shaves are repurchased. Especially widespread. sre buyback programs that offset the EPS dit tion from employee stock option programs those kinds of situations, employee option ex cetcises rather than valuation, determine the number of shares the company purchases ane the prices it pays ‘Value conscious companies repurchase shares only when the company’s stock is trading ‘below management's best estimate of value and no better return fs available from invest ing in the business, Companies that follow this guideline serve the interests of the more tendering shareholders, who, if management’ valuation assessment is corect, gain at the ex ‘pense ofthe tendering sharcholders. When a company's shares are expensive and there's no good longterm value tobe had from investing in the business, paying dividends is probably the best option Principle 6: Reward CEOs and other senior executives for delivering ‘superior longterm returns. Companies need effective pay incentives at every level tomaximize the potential for supe- rior returns. Principles 6, 7, and 8 set out ap- propriate guidelines for top, middle, and Tower management compensation. 1 begin with senior executives. As Pve already ob- served, stock options were once widely touted asevidence ofa healthy value ethos. The stan- dard option, however, is an imperfect vehicle for motivating tong-term, value-maximizing bbchavior. Firs, standard stock options reward performance sell below superior-return ley cls As became painfully evident inthe 19908, ina rising market, executives realize gains trom any increase in share price—even one substantially below gains reaped by their com: pettorsor the broad market. Second, the typical ‘vesting petod ofthe or four years coupled seit executives’ propensity to cash out early, significantly diminishes the long-term motive tion that options ate intended to provide. Finally, when options are hopelessly under snot‘aren, they lose thelr ability to motivate st al ‘And that happens more frequently than is generally believed. For example, about one- {hind of all options held by UL 5. executives ‘ere below strike prices in 1939 at the helght of the bull marlet. But the supposed reme- sles—inereasing cash compensation, granting restricted stock or more options, oF lowering the exercise price of existing options—are shareholderanttiendly responses that rewrite the rules in midstream, Value panies shoud extent the performance evalua tion period to atleast, say, rolling thiee-year cycle. The program can then tetain a portion Of the incentive payouts to cover possible fu ture urlerperformance. This approach eli nates the need for two plans by combining ‘he annual and longterm incentive plans into fone. instead of setting budgetbased thresh ‘olds for incentive compensation, companies can dovelop standards for superior yearto- race?year performance improvement, peer bench marking, ané even perfornrance expectations implied by the shave pice. Principle 8: Reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly. Although sales growth, operating margins, nd capital expenditures are useful financial indleators for tracking operatingunit SVA, ‘they are to broad to provide much day-to-day ‘uidance for middle managers and frontline cemplayees, who need to know what specific actions they should take to increase SYA, For more specific measures, companies can de- velop leading indicators of value, which are ‘quantifiable, easly communicated current ac- complshments that frontline employees can influence directly and that significantly affect the long term value of the business in a posi ‘ive nay, Examples might include time to mar- et for new product launches, employee turn- ‘over rate, customer retention rate, and the timely opening of new stores or manufactur: Ing factes ‘My own experience suggests that most bush nesses can focus on three to five leading ind ‘ators and capture an important part of their Tong-term value-reation potential. The pro cess of identifying leating indicators can be challenging, but improving leading indicator performance is the foundation for achieving superior SVA, which in turn serves to increase long-term shareholder retuins Principle 9: Require senior executives to bear the risks of ownership just as shareholders do. For the most part, option grants have not sue ‘cessfully aligned the long-term interests of se- lor executives and shareholders because the former routinely cash out vested options. The ability to sell shares early may infact motivate them to focus on near-term earings reslts rather than on longterm value in order to ‘boost the current stock price ‘To better align these interests; many compa nies have alopted stock ovmership guidelines for senior management. Minimum owmership is usually exprested as a multiple of base sl ary, which is then converted to 2 specified number of shaves. For example, eBay's guide ava #SINESS RV = SPT LANIER 206 “is cocuants saree ony 9 Prt 8 iat re ken Karo LV Raman Pol Yogesh Maneswar's PGP/TEN 2020-21 dn asta of Mariage Tre ons Oe 2020 an 202 Is ‘Ven Ways to Create Shareholder Value Tines require the CEO to awn stock in the com pany eduivalent to five times annual base sa ary, For other executives, the correspon number is three times salary. Top managers ate further required to retain @ percentage of shares resulting from the exercise of stock op tons until Chey amass the stipulated momber cof shares. But in most cases, stock ovenership plans fal to expose executives to the same levels of risk that sbareholders bear, One reason is that some companies forgive stock purchase las when shares underperfoom, claiming thatthe arrangement no longer provides an incentive fr top management. Such companies, just a5 ‘those that reprice options, risk insttutionaiz ing a pay delivery system that subverts the spirit and objectives ofthe incentive compen sation program. Anather reason iS that out. right grants of restricted stock, which are es sentially options with an exercise price of $0, typically count as shares toward satisfaction of ‘minimum ownership levels Stock grants mot vate key executives to stay with the company uml the restiictions lapse, typically within ‘three or four years, and they ean cash in thelr shares, These grants create a strong incentive for CEOs and other top managers to play it safe, protect existing value, and avoid getting. fred, Not surprisingly, restricted stock plans are commonly referred to as “pay for pulley rather than pay for performance, Im an effort to derlect the criticism that re stricted stock plans are a giveaway, many ‘companies offer performance shares that re- ‘quire not only that the executive remain on ‘he payroll but also chat the company achieve predetermined performance goal tied to EPS row, revenue targets, or return on-capital ‘employed thresholds Whe performance shares ‘do demand performance, i's generally not the right kind of performance for delivering Tongeterm value because the metries are ust ally not closely linked to value, Companies sceking to better align the inter feats of executives and shareholders need to find a proper balance between the benefits of requiring senior executives to have meaningful And continuing ownership stakes anc the re sulting restrictions on theit lguidty and diver sification, Without equity-based incentives, ex ceutives may become excessively risk averse to avoid faire and possi dismissal. If they ‘on too much equity, however, they may also enc §Ten Ways to Create Shareholder Value ‘The Corporate Performance Statement Investors need a baseline for assessing nanclng activities—new issues of ccruas of varying levels of uncer a compary’scash flow prospects and 3 stocks, stock buybacks, net borrow tainty characterized by long cash clear view oftheir potential volatiliy. ing, repayiment of previous borrous conversion eyeles and wide ranges of The corporate performance statement ing, and interest payments plausible outcomes, provides a way tocstimate both things Revenue and expense accruals. The Management discussion and analy- by separating realized cash flaws from second part ofthe statement presents sis, In the third section, management forwardtooking cere. revenue and expense accruals, which presents the company’s business Operating cash lows. The fist part estimate future cash receipts and pay- made ey performance indicators Df this statement tracks only operat-- ments triggered by curcent sales andl (both Financial and noninancial) and ing cash Rows. t does not replace the purchase transactions, Management. the ential assumptions supporting Uaditional cash low statemant be- estimates three scenarios mest each accrual estimate ‘cause it excludes cashflows from f-__lkely optimistic, and pessimistie—for Operating Cash Flows Revenue and Expense Accruals SL Total revenue rmastlitely optimistic pessimistic i = Operating expenses! | ‘Meaiurmncertaintyacerals ‘Unicaliceé gains on Feng term contracts s es i Uncoecbierecenables Worrany obligations — Restructuring ehaeoes ‘ooferred income taxes — Proton — Selling and marieting —— Aaminisation Coment anes "casi operating protic ater eaves — change in working capital, High uncertainty acruals Defined benefit pensions Employee stock options i as HH — casi tow trom operations Capital expenditures minis proceeds frm ase aes) Research and development | other ntangitie investments ee cash to for debt holders and shareholders) Management Discussion and Analysis Nona SINESS EVIE» SEPFEMIER 2006 Pace 9 ‘Tha doin sasharee fr we ony PIO B Fea Prot K Kron Kumar LV Ramana Pk Yogesh Maheshwari POPYT2IFN 2020.21 at an tie Warsgoment nore ram Oo 2020 oan 202" 16Companies need to balance the benefits of requiring senior executives to hold continuing ownership stakes and the resulting restrictions on their liquidity and diversification. eschew tisk to preserve the value of their largely undiversified portfolios, Extending the period before executives can unload shares from the exercise of options and not counting restricted stock grants as shares toward mint ‘mui ownesship fevels would certainly help ‘equalize executives’ and shareholders’ risks Principle 10: Provide investors with value-relevant information. “The Binal principle governs investor commnuni- cations such as a company's financial reports, Better disclosure not ony offersan antidote 10 short-term earnings obsession but also serves. to lessen investor uncertainty and so poten tially reduce the cost of capital and increase the shate price. ‘One way to do this, as described in my ath le "The Economies of ShortTerm Perfor ‘mance Obsession in the May-June 2005 iste ‘of Financial Analysts Jour, isto prepare & corporate performance statement. (See the e& hibit"The Comporate Performance Statement” for a template, This statement. + separates out cashflows and accruals, pro- viding a historical baseline for estimating a ‘company’s cash flow prospects and enabling analysts to evaluate how reasonable accrual estimates are; + clsifies scruals with long csh-cornersion ‘ces into medium and high kvelsof uncertainty, + provides a range and the most likely est- ‘mate for each accrual rather than traditional single-point estimates that ignore the wide vat ability of possible outcomes + excludes arbitrary, valuedirelevant accru- sts,such asdepreciation and amortization; and + details assumptions and risks foreach fine stem while presenting key performance indica tors that drive the companys value. Could such specific dlsclosure prove 100 costly? The reality is that executives in well ‘managed companies already use the type of information contained in a corporate perfor mance statement. Indeed, the absence of such information should cause shareholders to ques- tion whether management has a comprehen sive grasp of the business and whether the board is properly exercising its oversight re sponsity. Inthe present unforgiving ciate for accounting shenanigans, value-driven com- panies have an unprecedented opportunity (0 ‘feate value simply by improving the form and content of corporate reports. aevan Busi REVEW = SEPIRRINER 3006 ‘ie docueen ts tts use onyin Prt B Horgresd Pak Kis Kaa Prot LW Ramana ea ogee Nanestwar's PGPMTIFINZ52021 3 in ata of Monogr ‘nae rm Oe R00 an 2021 ia “Tem Ways to Create shareholder Value The Rewards—and the Risks ‘The crucial question, of course, is whether following these ton principles serves the long-term interests of shareholders. For most companies, the answer Is a resuunding yes. Just eliminating the practice of delaying of forgoing value-creating investments to meet ‘quarterly earnings targets can make a signif cant difference, Further, exiting the earnings ‘management game of accelerating reventies into the current period and deferring ex penses t future periods reduces the tsk tet, ‘overtime, a company will be unable to meet market expectations and trigger @ meltdown in Its stock, But the real payor comes in the difference that a tue shareholder-value of: cemtation makes 0 a company’s longtenn growth strategy. For most organizations, value-cresting growth is the strategie challenge, and to suc ceed, companies must be good at developing ‘ew, potentially disruptive businesses. Here's ‘hy. The bulk of the typical companys share price reflects expectations for the growth of caurent businesses. $F companies meet these expectations, shareholders wll earn only 2 m0 rma} retum. But to deliver superior longterm returns—that is to grove the share price faster than competitors” share prices--management ‘st either repeatedly exceed market exnectar tons for its current businesses or develop new value-creating businesses. R's almost imposs- ble to repeatedly beat expectations for current businesses, because if you do, investors simply raise the bat. So Une only reasonable way to Ue liver superior longterm returns isto focus on new business opportunites. (OF course if @ company’s stock price already reflects expecta tions with regard to new businesses—whieh it may do if management has a track record of delivering such value-ceating. growth—then, the task of generating superior returns be comes daunting; is all managers can do to ‘meet the expectations that exist.) Companies focused on shortterm perfor mance measures are doomed to fal in deliver jing on a value-creating growth strategy be- cause they ave forced to concentrate on citing businesses rather than on developing new ones forthe longer tenn, When managers spend too moch time on core businesses, they ‘end wp with no new opportunities in the pipe- tine. And when they get into trouble—as they inevitably do—they have litle choice but toValue-creating growth is the strategic challenge, and to succeed, companies must be good at developing new, potentially disruptive businesses. tty to pall a rabbit out ofthe hat: The dynamic of this faluve has been very accurately de scribed by Clay Christensen and Michael Raynor in their book The Jnmowator Salon: Creating and Sustaining Successful Growth (Ha vard Business School Press, 2003). With a lithe ‘adaptation, plays out Tie this: + Despite asloncdowm in growth and matin erosion in the company’s maturing core Duis ‘ess, management continues to focus on devel: ‘oping it at the expense of launching now growin businesses. + Eventually, investments in the core can 10 longer produce the growth that investors exe pect, and the stock price takes a it + To evialize the stock price, management announces a targeted growth rate that is well beyond what the core can deliver, thus intro- lucing a langer growth gap. + Confronted with this gap, the company. limits funding to projects that promise very lange, very fast growth. Accordingly, the com- pany refuses to fund new growth businesses that could ultimately fuel the company’s expan: sion but couldn't get big enough fast enough, + Managers then respond with averly opt amistie projections to galn funding fr initiatives ‘n ange existing markets that are potentially ca: pable of generating sufficient revenue quickly ‘enough to satisy investor expectations + Tomeet the planned timetable for rollout, the company puts a sizable cost structure in place before realizing any events, + As revenue increases fall short and losses persist, the market again hammers the stock price and a new CEO is Brought in to shore it up. + Sceing that the new growth business pipe ine is virtually empty, the incoming CEO tres to quickly stem losses by approving only expen tures that bolster the mature core. + The company has now come fullcicle and Jn lost substantial shareholder vale, Companies that take shareholder Value seri ously avoid ths selFreinforcing pattern of be: havior. Recause they do not dill on the mar let's nearterm expectations, they don't wait for the core to deteriorate before they inves in new grovith opportunites. They are, therefore, ‘mone likely to become rst mowers 3 market and erect formidable barriers to entry through scale oF learning economies, postive network effets, oF reputational advantages. Thsit man- agement teams ave onvard-ooking and sensi "vs doeumert sau fr se ony Pet B Harsresd Pra K Kran Kumar rt LV Ramana Pek Yoose Maheshwari POPVIZANW2OEC-2 anda alae Meson db ‘Ten Ways to Create shareholder Value tive to strategie opportunities. Overtime, they _get better than their competitors at seizing op: portunities to achieve competitive advantage. Although applying the ten principles will improve longterm prospects for many compar nis, a fev wil stil experience problems if in- vestors remain fixated on nearterm earnings, because in certain situations a weak stack pice ‘an actually affect eperating performance, The risks particularly acute for companies such as high-tech startups, which depend heavily on a healthy stock price to Finance growth and send Positive signals to employees, customers, and suppliers. When share prices are depressed, selling new shares either prohibitively citutes current shareholders’ stakes or, in some cases, makes the company unattractive to prospec tive investors AS consequence, management may have to defer or scrap its value-reating _grovrth plans. Then, as investors become aware ‘of the situation, the stock price continues t0 slide, possibly leading to a takeover at aire sale price orto bankruptcy, Severely capital-constrained companies can also be vulnerable, especially if labor markets are tight, customers are fey, or suppliers are particularly powerful & low share price means ‘that these organizations cannot offer credible prospects of large stockoption or restricted- stock gains, which makes it dificult to attract and retain the talent whose knowledge, idess, and skills have increasingly become a dom nant source of value. From the perspective of customers, fow valuation raises doubs about the company’s competitive and financlat strength as well a its ability to continue pro: eastrement frameworks such as Kaplan andl "Norton's Balanced Scorecard, Accenture’ Per formance Pris, or Skandla’sIntelleewal Cap- ital Navigator. And yet the frameworks’ own inventors rightly insist that every company neds to dig deep to discover and track the ac Aivties that trly affect the frameworks’ broakl domains (domains such as “financial,” “cus ternal business processes," and “i ‘novation and learning,” in the case ofthe Bal anced Scorecard)" But businesses often fail to establisy such links pasty out of laziness or thoughtlessness. Asa result, self-serving man agers are able to & manipatate— measures solely for the purpose of making SPB HeRBlabad Prot K kiran Kunur Prot Lv Raman 1c Yogesh htheshaa's POTN 2020-21 at dan alae of AEEaonentCCuistopherD. ners poeser of accounting a the Wharton Scho the Uninery of Penasyhani,n Pio- doers He 4 coauthor Lining Guay 0 Pots Quaty Bose Cost Moncgerent (SOC Fess, 1998 Dovid FLarher shots & Yeung fessor of Account Wharton ‘in dod ASHE RSINEUMEIENG ENB TAR a an Kan Pot V Ramana Pe Yogesh Maneshaaits PGPNAHW1202021 aaa swe of semen. Coming Up Short on Nonfinancial Performance Measurement themselves Wok good and eaming nice bo- How mindless or mendacious can m: bbe? Here are some examples: + One of the world'stop informationservice providers began evalating managers’ perfor mance according to how many patents the company fled each year. Whether it might have made more sense to license someone else's technology, whether the patents were ‘ever put to work, or whether they ever earned back their cost wes not considered. The reason. for tracking patent awards? A mote successful ‘competitor owned a larger number. +A large retail bank decided to base bo- ‘muses on customer satisfaction scores. But the polling company hired by the banik surveyed ‘only these customers who physically entered Dricksand:mortar branches. So one branch manager who had received poor satisfaction scores in the past coaxed customers o visit and ‘then put smlleson thei faces by offering them free food and drinks on the premises. + Managets of an automobile components manufacturer reached the firm’ quality ta gets by reclasiying as acceptable certain flaws ‘that once woul have caused a part t0 be re jected. ‘When such things happen, company’s ( nancial and nonfinancial performance di- verge—an janie outcome, since the original ‘eason for tacking nonfinanclal performance ‘was to fill out the picture provided by tra tional financial accounting. And yet, is I€ so surprising that nonfinancial measures would be equally if not more, susceptible to manip Tation as financial accounting? At Teast trad ‘anal accounting has rues that govern it. Tn fac, the misuse of nonfinancial measures may be even more damaging because of the Sgnificant opportunity costs incurred. AS the exhibit "The Difference It Makes” shows, the ‘companies in our study that adopted. nontt nancial measures and then established a causal link between those measures. and financial ‘outcomes produced significantly higher re turns on assets anal returis on egully over a five-year period than those that di not, In the following pages, we diseuss our re search findings, which reveal a number of ‘common mistakes companies mnake wien try ing to measure nonfinanetal performance. We then highlight a number of practices tht, in ‘our view, wll alow companies 10 realize the gers rarer et 20201 202 2a _genine promise of nonfinanetal performance eases. Mistace One: Not Linking Measures to Strategy Whether the goal of 3 performance measure ‘ment system isto help direct the allocation of resources, to assess and conimunicate progress toward strategic objectives, or toevalate ma agerial performance, a major challenge for ‘companies fs determining which of the hum dreds, if not thousands, of nonfinancal mea- suresto track. Many companies believe that they have solved this problem by adopting a framework like the Balanced Scorecard, mistaking It for an ofthe shelf checklist or procedure that is "universally applicable and completely compre hensive. But using such a framework by itself ‘won't help identify which performance areas—and which drivers—make the greatest contribution to the company’s financial out- ‘comes. In a number of companies we studied, Imlddle managers sarcastically weferred to the Balanced Scorecard as the "four bucket” of “sinongasbord” approach because top manage- ‘ment ordered them to come up with some- ‘thing foreach of the scorecart’s four persp tives, regardless of thelr business unit's sategy or objectives. ‘More successful companies have attacked this problem by choosing their performance veasures on Ue basis of causal models, also called value driver maps, which lay out the plausible cause-andeffect relationships. that ‘may exist between the chosen drivers of strate- sie success and outcomes. The exhibit “Which ‘Measures Matter” shows how one very success ful fast food chain dlagrammesl it drivers of strategic success. The diagram demonstrates how better employee selectlon and staffing should lead to higher employee satisfaction nd thus improve employee performance. The latter in turn should increase customer satis faction and thus purchase frequency, customer retention, and roferals, ultimately leading to sustained sales growth” and increased share- holder value. This mode! became the basis for selecting performance measures directly tied tothe goals ofthe strategic plan, which was t0 become the premier generator of free cash slow in the fast foods sector ane! lead stack: price performance in that industy. Despite the appatent logic and good sensensanoed iy BH BE Ftibaa Prot i Kican Kumar Pro. LV Reman Prot Yo Coming Up Short on Nonfinancial Performance Measurement ‘of making such connections, Fewer than 30% ‘of the companies we surveyed have developed! ‘causal models, hich shavy what areas are ex pected to improve as the result of coms ‘ments to particular courses oF action, and then show how those improvements should affect long-tesm economic performance Mistake Two: Not Validating the Links Even those companies that create eastsal max cls rarely go on to prove that actual improve ‘ments in nontinancial performance measures affect future financial results, OF the comps: nies we surveyed, only 21% did so. fy far t00 The Difference It Makes Jn our survey of 157 companies only 230 consistently built and verified causal models (agra aying out he cause andeect relationships between the chosen drivers of strategie success and outcomes) 23% of | Companies meavecusl 2 trodetngand ‘ohiten Yet those 23% on average, had 2.95% higher ROA and 5.12 higher ROE than companies thot diet ute causal models. = 23% of g Zeompanies = sadaiogand = 159, con 2 ron] a | g o g ROA AY ‘many cases, management simply relied on its preconceptions about what was important to customers, employees, supplies, investors, or other stakeholders rather than verifying whether those assumptions had any basis i fact. Overlooked were questions like, Do expe: rienced employees make fewer errors, and, if so, should we do whatever we can to reduce turnover? (Not before testing the hypothesis and determining which employees. matter ost) Boes accelerating. producttevelop- meat time lead to increased market shave? (Not if our new products are only minutely different trom our earlier models, oF we have merely reverse-engineered those of our com- petitors.) If companies don't investigate whether there is @ plausible causal relation. ship between actions and outcomes, they con- cdoman themselves to measuring aspect of per formance that don’t matter very much, When we asked managers why they didn’t iy to establish these connections they often responded that the links were self evident: OF ‘course improvements in customer loyalty, em ployee retention, new product introductions, Cr other common nonfinancial measures lead to higher profits and shareholder value. But ‘unfortunately, our research indicates that such assumptions are often half-baked of wrong. Consider the fastfood chain discussed cate Before creating its causal model, the company chose employee turnover as @ key perfor: ‘mance indicator, believing that high employee retention indicated a high level of satisfaction and motivation, which would in turn improve customer service and eventually boost profits, ‘This set of assumptions led the chain to con sider implementing a series of costly tives, such a cash bonuses and increased bene= fits at employees’ one-year anniversaries, to reduce voluntary turnover. Subsequent analy- sis, however, found that the proitability of ree. taurants with identical turnover rates varied dramatically. That's because 2 150% annual ‘tumover rate at one restanrant could include tunnover of cooks and cashiers as wll as nan agement and supervisory personnel, while that same 150% turnover rate in another restaurant could reflect 200% turnover among lower evel \woricers but only 30% turnover arnong super sors. What distinguished profitability was the ‘tumover among supervisors, not among lower Jevel workers, The company was not wrong in believing that zurnover was important. But afailure to investigate whose turnover relly ‘mattered nearly led to a substantial waste of Tm another case an information service pro- vider believed that it could improve its service ‘offerings by creating allances with vendors of technology products. The higher service levels, in tuin, were expected to strengthen tes to Which Measures Matter (One of the companies in our study, a SUCCEstu fast food chain, developed this causal model proposing the drivers of strategic success. Note that behind the rivers of performance le the drivers of those dives: For instance timeliness and quality dive customer satisfaction, which in uen dives customer buying behavior whieh in turn dives profs, newbies selection | and staffing eee vot ‘employee : satisfaction ‘customer buying behavior waa ier ‘sustaines i Promtabilty }<—Ceecting etterthan competion 3 & shareholder © value mes a Cconuing Up Short an Nontinanciat Performance Measurement castomers, who would then, theoretically, put chase more services. The company accordingly went to great lengths ta forge alliances ad rate its progress at doing so. Yet we could find no evidence that the alliances improved the company’s chances of winning mew work or having its contracts renewed. ‘Businesses that doer scrupulously uncover the fundamental drivers of theie units’ perfor ‘mane face several potential problems. They ‘often endl up measuring too many things, ny Ingo fil every perceived gap In the measure seat system, The result i wild profusion of peripheral, wivial, or invelevant measures, Amit this excess, companies can tell which measures provide infosmation about progress toward the organization's ultimate objectives, and which are noise. 4 Jeading home-finance ‘company, for example, implemented an "exec- utive dashboard” that eventually grew to ene compass nearly 300 measures. The company’s hie? operating officer complained, “There's tho way 1 can manage my business with this, ‘many measures, What I'd really lke to Know fare the 20 measures that tell me how we are really doing.” TE companies can't prove basic causality ‘they certainly cant determine the relative im- ‘portance of the measures they select, And not boeing able to weigh Uexe measures makes it hard to allocate resources according to their most beneficial uses or to create meaningful incentive plans. For instance, does a datlarin- vested in product development yield higher re- ‘uaens than a dollar spent on customer reten- tion? In the absence of such knowledge, compar nies in our study came up with various solu: tions for assigning relative weights to different ensures. One ofthe simplest solutions was t0 sive each performance measure equal weight {As ome executive at a consumer electronics ‘manufacturer put it, “t's dificult to precisely assign weightings, 901 just assume they are of ‘equal importance.” But perhaps even more of ten, managets base weightings purely on their assumptions about the measures’ stratege im- portance, Or they stress the measures that hhave become mest fashionable in the business press or among consttans. Or, particularly them bonuses are at stake, they place greater ‘weight on measures whose targets they know they can bit “re sod ANGRY HRSA RUG ASHEN BURA ag tk ean Koma Pat LV Ronana Pel ogee Masta PGRZAINA2D202% a aio tte oF Mhenent Tree Yorn a 2020800 22 ByIt's not uncommon for business units within the same company to use different methodologies to measure the same thing Mistake Three: Not Setting the Right Performance Targets Outstanding nonfinancial performance is not always beneticial Indeed, i often produces d- ‘minishing or even negative economic te. ‘ums—and again, most companies have no idea when they have achieved too much of a ‘3004 thing, We studied one company in an unregulated segment of the telecommunications Indust In which customers switching costs were mini- ‘mal. To hold on to the customers it had, the company set ls sghis on achieving 1008 Satis Faction for every one of them. However, the company never attempted to discover whether correlation actually existed between an ind Vidual customer's level of satisfaction and the evenues and profits that customer generated, Wie discovered, in fac, that the expected rele tionship did appear—but only up to a point Customers ieho were 100% satisfied spent no more money than those who were only 80% satisfied, In short, geting to 100% requived Considerable investment, with little oF no pay- back. Only by determining the level at which satisfaction ceases to contribute to revenue agrovrth can a business know whether and how uch to invest, at any given point, in trying to alee it “Target setting is inherently dificult because st always takes avshile For improvements in river of corporate performance to produce Jmprovements in the performance it's meant to affect. Sometimes, efforts to improve nonf ‘nancial measutes can even damage short-term returns. However, if a company can reason ably estimate when the nonfinancial perfor: ‘mance improvements will pay off, and by how much, it can set lower interim financial goals, Which can subsequently be adjusted upwrarcs Unfortunately, many companies don’t make the effort, preferring to focus on initiatives that promise short term financial results even, ‘though othe initiatives may have higher long- term payotts, MisraKe Four: Measuring Incorrectly Finally, even companies that build a valid cousal model and track the right elements can fal! down when determining how to measure them. AL least 70% of companies, we found, ‘employ metrics that lack statistics! validity toe om Oct 290 eh 2029 RS ing Up Short on Nonfinancial Performance Measurement and reliability. “Validity” refers to the extent to which a metric succeeds in capturing what itis supposed to capture, while “reliability” re fers 10 the degree to which measurement techs ques reveal actual performance changes and do not introduce errors of their wn. For ex ample, many companies attempt to asses ex tuemely complex performance dimensions using surveys containing only one or a few ‘questions. The questions may offer respon: «dents only a small number of scale points (for Instance, t= low, and 5 = high). Many compa is then collapse these already simplified an- swers into ctude binary scales (For example, ‘customers are deem satisfied ithe score is4 fr 5, and dissatisfied ifthe seore is 1 through 3). Although inexpensive to use and easy to ‘understand, such simplistic surveys ack valid ity and reliability and impair companies’ abit ity to iscern superior performance or predict ‘Gnancia results. ‘Many companies also make the mistake of collecting data before deciding what they Want to find out. By the thme they have identifled the leve] of analysis they want to undertake and the areas of performance they want 10 ‘compare, the data have already been gathered nd organized in a mamer that rendets the de sired! analyses impossible. For example, one managementconsuiting firm we studied ‘tracked customer satisfaction atthe individual On September 10, 1990, in an attempt to capture sales from small businesses and first time consumers, Dell announced it was breaking, from its direct-only business model and would begin to 1 Anon, "Selling PCs ike Banana," The Reon; Landon, Octobe 5, 1996, . 63 Clare Gokisbeny, inpater Makers May Overcome JT Troubles” Pits News, August 18, 19%. 20 ® Michacl Del with Catherine Frecinan, "Dice rom Del Stages That Revoluionied an lndsty,"1989, p22 an Rivkin and Michel Pores, “Matching Dl” HBS case 799 Je 61999, p15, S Michael Del wath Catherine Feta ‘net foe DELL, Sales That Revolatonized a Inet,” 1999, pA. ‘The docunontis shred ruse sly Pel Haired Pro KK KP LY Ramana PrYogah Maeshwsis PGP 1202021 eon ts of Mangement Inde tom Oct 204 on 2028 €@Del's Working Capital ana sell its PCS® through CompUSA (formerly SoftWarehouse Superstores). Over the next two and a hall years, Dell expanded this indirect distribution channel by adding other mass market retailers (i.e, Staples, Inc) and marketing its Precision line exclusively through Price Club. Additionally the company continued aggressive pursuit of foreign markets, relying on resellers to distribute Dell product when timing limitations or infrastructure obstacles complicated direct distribution. Annual sales increased by 268% within two years, compared to industry growth of 5%, and moved Dell into, the top five in worldwide market share? Exhibit 1 details sales growth for Dell and the PC industry, 1m Angust 1993, Dell reported a $76 million dollar loss forthe secondl quarter of 1993 is first loss. ‘The loss wos tied to $71 million in charges relating to the sell-off of excess inventory and the cost of sceapping a disappointing notebook computer line The company also took restructuring charges to consolidate European operations that hac become reduaclant and inefficient, Del’s profit margin fell to 2% forthe first quarter, ending May 2, 1993, ~ well below the company’s target of 5% that they had achieved or exceeded for 11 consecutive quarters. With $32 million in cash and cash equivalents, analysts thought Dell had enough cash and credit to last at least another year, but many wondered if the company had the resources to keep pace should the battle for marketshare intensity? Like many companies, we were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic. It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas.!" September 1993 ~ January 1996 Dell shifted its focus from exclusively growth to liquidity, profitability, ancl growth. It adopted. company-wide metrics around the new focus, requiring each business unit to provide detailed profit & loss statements. In July 1994, less than a year after shifting the company’s focus, Dell exited the low margin indirect retail charuvel where, CEO Tom Meredith noted, “ove were losing our shirts.” # Late in 1995, Del instituted goals on ROIC (Return on Invested Capital) and CCC (Cash Conversion Cycle), Exhibit 2 presents Dell's CCC performance. The company took measures to improve its internal systems for forecasting, reporting, andl inventory control. A new vendor certification progtam was put in place, reducing the number of suppliers, ensuring component quality, and improving delivery performance. Dell also brought in seasoned managers to lead the company uring its next stage. ‘These changes, combined with Dell’s re-entry into the notebook market, and its rapid introduction of computer systems based on Intel Corporaiion’s new Pentium microprocessor chip, fueled the company’s recovery. Dell's direct contact with customers helped it anticipate demand for newly developed Pentium-based systems and its low inventory of 386 and 486 technology made it less costly for il to move quickly. Dell beat the competition to the market place with Pentium-based systems sold through the retained were nied 1 certain predetermined configurations and ver not customized 7 Jan Rivkin and Michael Port ‘Matching De |" HS Case 79.155, Je 6 199,915 8 kyle Pope, “Del Comput 1983, p- BS Pater urs al Stephanie Anderson Forest, “Dell Computer Gs nt te Sho" Busts Wek July 1992, p38 10 diel Dell with Catherine Frdoaa, "Dive os Lass for Quote, Backs Away Trom Ferscst of Rebound,” Wall Sit Jorn, August 18 r DELL, Sales That Revolutionize an Inesty" 198, p47 2 au Jos, “The Resurrection of Michael Dell Fart Sepleiber 8, i pa “The document autos ruse ony Fro 8 Harrasad Prot Kan nero LY Rea PrtYegsh Maheshaas POPIT2FN720202 a ran nthe of Mangere s4201-09 Dell's Working Capital products and was the First in the industry to achieve volume production of systems with the 120 mhz Pentium processor." Exhibit 3 presents Dell’s percent of computer system sales by processor type In July 1995, Dell became the first manufacturer to convert ils entive major product line to the Pentium technology." By that time, in less than tiwe years, the Pentinm chip was at 133 MHz ~ the ninth upgrade, Dell was able to offer faster systems at the same price that rivals were marketing, older Pentium technology. Because ofits low finished goods inventory, Dell didn’t have to dismantle PCs to replace the microprocessor when Intel Corporation discovered its Pentium chip was flawed in 1994, Itwas able to quickly manufacture systems with the “updated” Pentium chip, while others (ie, Compaq) were still selling flawed systems from inventory. In a similar vein, Dell was able £0 begin shipping its Dell Dimension systems equipped with Microsoft Corporation's new Windows 95 operating system on August 25, 1995 — the very day Microsoft launched the product. As a direct ‘marketer, Dell was able to bring new component technology to the matket within an average of 35, days ~a third of the time it took competitors to move a new product through indirect channels. The Future For its 1996 fiscal year, ended January 31, 1996, Dell reported revenue of $5.3 billion with net income of $272 million, oF 5.1% of sales. Revenue was up 52% over the prior year compared with an industry increase of 31%. Exhibits 4 and 5 presents Dell’s Income Statement and Balance Sheet, respectively. Though favorable, the 1996 results suffered somewhat from component shortages. Michael Dell predicted the company’s growth rate for the next year would again outpace the industry's growth, "Anon, “Dell Fist o Ship Systems wth New Pentium Processor,” PR Nees, Apri 19,1995, "9 Anon, “Doll Taking, Ores for Patory Installed Windows 9S on Dall Dinension Dosktop PC" PR Newsies Avgust 2 1995, "4 July Ward, “Ranauray hors: Michact Dell wants ta rein in gaowthy shareholders want whip” Finacial Wer, tod 24, 1985, p 36 “This cine aihrzed fo se oy Pi Havas Pr. Keon Kune. PL V Rema 0 ones Masha PGPI2IEN- 22021 ein thc Manage 60atts Working Capital 2aor-09 Exhibit 1 Dell's annual worldwide sales dollar growth versus industry. Calendar Year Del Industry T99t 5% Pe 1992 128% 7% 1993 42% 15% 1904 24% 3m 1005, 52% 31% Source: Deli Computer Corporation Peal 19% Annual Report ase writer esimates from industry make share data fon International Dats Corporation Ds fal year lass in ligament to calendar ye state, Exhibit 2. Working Capital Financial Ratios for Det sit bso prot cect ‘ares 40 et 46 48 233 a4 st 58 40 cass a7 52 st 48 asa 55 5a 33 56 a1a4 55 58 56 37 238 at 53 43 5 a39¢ 38 53 48 a 494 38 50 42 at 195 2 53 ery 0 235, 35 49 44 0 395, 35 50 46 89 2495 32 a7 44 35 196 4 a7 42 38 0296 36 50 43 43 86 37 49 4 “3 486 at 42 33 40 Sousce: Dall Compt Corporation sca 1950-16 annual and quately reports ‘51 Days Sales Inventory) = Not inventory / (Quarterly COGS. 150 Daye Sales Outstanting) ~ Net Accounts Recvables/ (Quartet Soes/9}. = DRO (Days Payables Outionng) = Accounts Payables /(Quarely COGS/90) CCE (Cash Conversion Cyele)=DSI + DS -DPO, Exhibit3 Percent of Dell Computer Systems Sales by Microprocessor ‘Computer Systems Fv94 Fy95 Fy96 ‘385 models 7% 0% O% 486 models 92% 71% 25% Pentium models 1%. 29% 75%, Source: Dell Computer Corporation isc 199456 Arnust Reports “Tui eccuents aoe we oni PB Maras. Pa Kina Kaa ro LV Rev Po Yopteh Maheshan's POPVTIFUUA024 21a an tale Monger 6)201.029 Dells Working Capital Exhibit Profit & Loss Statements for Dell Computer Corporation (millions of dollars) Fiscal Year 1996, 1995, 994 1995 1992, Sales $208 «88.475 $2,873 ~$2,014 $890 Gost of Sales 4z29 2037 24a, 11585 0 Gross Margin 1,067 738 433 449 22 ‘Operating Expenses ‘690 499 are ato 2158, ‘Operating Income a7 29 oo 139 87 Financing & Other Income 6 (6) 0 4 7 Income Taxes at 4 a an 23 Net Prot 22 149 66) 102 st Source: Dell Computer Conperation Fiscal 19% Annual Repo Exhibit S Balance Sheets for Dell Computer Corporation (millions of dollars). Year Ended ‘January 25, ‘January 29, January 30, 1896 1995) 1994 Gaivent Assets Gach 55 43 3 ShottTeimn investments s3t 44 334 Accounis Receivables, net 726 538 ant Invontonies 420 298 220 Other 186 42 80 Total Current Assets 1957 1470 1.008, Propeity, Plant & Equipment, net 178 7 87 Other 12 Z 3 Total Assets 2,48 1,594 4.440 (Curent Liabilities: ‘Accounts Payatie 496 403 NA ‘Aceruad and Other Libiltes 473 49 NA Total Curren Liabilities 908 782 538 Long Tern Debt 113 13 100 Other Liabtties 123 a at Total Liablitios 1975 942 669 Stockholders’ Equity: Preferred Stock™ 6 120 NA Common Stock? 40 242 NA Retained Eamings 570 att NA Other a3) ey NA Total Stockholders’ Equity 973 652, ar 2.148 1504 1.140 Source: Dell Computer Coeporation Fiscal 1994-199 Anmual Repo. *1190.00 shares preferred stock converte to common stock nfs yer 1986 6 Ts dosunenis sumonzud lo use ot in Pro B MarigrazaProt Kron Kort LV Ramana rot Yogesh Maneshas POP 20202 at non ste of Maes RZ9-298-080 December 30,1997 Fixed Income Valuation 1. On December 20, 1994 the Nippon Telegraph & Telephone Corporation (NTT) issued ¥i billion of 10-year cebentures due December 20, 2004. ‘The debentures carried a 4 3/4% coupon, ‘They were priced at par, that is, they cost the investor ¥100 per ¥100 of face value, ‘The entire amount of borrowed principal would be repaid at maturity. Interest would be paid annually upon the anniversary date of the issuance (.e., on December 20th of each year). The debentures carried a AAA credit rating A. Whit roa the yield to maturity of NTT's debentures al the Lime of fsuamie? What would it Ime been if the bonds were priced at 99 instead of 100 (ie, af 99% of face watue)? at 101 instead of 100? B, By 1996 yields on AAA yen deb! maturing i & years had svopped to 3,00%. Giver this yield to motusity, at what price should the NTT debentures aoe been selling? 2, Ms, Alumm is the portfolio manager for a large insurance company. She is considering investing $1 million to purchase some bonds of Patriot Enterprises, Inc All of Patriot's bonds have masket prices that imply a yield lo maturity of 8% “bond equivalent yield” (Qhat is 4% every month period). ach Patriot bond! is described here, base! on a $1,000 face value (par value), whieh i the promised payment at maturity. + Bond A matures in five years and pays a 9% coupon yield (645 every 6 months on a $1,000 face value bond). Bond matures in ten years, pays an 8% coupon yield ($40 seminannual payments), and {s being offered at par. "Most domestic US bonds pay intrest of half the coupon rate semiannual. Te “bond-euivalent” yield to naturity i generally sine in terms of twice the semana ye, ignoring the campoureding ofthe midyear Coupon payment. Thus the yek-to-maturity as comsnenly stated for sendansal bonds utaally understate the true annual effective ye “This case ws prepared the basis fr lass dsesion iter sin) (odusbnte other effective or infective hang of at rulministetve situation. Problems 2 and appear in the ens, “Valuation and Discounted Cash Fl” (HBS ose 0, 291- (28) ty Professor Michael E. Edeson snd were sevised for inclusion in this cnse. Problew 3 appears in the ans, “Intratction to Inoesbnent Eenuation Technipws” (HBS ease no 285-115) by Profesor Duet B. Chae ud was also revised for incnsin inthis ease. Copyright © 1997 by the President and Fellows of Hayward College. To order copies or request permission to reprivtice materials, call 1-800-515-7685 or write Harvard Business Schoo! Publishing, Boston, MA 02163. No patt of this publication may be repraduced, stored in a tetieval system, used in a spreadshuet, oF transmitted in ‘any form oF by any mears—electronic, mechanical, photocopying, recording, or otherwise—without the Detmission of Harvard Busimess School 7 “This documents autora ris on Po B oxigen Prot Kan Kumar LV Ramona Pro Yogesh Mahe PGP 1220-21 3 an sie ef anagem efor ha Oct 270 Jon 2021, 6a298-000 Fixed Income Val + Bond C is a zero-coupon bond that pays no explicit interest, but will pay the face amount (of $1,000 per bond at maturity in ten years, A. Abiohet price should each Bond currently sell? As an alternative, Ms, Alumm has been invited to invest $1 million in a 10-year Eurobond of 4 second firm, Nationaliste, S.A? Nationaliste bonds aze similar in risk to "Bond B” above: they promise an 8% coupon yield for 10 years, but coupons axe paid annually, not semiannually. The Nationaliste bonds are priced at a 1% discount from pat, or $990 per $1,000 face value, B. What yietd to maturity is implied by the Nationaliste Eurobond? Compare this yield to the 8% “hombeguivalent yickd” of the Patriot sesntannial coupon boned (Bond B) above. In tole bond should Ms, Alri invest? 3. A prospective homeowner wants to determine how much she can borrow in the form of a fixed-rate 20-year mortgage. Mortgages of that maturity carry a fixed interest rate of 9.00%, She estimates that she can afford annual, pre-tax payments (interest plus principal) on her mortgage of §25,000 (for simplicity, assume that mortgage payments are made once a-yeav at the end of the year). A. How large « mortgage can she afford, assuming she makes steady payments of $25,000 per year for 20 yenrs? How nui total interest wll be paid over the 20-year life ofthe mortgage? How much interest will be paid durieg the first year ofthe mortgage? How much principal twill be repaid inthe first year? How much of the final $25,000 payment at the end of 20 yeas cil be tnterest ane eco racic wit be principal? B. Suppose the prospectioe home ovoner expects her income to grow such thal she could aford $825,000 per yenr of total debt seroice in the frst fre years of « 20-year mortgage, $30,000 per year in the Second five years, $35,000 in the third five years, and $40,000 im the last five years. How large mortgage at 3.00% could she afford under these circumstances? 4, To help ease a continuing need for financing, the Consolidated Chemical Company is considering borrowing from insurance companies through a so-called “private placement” of bonds in addition to issuing bonds in public debt markets. The company must choose between transactions suggested by two different insurance companies. In both transactions, Consolidated Chemical would receive $10,000,000 up front in exchange for issuing a bond promising a single (larger) maturity payment from Consolidated Chemical in 15 years at a Promised interest rate. The two options open to Consolidated Chemical are as fellows: + A 15-year bond to Pru-johntower Life Insurance Company, promising an annual rate of interest of 10%; A 15year bond to Tom Paine Mutual Life Insurance Company, promising a rate of interest of 8.72% per year, compounded monthly. AL What the efecticw unravel yiold (9 maturity on each ofthe bons? 2A Burobond is boul Issued outsie ofthe domestic market of the counlay in whose currency the bond! is tenominated. Historically, mast such bonds wore sold by London-based underwriters to European inventors hence, the prefix “Eur.” In contast to typical domestic US. bons, which pay Inferest semiannual Eurabonds pay interest analy z ‘Ths docuents eh fr ae oly Pu 8 Haryrasa Po Kan Kon Pro LY Ramana el ope Maheshwari POPE W-2020-21 a an nie of Manger Indere war Oe 2020 on 2024 64