1

CHAPTER 9: Visual Overview

Objective: To explain the issues of performance measurement in the private sector.

1.1 Financial Objective of Profit-Making Organisations

Financial performance is concerned with the profitability, liquidity and financial

position of an organisation. Financial performance is interesting to many stakeholder
groups. However, it is primarily of interest to the shareholders of a business
because:
 The shareholders are the owners of the business. They take the biggest
risk of all stakeholders by investing in the equity of the business.
 The mission of a commercial organisation is usually to maximise the
wealth of the shareholders.
Although, the requirements of a broad range of stakeholders are important in terms
of organisational performance measurement (see Chapter 5), performance reports in
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profit-making organisations often tend to focus on financial performance and the

needs of shareholders in particular.
The reason for this is because the shareholders are the owners of the organisation
and so their interests are of the utmost importance. As a result, the maximisation of
shareholder wealth is the financial objective of profit-making organisations.

9.1.2 Maximising Wealth of Shareholders

1.2 Maximising Wealth of Shareholders

Shareholders' wealth comes from two sources:

1. Dividends; and
2. Changes in the value of their shares in the company.
The maximisation of shareholders' wealth depends on the following:
 Investment policy – the organisations' funds should only be invested in
projects in which the return on the project exceeds the required return (i.e.
positive net present value).
 Dividend policy – should reflect the needs of the shareholders.
 Financing policy – having the right mix of debt and equity to minimise the
overall cost of financing.
Exam advice

These policies are assumed knowledge from the Financial

Management exam.

2.1 Ratio Analysis

Changes in the value of an organisation's shares are influenced by the organisation's

current and forecast financial position, which can be assessed using financial ratio
analysis.

Exam advice

Ratios and measures that are not specified in the syllabus will be given credit in
the exam if they are relevant to the requirement and make appropriate use of
information provided.

2.2 Return on Capital Employed

Some points to note about the calculation of ROCE:

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 ROCE can be calculated with net profit rather than PBIT. Use whichever is
provided in the question.
 Capital employed is equivalent to total assets less current liabilities = total
equity plus long-term debt.
 Capital employed can be based on net or gross book values or
replacement cost. Use whichever is provided in the question.
 Where opening and closing capital are known, an average is usually used.

2.2.1 Meaning of Return on Capital Employed

ROCE shows the return generated on the company's capital. This can be compared
to other companies in the same industry sector, or to the company's cost of capital.
Opening capital rather than the average may be used for some businesses (e.g.
where a significant investment in non-current assets will take time to generate cash
returns).
Comparing companies in other sectors does not provide valid information. Service
industries, for example, tend to have higher ROCE due to the fact that less capital is
required than for manufacturing industries.
ROCE of a firm may also be compared to a target ROCE requirement by investors
when evaluating the investment potential of firms.

2.2.2 Advantages and Disadvantages of ROCE

Advantages Disadvantages

 Easy to calculate and

the figures are readily
available.
 Often used by external
analysts and investors.
 Relates the profit earned
to the amount of capital
invested in producing it.
 A higher ROCE should
lead to higher wealth of
shareholders, so it is
consistent with the
organisations' main
objectives.
 ROCE is a relative
measure, allowing the
performance of
companies to be
compared.
 Capital can be based on
book values or market
values.
 Profits and capital employed can
be impacted by the use of different
accounting policies.
 Managers may take action to
manipulate the measure (e.g.
delay investment in new plant and
machinery) that may harm the
organisation in the longer term.
 Profit maximisation is not the
same as maximising the wealth of
shareholders. A company may
invest in projects that generate a
net present value below zero, for
example, but increase the profits
of the company.
 Research shows little correlation
between ROCE and shareholder
value.
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Example 1 Goal Incongruence

Omega Co has numerous divisions, including Alpha and Beta, which are treated
by management as autonomous investment centres. Omega’s weighted average
cost of capital is 13%.
Division Alpha is underperforming in a declining market (i.e. a “Dog” in the BCG
matrix). The manager of Alpha is assessed on ROCE, which is currently 5%. She
has the option to invest shareholder funds in a project that will improve her
division’s ROCE to 7%. She accepts the project.
Division Beta is the leader in its fastest-growing market (i.e. a “Star” in the BCG
matrix). The manager of Division Beta is currently achieving a ROCE of 21%. He
has the opportunity to invest in a new project. However, when the profits and
investment of this new project are added to his divisional ROCE, he calculated
that it would fall to 19%. Hence, he rejects this investment.
Both managers made decisions based on an accounting profit measure that
ignores cash flows, the impact of tax and the effect of their actions on the value of
the company. Division Alpha’s project, while delivering increased profits, most
likely did not exceed the company’s cost of capital. Division Beta’s potential
project might have exceeded the cost of capital, however, the manager rejected it.
This illustrates the problem of “goal incongruence”.

9.2.3 Profit Margins

2.3 Profit Margins

Profit margins relate profit to revenue. Because there are many profit sub-totals in
the income statement (gross profit, profit before interest and tax, etc.) there are
many potential profit margins.
The most commonly used are the gross profit margin and the net profit margin.

2.3.1 Gross Profit Margin

Gross profit is the profit after deducting the costs of buying or making the products
the company produces. It therefore reflects performance of the company's products.

2.3.2 Meaning of Gross Profit Margin

A falling gross profit margin over time means that:
 the selling price at which the company sells its goods is declining; and/or
 the cost of making or buying those goods is increasing, but those
increases cannot be passed onto customers.
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In any case, a prolonged decline is a bad sign. It suggests that the company’s
products or services are losing popularity, which raises concerns for the viability of
the business.
Gross profit margins may also reflect an organisation's pricing strategy.
 Companies that use a premium pricing strategy are likely to have a high
gross profit margin.
 Companies that aim to sell for a low price, to achieve a larger volume of
sales, are likely to have a low gross profit margin.

2.3.3 Methods to Improve Gross Profit Margins

 Introduce new products that are popular with customers. These can be
sold for a higher margin.
 Use target costing to reduce cost of sales.
Target costing would be an applicable technique during product / service
development stage, before costs are locked in (committed).
Once costs are committed to, cost control would shift to the use of
techniques such as Kaizen.
Definition

Target costing – subtracting a desired profit margin from a competitive market

price to determine the minimum acceptable sales price.

2.3.4 Operating Profit Margin

Operating profit (also referred to as earnings before interest and tax) shows the profit
achieved by operations without taking into account interest, which is a financing
issue, and tax, which is determined by tax rules.

2.3.5 Meaning of Operating Profit Margin

The operating profit margin indicates an organisation's profitability after all operating
costs have been deducted. It reflects:
1. The underlying popularity of the company's products and services (this is
also reflected in the gross margin).
2. The amount of control the company has over administrative type
expenses.

2.3.6 Ways to Improve the Operating Profit Margin

 Introduce new products that are popular with customers for sales at a
higher margin.
 Use target costing to reduce cost of sales.
 Increasing sales volume should increase operating profit margins if a high
portion of the company's costs are fixed (e.g. in a training company).
 Better control over administrative expenses (e.g. salaries).
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2.4 Earnings per Share (EPS)

Exam advice

Calculations of earnings per share and the potential complications are examined in
financial reporting exams. Such calculations are unlikely to be required in the APM
exam

2.4.1 Advantages of Using EPS as a Performance Measure

 It is easily understood by shareholders.
 The figures needed to calculate it are readily available.
 It is useful for comparing the performance of a company over time. Unlike
total profits, EPS takes into account changes in the capital of the
company.
 It enables comparisons to be made of different companies' share prices by
using the Price Earnings (or PE) ratio. It is therefore widely used in the
financial markets.

2.4.2 Limitations of Using EPS as a Performance Measure

Earnings per share is a profit-based measure. It therefore suffers from all the
disadvantages that apply to using profits as a measure of performance:
 Profits do not show how much wealth a company has created during the
period, as they ignore the cost of equity finance. Economic value added
(see Chapter 10) is an example of a metric that aims to remedy this.
 Profits can be impacted by accounting policies in the short term (for
example, inventory valuation policy); this clearly affects the reliability of
EPS.
 Profit-based metrics can give a distorted view of performance (e.g.
significant noncash expenses, such as provisions, reduce reported profit
but do not decrease cash).
 Profits and EPS are historic measures based on annual results. Focus on
annual profit may be detrimental to long-term growth (e.g. reducing
R&D/marketing expenditure).
 Bottom-line profits figures may include unusual items of profit or loss.
 Research shows little correlation between EPS growth and shareholder
value. In fact, total shareholder return may decrease even though profits
are increasing.
2.5 Earnings Before Interest, Tax, Depreciation and
Amortisation (EBITDA)
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EBITDA is often used in business valuations, as it is believed to be a good measure

of the underlying performance of the business. It is regularly used as a performance
measure in retail.
EBITDA is commonly used in the following situations:
 To value companies for acquisition purposes. The value of the company is
calculated by taking a multiple of EBITDA. By ignoring the finance charge
(which depends on capital structure rather than underlying business
potential) and depreciation (which is considered to be a sunk cost), it is
argued that EBITDA gives a better indication of the ability of the business
to generate operating cash flows.
 To assess an organisation's ability to service its debt. Amortisation and
depreciation are non-cash expenses, so adding these back to the profit
provides a more accurate indicator of the organisation's ability to generate
cash.
Also, loss-making companies may report EBITDA to distract users of the financial
statements from the "bad news" that is reflected in the GAAP profit or loss.

Advantages Disadvantages
 Depreciation and amortisation are sunk costs.  EBITDA does not indicate how
 EBITDA is a proxy for cash flow − which may be much cash will be needed to
more relevant to investors than profits. replace non-current assets.
 If amortisation or depreciation charges are  It does not take into account
particularly high in a particular year then profit after required changes in working
tax may not reflect the true underlying performance capital.
of the company.  As it does not conform to GAAP
 Tax and interest are externally-generated costs and principles it can easily be
can therefore be argued not to be relevant to the manipulated to show good
underlying success of the organisation. performance.
 EBITDA is easy to calculate and understand.
2.6 Net Present Value and Internal Rate of Return

Net present value and internal rate of return are normally associated with investment
appraisal rather than performance evaluation. However, they may also be used for
performance evaluation, although this may be more appropriate for divisional
performance evaluation.
In cases where NPV is used as a performance measurement tool, it would be
calculated retrospectively rather than before a project is started.

2.6.1 Advantages and Disadvantages of Using NPV and IRR

Advantages Disadvantages
 The measures are based on cash flows rather than  Difficulty in calculatin
profits so unlikely to be distorted unlike profits. of capital.
 Positive NPV is consistent with the objective of  Difficulties in estimati
maximising the wealth of shareholders. life of the cash flows.
 Research shows there is a strong correlation between
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Advantages Disadvantages
NPV and shareholder value.
Example 2 Net Present Value

A division invested $4,000 in a new project five years ago. The project has just terminated, and the assets have
disposed with no residual value. The management now wish to assess whether or not the project was a succes
The actual cash flows of the project were as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

$ $ $ $ $

Cash flow 400 800 800 1,600 2,510

The project will be evaluated by calculating the net present value of the cash flows, as at the start of year 1, whe
initial investment was made. The cost of capital is 12%:

Cash flow Present value

Time $ Discount factor at 12% $

Start year 1 (4,000) 1 (4,000)

End year 1 400 0.893 357.2

End year 2 800 0.797 637.6

End year 3 800 0.712 569.6

End year 4 1,600 0.636 1,017.6

End year 5 2,510 0.567 1,423.2

5.2
The overall NPV was positive.
This means that the return on the project was slightly higher than the cost of financing it. It was a successful pro

9.2.7 Internal Rate of Return and Modified Internal Rate of Return

2.7 Internal Rate of Return and Modified Internal Rate of
Return

2.7.1 Internal Rate of Return (IRR)

The IRR is the discount rate which results in an NPV of zero for a project or
investment. It represents the maximum cost of capital at which the project is viable.
IRR is estimated by linear interpolation between two NPVs using the following
formula (which is assumed knowledge):
 9

Where A = Lower discount rate

B = Higher discount rate

NA = NPV at rate A

NB = NPV at rate B
The use of IRR of a project for decision marking can be criticised because:
 It implies that any positive cash flows generated during the life of a project
are reinvested at the rate of return generated by the project. This is
unrealistic. (It is more realistic to assume that such interim cash flows are
reinvested at the company's weighted average cost of capital.)
 Where cash flows alternate, a project may have more than one internal
rate of return. This is confusing for the decision-maker.

2.7.2 Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) attempts to overcome these two
weaknesses of IRR by calculating the return over the life of the project in a more
sophisticated way:
 First, it assumes that any cash inflows are reinvested at the company's
weighted average cost of capital. The future value of these can be
calculated by compounding these cash flows using the company's cost of
capital, thereby converting them to a single cash inflow at the end of the
last year of the project.
 The present value of the cash outflows is calculated as at the start of the
project. In effect, these negative cash flows represent investment in the
project.
The MIRR is the return which equates the present value of the cash outflows to the
net future value of the inflows.
MIRR is then given by the following formula:

MIRR = −1
Where n is the number of periods covered by the project.
Example 3 Modified Internal Rate of Return

An investment project has two phases; a two-year investment phase and a three-year return phase starting in y
The cash flows of the project are as follows:

Investment phase Return phase

0 1 2 3 4
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Example 3 Modified Internal Rate of Return

Cash flow (700) (300) 400 600 300

The cost of financing the project is 10%, and any positive cash flows are reinvested at 10% until the end of the p
The internal rate of return of this project is 10.59%.
The future value of the positive cash flows from the return phase can be calculated as follows:

2 3 4

Cash flow 400 600 300

Compounded until time 4 at 10%

Cash flow × (1 + r)n 484 660 300

Future value of positive cash flows 1,444

The present value of the cash outflows during the investment phase are as follows:

0 1

Cash flow (700) (300)

PV at time t0 at 10% (700) (272.73)

Net present value of negative cash flows (972.73)

Using the formula, MIRR

= −1

= − 1 = 10.4%

2.7.3 Advantages of MIRR

 The MIRR does not make the assumption that is implicit in standard IRR
and NPV that positive cash flows are reinvested in the project. It therefore
represents a more reliable indicator of the return on a project.
 Even if the project's cash flows change direction more than once there will
be a unique MIRR.
Activity 1 Internal Rates of Return

Investment phase Return phase

0 1 2 3

Project cash flow (5,000) 0 5,000 2,000

A project has the following cash flows:
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The cost of financing the project is 10%, and any positive cash flows are reinvested
at 12% until the end of the project.
Required:
a. Calculate the internal rate of return of the project.
b. Calculate the modified internal rate of return of the project.
*Please use the notes feature in the toolbar to help formulate your answer.
a. 0 1 2 3

Project cash flow (5,000) 0 5,000 2,000

Discounted at 10% 5,000 0 4,130 1,502

NPV at 10% 632

Discounted at 20% (5,000) 0 3,470 1,158

NPV at 20% −372

b. IRR
c. Using linear interpolation, the estimated IRR is given by the following formula:

=
d. The IRR of the project is estimated to be 16.3%.
e. Spreadsheet computation using IRR formula yields 16.0%
f. MIRR
The PV of the negative cash flows during the investment phase
(discounted at the cost of financing of 10%) is:

= (5,000)
The future value of the cash flows arising during the return phase of the
project, compounded at 12% is as follows:
>>>>>

2 3

Project cash flow 5,000 2,000

PV at time 3 5,600 2,000

Total PV 7,600
MIRR is therefore:

= −1

= − 1 = 15.0%
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3.1 Liquidity Ratios

3.1.1 Current Ratio

The purpose of the current ratio is to measure the adequacy of current assets to
meet short-term liabilities (without having to raise additional finance).
If the current ratio is:
 Low/declining − the entity may be unable to meet its short-term obligations
as they become due.
 High/increasing − it might suggest over-investment in current assets such
as inventories or receivables or cash.

3.1.2 Quick Ratio (acid test ratio)

The quick ratio aims to measure immediate liquidity (by eliminating the least liquid
assets, namely inventories, from current assets).

3.1.3 Interest Cover

Interest cover shows the extent to which return on debt (interest) is covered by profit
(before tax because interest is an allowable expense for income tax purposes).
It is used by lenders to determine vulnerability (sensitivity) of interest payments to a
drop in profit.

3.2 Gearing

3.2.1 Gearing Ratios

Or
Gearing ratios measure the proportion of borrowed funds (which earn a fixed return)
to equity capital (shareholders' funds). It is used to provide information about the
financial risk of a company.

Example 4 Gearing

A B C
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Example 4 Gearing

$ $ $

Share capital and reserves 10,000 3,000 7,500

Loan notes – 7,000 2,500

Capital employed 10,000 10,000 10,000

Solution

70% 25%
highly low
No gearing geared gearing

3.2.2 Advantages of High Gearing

 Debt is a cheaper form of financing than equity because:
o It is less risky than equity. Holders of debt must be paid
their interest. Equity shareholders only receive dividends if there
are sufficient profits.
o Interest is often a tax-deductible expense, whereas
dividends are not.
 The inclusion of debt in the financing of an organisation therefore reduces
the overall weighted average cost of capital.

3.2.3 Disadvantages of High Gearing

 Risk of bankruptcy if the company cannot repay loans when they become
due, or if they cannot pay interest.
 The profit after interest becomes more variable with geared companies:
o High gearing suits entities with relatively stable profits (to
meet interest) and suitable assets for security (e.g. those in
hotel/leisure service industry).
Example 5 Gearing and Operational Risk

Companies A and B have the same operating profits. Company A has no debt. Company B is required to
pay interest of $50 each year.
See the effect of the gearing on the variability of profits:

Company A Company B

Year 1 Year 2 Year 1 Year 2

$ $ $ $

Operating profit 75 100 75 100

Interest 0 0 50 50
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Example 5 Gearing and Operational Risk

Profit before tax 75 100 25 50

Tax at 20% 15 20 5 10

Profit after tax 60 80 20 40

This example shows two interesting points about gearing:
1. Although Company B's interest is $50 per year, the difference between the profits after tax is
only $40 each year. This is due to the tax shield (i.e. interest is tax deductible).
2. The profits after tax of the geared company are more variable than the ungeared company.
When operating profit increases by 33.33%, profit before tax increases by the same for
Company A, but for company B it increased by 100%. This means Company B is more risky for
equity investors than Company A.

3.2.4 Why Liquidity and Gearing Need to Be Considered

A low level of liquidity or a high level of gearing means that the organisation is in
more danger of corporate

4.1 Potential Conflict

One of the dangers of using financial targets for the current financial period is that it
can lead to actions that may improve reported performance in the short term but
harm the organisation in the longer term. Examples of this are:
 Reducing investment in development will reduce capital and therefore
increase ROCE. However, in the longer term the organisation may not
have new products to offer to customers.
 Cutting the quality of products could lead to a loss of customers.
 Salary freezes may lead to staff dissatisfaction, which may be reflected in
the service that customers receive. It may also increase staff turnover,
which increases the cost of recruiting and training

 9.4.2 Management Issues

 4.2 Management Issues

 The performance management system should be based on longer-term
measures, which are consistent with the overall objective of maximising the
wealth of shareholders. In theory, measures that are consistent with net
present value are most consistent with this. In practice, it is difficult to
measure, because decisions taken today will influence net present value in
the future.
 The use of non-financial measures should also focus management’s attention
on longer-term financial performance. The balanced scorecard (covered
in Chapter 15) could be used.
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 The chapter on divisional performance evaluation (Chapter 10) considers

three specific methods of assessing the performance of divisional managers
and looks at the issue of short-termism in more detail.
 Management remuneration schemes can also help to encourage managers to
think about the long term if they are designed appropriately (e.g. bonus
schemes that depend on long-term financial performance). Remuneration
schemes are covered in more detail in Chapter 14.

9.5.1 Benchmarks
5.1 Benchmarks

Assessing the performance of an organisation can be made more meaningful if

comparisons are made with appropriate benchmarks (see Chapter 1).
A more meaningful evaluation of performance using financial performance indicators
can be made using benchmarking, as performance is compared with competitors or
best in class (rather than previous periods). This will help identify whether the
organisation is achieving its potential.

Exhibit 1 Industry Benchmarks

The Financial Times reported in January 2020 that John Lewis was to stop publishing its weekly sales
figures, thereby depriving the retail sector of a widely used benchmark and further diminishing the group's
status as an industry leader.
"The group had published the figures externally for more than 10 years. No other UK retailer, public or
private, disclosed its sales trends so frequently, which had made the numbers a useful leading indicator
for investors, rivals, analysts and economists. The British Retail Consortium and the Office for National
Statistics both publish monthly figures, while Kantar and Nielsen distribute monthly rolling three-month 'till
roll' data that track supermarkets' sales and relative market shares."
Analysts were quoted as saying that the figures "had become less useful as John Lewis's status as a
leader had decreased". At one point the organisation provided weekly sales performance by store, but
that stopped and then so did provision of online sales growth figures.
Source: Financial Times, January 28 2020

Appropriate benchmarks must be used in order to make valid comparisons. Factors

to consider:
 The industry of the organisation for which financial performance is being
compared should be the same. As an extreme example, comparing ROCE
of a manufacturer with that of a consulting firm would not be valid, as the
capital requirements of manufacturing companies are much higher than
those of service providers (which have higher ROCE).
 The strategy of the organisations should be comparable, too. The gross
profit margin of a low-price, high-volume retailer is likely to be very
different from that of a premium-brands retailer.
 Published data may already be out of date and may not reflect what the
benchmark is currently achieving.
 16

The objective of the benchmarking exercise is also relevant to deciding which

metrics are appropriate.
 If the organisation is trying to benchmark its return on the wealth of
shareholders with a competitor, metrics such as economic value added
(see Chapter 10) and total shareholder return are better measures than
profit-based measures.
 For operational efficiency, however, profit-based metrics may be
appropriate.
5.2 Financial Benchmarks

Provided that information is available, any of the financial ratios included in this
chapter could be used for comparison purposes. In addition to ratios, areas such as
growth in profits, growth in revenues, market share and revenue per outlet could be
compared.
Activity 2 Financial Performance

V-Com is a mobile telephone company based in Homeland.

The company has grown rapidly through acquisitions. The acquired companies have
substantial infrastructure assets and only 10% of the available network capacity is
used in the provision of services to customers. 35% of the assets are categorised as
intangible and are composed of goodwill and licence acquisition expenditures. The
board has announced that it will not acquire any further companies and will maintain
the same level of debt for the next decade.
V-Com wishes to benchmark its financial performance against Talk Co, the leading
provider of mobile telephone services in Homeland. It is estimated that 50% of the
network capacity of Talk Co is being utilised.
Highlights of V-Com's financial statements for the most recent financial year 20X4
are shown below, along with comparatives from the year 20X1 (which was three
years earlier) and highlights from Talk Co's most recent financial statements.

V-Com V-Com Talk Co

20X1 20X4 20X4

Revenue 173 1,591 3,845

Costs

Operating 76 813 1,900

Selling 87 566 860

Depreciation 40 791 670

Interest – 689 120

 17

V-Com V-Com Talk Co

20X1 20X4 20X4

Profit/(loss) (30) (1,268) 295

Average net assets (NBV) 463 12,261 7,100

Average long-term debt – 8,997 2,200

Year-end share price $5 $110 Not given

Financial Highlights ($m)
Required:
Write a report to the CEO of V-Com to:
a. Evaluate the financial performance of V-Com including a comparison
against Talk Co.
b. Assess the appropriateness of using Talk Co as a benchmark.
*Please use the notes feature in the toolbar to help formulate your answer.
To: CEO
From: Management Accountant
Date: April 20X5
Subject: Financial performance of V-Com and benchmarking against Talk Co
This report evaluates the financial performance of V-Com for the latest financial year.
Some areas have also been benchmarked against Talk Co, which is the market
leader. The report includes an appendix showing supporting calculations.

Exam advice**

In a question of this nature, where you are asked to provide a report on the performance of a
company, there is no one right answer. Provided that you made sensible comments, and tried to
explain what is behind the numbers, you will gain credit, even if your answer does not match the
model answer presented here.
a. Financial performance
The revenue of V-Com rose from $173m in 20X1 to $1,591m by 20X4, that
is nine-fold over three years. This was probably due mainly to acquisitions
rather than organic growth, so the increase is rather meaningless. It would
be interesting to see how much organic growth was actually achieved.
The company is making a huge loss and this has increased between 20X1
and 20X4. Earnings before interest, tax, depreciation and amortisation
(EBITDA) have been calculated and these were positive in both years,
showing that the company is generating positive operating cash flows.
The EBITDA margin increased from 5.8% in 20X1 to 13.3% in 20X4,
showing that the company is managing to convert a higher portion of its
revenues into cash flow. However, the EBITDA margin is way below that
of Talk Co, which was 28.2% in 20X4. The difference is most likely due to
the underutilisation of the network; V-Com utilises only 10% of the network
capacity whereas Talk Co utilises 50%.
In order to cover the interest and depreciation, EBITDA would need to
increase to $1,480m (i.e. an increase of 7 times). This may be possible
since a large portion of costs is likely to be fixed, so any increase in
 18

revenue would have a more significant effect on profit. Even so, it would
still be a big challenge to increase EBITDA to this extent.
The large amount of interest payable in 20X4 is due to the high gearing,
which has increased from nil in 20X1 to 73.4% in 20X4. This compares to
gearing of 31.0% for Talk Co. The reason for the high gearing is most
likely the acquisitions made, which appear to have been financed mainly
by increased long-term debt. Currently, V-Com can only just repay the
interest on its debt from operating cash flow; interest cover (based on
EBITDA) is only 0.31 times. EBITDA needs to rise three times in order to
cover the interest; if it does not, the company is in grave danger of
bankruptcy.
Depreciation is also a major portion of V-Com's expenses as it amounts to
almost 50% of revenue in 20X4 and 23% in 20X1. Talk Co, in contrast,
has depreciation expenses amounting to only 17.4% of revenue. This may
again be related to the underutilisation of the network assets of V-Com. It
could be argued that because depreciation is a sunk cost, the company
could survive and generate positive cash flows provided that it manages to
at least cover its interest expense.
However, depreciation may also indicate the amount of cash required to
replace old assets.
Despite this bleak picture, the share price of V-Com rose from $5 in 20X1
to $110 in 20X4. The share price is a forward-looking indicator as it
reflects the expectations of investors about the future of the company and
they are clearly confident. Perhaps investors believe that the company will
be able to increase its customer base sufficiently to achieve profits and
positive cash flows in the future.
The overall assessment is that the company has grown by acquisition that
has been financed largely by debt. The company is currently in a
precarious position as it can only just repay the interest on the debt from
current cash flows. However, the network is underutilised, so if the
company can survive long enough to increase utilisation and therefore
reach breakeven, it may succeed in the long term. In the short term,
however, the prospects look very risky.
b. Appropriateness of using Talk Co as a benchmark
Talk Co is the market leader in the industry that V-Com is in. Because they
operate in the same industry, it would seem appropriate to use this
company as a benchmark for financial performance comparison. In
particular, areas such as gearing might be expected to be similar, as the
businesses face the same business risk. Therefore, it might be expected
that V-Com (and other companies in the same industry) would try to obtain
the same financial risk by having similar levels of gearing. This would
apply to interest cover, also.
V-Com V-Com Talk Co
20X1 20X4 20X4

(1) EBITDA* 10 212 1,085

(2) EBITDA margin 5.8% 13.3% 28.2%

 19

V-Com V-Com Talk Co

20X1 20X4 20X4

(3) Interest cover based on EBITDA

= n/a 0.31 times 9 times

(4) Gearing

= 0 73.4% 31.0%
As Talk Co is the market leader, it may be unfair to use Talk Co as a
benchmark for other areas of financial performance. Profit margins in the
mobile telephone network business are highly influenced by utilisation
rates, and Talk Co most likely has the highest rates (as the market leader).
It would therefore be unrealistic to expect V-Com (or indeed any other
company in the same industry) to have similar margins. A more
appropriate benchmark for profit margins and utilisation rates might be
industry averages.
Appendix – Relevant Ratios
*Calculated by adding interest and depreciation to the net profit/(loss).

Summary and Quiz

 The mission of a commercial organisation is usually to maximise the
wealth of shareholders and hence financial performances measurement is
key to determining the extent to which the mission is being achieved.
 Financial measures of performance include:
o return on capital employed;
o profit margins;
o earnings per share;
o earnings before interest, tax, depreciation and
amortisation;
o net present value; and
o internal rate of return and modified internal rate of return.
 Liquidity and gearing should also be considered when assessing the
financial performance of an organisation, as the risk of corporate failure
depends to a large extent on these two factors.
 There is often a conflict between short-term and long-term financial
performance of an organisation; managers may often take actions that can
improve performance in the short-run, but harm performance in the longer
term.
 Financial performance evaluation becomes more meaningful if
organisations are compared using benchmarking.
20

10.1.1 Challenges with Divisional Structures

1.1 Challenges with Divisional Structures

A feature of modern business is the practice of splitting an organisation into semi-

autonomous units with devolved authority and responsibility. These units might be
called divisions or subsidiaries or strategic business units, but the principles applied
for the measurement of their performance are the same.
These units can be:
 cost centres – managers are responsible for decisions about costs;
 revenue centres – managers are responsible for decisions about revenue
(and selling costs);
 profit centres – managers are responsible for decisions about costs and
revenues; and
 investment centres – managers are responsible for decisions about cost
and revenues and investments in assets.
A fully-fledged strategic business unit (SBU) would most likely be an investment
centre, meaning it has the means and responsibility to make its own capital
investments.
Before looking at how to measure divisional performance it is worth considering the
issues that can arise in a divisional structure.
 Goal congruence – How to ensure that managers take decisions that are
in the best interests of the organisation as a whole.
 Co-ordination – How to coordinate the activities of divisions to ensure
that overall corporate objectives are realised.
 Controllability – How to ensure divisional managers are only held
accountable for the factors they can control. (The performance of the
division and the performance of divisional managers must be dealt with
separately.)
 Inter-dependence of divisions – How to measure performance when one
division’s performance may affect that of another.
 Head office costs – How to/whether to apportion central costs.
 Transfer prices – How to set these effectively.
Divisional performance measures must take into account and overcome these issues
to ensure performance is measured appropriately.

1.2 Possible Measures

The measures used will depend on the type of business unit being monitored. It is
dangerous to focus on one key measure of performance. A range of measures
should be used to assess all elements of performance, both financial and non-
financial − a balanced scorecard approach.
The range of measures could include:
 21

 variance analysis (taking care to identify the controllability of and

responsibility for each variance);
 ratio analysis;
 return on investment;
 residual income; and
 non-financial measures.
Profitability
Measures Liquidity Measures Other Measures

 Net profit
margin
 Gross profit  Contribution per key factor/ limited
margin  Current ratio resource
 Contribution  Quick ratio  Sales per employee
margin  Receivables  Industry specific
 Expenses days cost-related ratios such as:
as  Payables days o transport cost per km
percentage  Inventory o overheads per
of sales turnover chargeable hour

1.2.1 Ratio Analysis

1.2.2 Non-financial Measures
Non-financial measures include, for example:
 Staff turnover (also days lost through absenteeism).
 New customers gained.
 Proportion of repeat bookings.
 Orders received.
 Set-up times (also customer waiting times).
 New products developed.
 % returns.
 % rejects/reworks (or number of complaints received).
 On-time deliveries, client contact hours, training time per employee.

10.1.3 Managerial and Divisional Performance

$ $

External sales x

Internal sales x

Variable costs x

controllable by manager

Fixed costs x
 22

$ $

(x)

Controllable Profit x

Divisional costs outside manager's control (x)

Traceable Profit x

Allocated head office cost (x)

Divisional net profit x

1.3 Managerial and Divisional Performance

The principle of controllability means that when assessing the performance of the
manager of a division, only those items which are controllable by the manager
should be included in the calculation of profit. This "controllable" profit excludes
items such as expenses in respect of agreements that were not made by the
manager (e.g. the annual audit fee agreed by the head office).
When assessing the performance of a division, as opposed to the manager of the
division, central management is interested in profit that relates directly to the division,
so it can ascertain, for example, how profit would be affected if the division were to
be closed down. This "traceable" profit should exclude allocated costs, because
these costs do not relate directly to the division. However, traceable profit may
include some direct expenses which are not controllable − so they are not included
in the calculation of controllable profits.
 Controllable profit should be used to assess the manager's performance.
 Traceable profit should be used to assess the division's performance.
Example 1 Controllable v Traceable Profit

In a profit centre, the manager has no authority to make investment decisions. When calculating
controllable profit, therefore, depreciation would be ignored as this is outside of the control of the
manager. When calculating the traceable profit, however, depreciation would be included, as it is a cost
that relates to the profit centre.

2.0 Definition

Definition

Return on investment (ROI) – the profit or gain on an activity for a period relative to the amount invested.
ROI is the divisional equivalent of ROCE used to evaluate the performance of a
division or the manager of a division.

2.1 Calculations
 23

Key point

Profit is before interest and tax because interest is affected by financing decisions and tax is an
appropriation.

2.1.1 For Manager

2.1.2 For Division

2.1.3 Decision Rule

If ROI is greater than the cost of capital (the required rate of return), accept the
project.
Activity 1 ROI

Divisional managers are assessed on the value of the return on investment (ROI)
that their division achieves. The higher the ROI is, the higher will be their bonus at
the end of the year. The managers of Division X and Division Y are considering two
potential projects for their division.
Details of these and the divisions' current ROI (without the proposed projects) are
shown below:
Division X Division Y
Controllable investment in possible project $100,000 $100,000
Controllable profit from possible project $16,000 $11,000
Current division ROI 18% 9%
Company cost of capital 13%
Required:
(a) Determine whether the divisional managers would accept the project
available to their respective divisions.
(b) Comment on whether the managers' decisions are consistent with the
overall objective of the organisation, which is to maximise the wealth of its
shareholders.
*Please use the notes feature in the toolbar to help formulate your answer.
24

(b) Comment
 The new project available to Division X has an ROI above the cost of
capital and should probably be accepted.
 The new project available to Division Y has an ROI below the cost of
capital and should probably be rejected.
 The divisional managers are making decisions in their own best
interests, not in the company's best interests.
 Lack of goal congruence.

10.2.2 Advantages of ROI

2.2 Advantages of ROI

 Relative measure − easy to compare divisions with different scales of

operation.
 25

 Similar to ROCE used externally by analysts.

 Focuses attention on scarce capital resources.
 Encourages reduction in non-essential investment by:
o selling off unused fixed assets; and
o minimising the investment in working capital.
 Easily understood (especially by non-financial managers).
 Can be broken down into secondary ratios for more detailed analysis (i.e.
profit margin and asset turnover).

10.2.3 Disadvantages

2.3 Disadvantages

Risk of dysfunctional decision-making (as seen in Activity 1).

 Definition of capital employed is subjective. For example, should non-
current assets be valued using:
a. carrying amount (i.e. net book value);
b. historic cost; or
c. replacement cost?
Should leased assets and intangible assets be included?
 If net book value is used, ROI will become inflated over time because of
depreciation. This may encourage managers to hold on to old, potentially
inefficient, assets rather than investing in new ones.
 Risk of window dressing; boosting reported ROI by:
o under investing; and/or
o cutting discretionary costs (particularly if ROI is linked to
bonus systems).
 3.0 Definition
Definition

Residual income – pre-tax profit less imputed interest charge for capital invested.

 Residual income focuses on the creation of wealth by deducting an imputed
interest expense, which represents the cost of capital invested, from profit.

 10.3.1 Calculations
 3.1 Calculations


Controllable profit x
 26

Imputed interest charge (x)

Residual income x

 3.1.1 For Manager

 3.1.2 For Division
$

Traceable profit x

Imputed interest charge (x)

Residual income x

 3.1.3 Imputed Interest

 Imputed interest is a notional interest charge on the division by the head
office.
Imputed interest = Capital employed × Interest rate

 The company's cost of capital is often used as the basis for the interest rate.
 3.1.4 Decision Rule
 The decision rule is to accept a project if the RI is positive.
 Activity 2 Residual Income


 Assume that the divisional managers of Division X and Division Y

from Activity 1 are now assessed using residual income rather than return on
investment.
Division X Division Y

Controllable investment in possible project $100,000 $100,000

Controllable profit from possible project $16,000 $11,000

Current division ROI 18% 9%

Company cost of capital 13%

 The information about the two projects is repeated below:

 Required:
27

 (a) Determine whether the managers would invest in the new project.
 (b) State whether the decision making is consistent with the goal of
maximising the wealth of shareholders.
 *Please use the notes feature in the toolbar to help formulate your answer.

(a) Division X Division Y

Controllable profit
16,000 11,000

Imputed interest
(13,000) (13,000)

Residual income
3,000 (2,000)
 The manager of Division X will accept the project.
 The manager of Division Y will reject the project.
 (b) Goal congruent? Yes

10.3.2 Advantages

3.2 Advantages

 It reduces the problems associated with ROI (dysfunctional behaviour and

holding on to old assets).
 A risk-adjusted cost of capital can be used to reflect different risk positions
of different divisions

10.3.3 Disadvantages

3.3 Disadvantages

Activity 3 RI and NPV

 28

A divisional manager is evaluated by the head office using RI and therefore uses RI
to appraise projects.
Company cost of capital = 10%

New project details: Investment $600,000

Three-year life

No residual value

Annual cash inflow $500,000.

Required:
a. Calculate RI for each of the three years. Use net book value at the start
of each year as capital employed.
b. Discount RI for each year to present value using 10% discount rate.
c. Calculate NPV of the project cash flows.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Calculate RI
b. Year
(1) (2) (3)
$000 $000 $000
Cash flow 500 500 500
Depreciation (200) (200) (200)
Profit 300 300 300
Net book value 600 400 200
Imputed interest 60 40 20
Profit − interest = Residual income 240 260 280
c. Discount RI

d. Calculate NPV

10.4.1 Effect of Depreciation

4.1 Effect of Depreciation
29

If capital employed is defined as net book value at the start of the year and straight-
line depreciation is used.
 Then, over the life of an investment:
o Capital employed will fall;
o ROI and RI will tend to rise.
 Hence straight-line depreciation inflates reported performance over time,
even if actual performance is constant.
 This can cause dysfunctional decision making, even if RI is used.
Activity 4 RI/ROI and Depreciation

Investment $2.1 million

Life of asset Four years

Residual value zero

Cash inflows Year 1 $700,000

Year 2 $700,000

Year 3 $700,000

Year 4 $700,000
Capital employed is defined as net book value at the start of each year. Straight-line
depreciation is used.
Cost of capital 10%.
Required:
a. Calculate:
i. residual income for each year;
ii. return on investment for each year;
iii. NPV of the investment.
b. Explain whether decision making will be in the best interests of the
company if RI or ROI is used for investment appraisal.
*Please use the notes feature in the toolbar to help formulate your answer.

4.2 Conflict with NPV

Activity 4 shows the possible conflict between RI/ROI and NPV:

 Projects with positive NPV increase shareholder wealth and should be
accepted.
 But if RI or ROI are used for divisional performance appraisal, and
therefore divisional investment appraisal, positive NPV projects may
be rejected.
This is because straight-line depreciation causes poor performance to be reported in
early years, and high performance in later years.
 30

Non-goal congruent decision making is likely to occur if managers are myopic (i.e.
obsessed with short-term performance).
Using annuity-based depreciation can reduce the problem.

10.5.1 The Concept

5.1 The Concept

EVA™ is a trademark of the Stern Stewart & Co consulting organisation.

EVA is a performance evaluation tool that can be used to appraise the performance
of an organisation. It is similar to residual income in that a charge on capital is
deducted from the profits in reaching economic value added.

Net operating profit after tax (NOPAT) x

Finance charge (x)

Economic value added x

Example 2 EVA

Division A made $10,000 net profit after tax during the most recent financial year. The division’s
opening capital (equity plus long-term debt) was $70,000. The company’s weighted average cost of
capital is 13%. EVA of Division A was therefore:

NOPAT 10,000

9,100
Finance charge (70,000 x 13%)

900
EVA
The finance charge represents the minimum return required by the providers of the $70,000 capital.
Since the actual profit of the division exceeds this, the division has recorded EVA of $900.

Key point

EVA = NOPAT – (k x capital), where k is the firm’s weighted average cost of capital.
Capital is usually opening capital.

The calculation of EVA can be summarised as:

10.5.2 The Rationale Behind EVA

5.2 The Rationale Behind EVA

 31

Many organisations simply use profit as a measure of performance. However profit

does not take into account the cost of the equity finance required to make the profit;
it only takes into account the cost of debt finance. As one commentator noted, "until
a business returns a profit that is greater than its cost of capital, it operates at a
loss".
It is argued that the adoption of EVA as a performance measure for managers aligns
the interests of managers with the objective of the organisation to maximise the
wealth of shareholders. The EVA generated each year shows the amount of wealth a
business has created, or destroyed, during the year.
Example 3 Value Destroyed

Alpha is 100% equity financed. Its shareholders require a 15% return on investment. During the year, the
company made a profit of $100,000. The value of equity at the start of the year was $1 million. Although
the company made a profit, this profit was not sufficient to meet the requirements of the shareholders.
The company destroyed value as follows:

$000

Profit after tax 100

Required return of shareholders (1 million × 15%) (150)

Economic value destroyed (50)

In this very simplified example, the profits earned by the company were not sufficient to provide the
required return to shareholders on their investment.

10.5.3 Net Operating Profit After Tax (NOPAT)

5.3 Net Operating Profit After Tax (NOPAT)

As the finance charge on capital employed is deducted from profits in the calculation
of EVA, profit must be before interest, to avoid double counting in the cost of
financing debt.
Because the cost of capital used in the calculation of the finance charge includes
only the "after tax" rate of interest, after tax interest is added back. This has the
effect of showing the profit of the company as if it had no debt finance. There are two
approaches to making the adjustment:
1. Start with operating profit
Deduct the adjusted tax charge (because tax expense includes the tax
benefit of interest) by adding interest multiplied by the tax rate to the tax
charge; or
2. Start with profit after tax
Add back the net cost of interest. This is the interest charge multiplied by
(1 − rate of corporate tax).
Example 4 Calculating NOPAT
 32

Eve's statement of profit or loss for the year just ended showed the following:

$000

Operating profit 1,000

Less interest 300

Profit before tax 700

Tax at 25% 175

Profit after tax 525

Method 1
Interest adjustment to the tax charge is $75,000 (300 × 25%).
Adjusted tax charge = $250,000 (175 + 75)
NOPAT = $750,000 (1,000 − 250)
Method 2
Net cost of interest = interest × (1 − tax rate) = $300,000 × 75% = $225,000.
So NOPAT is $750,000 (525 + 225).

10.5.4 Accounting Adjustments

5.4 Accounting Adjustments

5.4.1 Need for Adjustments

In addition to the finance charge on capital, EVA differs from residual income in that
it is based on "economic profit" rather than "accounting profit". Its proponents believe
that the way financial accountants calculate profit under GAAP (US GAAP, IFRS and
similar accounting systems) does not reflect the true economic profit. Many
adjustments are therefore made to the accounting profit (and also, therefore, to the
equity shown in the statement of financial position) before EVA is calculated. The
three main reasons for these adjustments are:
 To convert from accrual basis to cash basis. Investors are interested in
cash flows, so non-cash items (e.g. allowances for trade receivables)
should be eliminated.
 To capitalise spending on “market building” items (e.g. research, staff
training and advertising) that has been expensed in the financial
statements. Stern Stewart believes that financial reporting standards (e.g.
IAS 38 Intangible Assets) are too strict and discourage managers from
investing in items that bring long-term benefits.
 To ignore unusual items of profit or expenditure.
33

Exam advice

Only the most common adjustments, which follow, will be examined.

5.4.2 Investment in Intangibles

Under GAAP accounting, expenditure on research, advertising, staff training and
similar items are not capitalised, but rather are expensed to profit or loss when
incurred. Under EVA, such items are considered to be investments that will bring
benefits in the future. Therefore, any such items expensed during the year should be
added back to profit for the year, and to capital at the end of the year.
Amortisation of such items will also be required in future accounting periods when
calculating EVA. No amortisation would have occurred in the GAAP profit, as these
items were written off when they were incurred.

5.4.3 Depreciation
Accountants typically use methods such as straight-line depreciation. These do not
reflect the real use of the asset over the period. Accounting depreciation should
therefore be added back to profits and economic depreciation deducted instead.
Economic depreciation is the true change in value of the assets during the period.
A similar adjustment will be made to the value of non-current assets in the statement
of financial position, and therefore to the capital employed figure.

Exam advice

If no details of economic depreciation are provided, assume that accounting depreciation is a reas
approximation.

5.4.4 Allowances and Provisions

The creation of allowances for bad and doubtful debts and provisions for deferred tax
in financial accounting is too prudent, according to the proponents of EVA. Any
increases in such provisions reflected in the profit or loss during the year should
therefore be added back to profit in calculating EVA. Similarly the value of such
provisions should be added to the capital employed figure in the statement of
financial position.

5.4.5 Non-cash Expenses

Non-cash expenses such as impairment of goodwill are not real expenses according
to EVA. They should therefore be added back to the profit or loss and the capital
employed in the statement of financial position.

5.4.6 Tax expense

This is adjusted to “cash taxes” rather than the accruals based methods used in
financial reporting. The cash taxes are calculated as follows:

Tax expense per statement of profit and loss x

 34

Less increase/add decrease in deferred tax provision (x)

Add tax benefit of interest x

Cash taxes x
No further adjustments are made (e.g. in respect of the accounting adjustments).

5.4.7 Summary of Adjustments

The following table may help you to remember which adjustments are required. Be
aware that for the calculation of the finance charge, capital employed is taken at
the start of the year, so some of the adjustments to profit in the current year do not
affect capital employed until the following year.
Exam advice

The exam will most probably include some degree of computation, and provide the information for the
overall calculation of EVA without testing the intricacies of accounting adjustments.
Remember the finance charge is computed on capital employed at the beginning of the year.

Change to Profit Change to Capital Employed

(only if affecting opening balance at beginning of
year)

Advertising, Increase current year profits Increase capital employed at the end of the year
research and Deduct economic Increase capital employed in respect of similar add-
development depreciation on previous backs of previous year's investments not treated as such
year's EVA adjustment in the financial statements, net of economic depreciation
items
expensed,
staff training

Depreciation Add accounting depreciation Adjust value of non-current assets (and capital
Deduct economic employed) to reflect economic depreciation not
depreciation accounting depreciation

Note if economic value of assets is given, no adjustment

required.

Operating Addback lease payments to Add present value of future lease payments to capital
leases profit employed
Deduct depreciation on
assets

Provisions Add increases in provision/ Add back the value of provisions to capital employed
deduct decreases in
provisions to/from profits
 35

Non-cash Add back to profit Add to retained profits at the end of the year
expenses

10.5.5 Finance Charge

5.5 Finance Charge

 The finance charge in EVA calculations is the weighted average cost of

capital (WACC) multiplied by the capital of the division. Here capital is
taken to mean equity (net assets) plus long-term debt.
 WACC is an average cost of capital, which takes into account the various
sources of finance used by the division, including equity capital and debt.
The formula for WACC is as follows:

Where:
ke = required return on equity
kd(1 − T) = after-tax return on debt

= portion of financing coming from equity

= portion of financing coming from debt

 It is normal to take capital at the beginning of a financial year, not at the
end.
 The best approach is to start with capital employed (per the published
financial statements) and then make the accounting adjustments (as
above).
Activity 5 EVA

Extracts from Adam's statement of profit or loss for the most recent financial year
show the following:

$m

Operating profit 25

Interest on loans 1

Profit before tax 24

Tax at 25% 6

Profit after tax 18

Included in the calculation of the profit was an expense of $4 million relating to
development costs, which had been incurred during the year, but were not
capitalised because they did not meet the requirements of IAS 38 Intangible Assets.
The development was not complete until the final day of the financial period.
36

Accounting depreciation is considered to be the same as economic depreciation.

In the previous financial year, development expenditure of $10 million was incurred
on another product. This had been expensed as incurred. Sales of this product
began during the current financial year, and are expected to continue for another
three financial years.
The weighted average cost of capital of the company is 12%. Capital employed
(long-term debt plus equity) per the statement of financial position was $89 million at
the end of the previous financial period.
Required:
Calculate the Economic Value Added by Adam during the current financial
year.
*Please use the notes feature in the toolbar to help formulate your answer.

10.5.6 Interpretation and Use

5.6 Interpretation and Use

5.6.1 Interpretation
Consider the following factors:
 Is it positive? If yes, the organisation or division is generating a return that
is greater than that required by providers of finance. It is creating wealth.
 What is the trend over time? Is it increasing? Even if the trend is down,
performance is still favourable if EVA is positive.
 Why has EVA changed? For individual projects, EVA is only really
meaningful when considered over its lifespan. In early years, when the net
book value of assets is higher, the finance charge may also be higher,
leading to a lower EVA; in later years, the reverse is true.

5.6.2 Use as an Organisational Performance Measure

EVA should motivate directors to improve EVA and thereby maximise shareholder
wealth in one of four ways:
1. Investing in divisions whose returns exceed the cost of capital.
2. Increasing the operating performance of existing divisions.
This increases NOPAT without increasing the finance charge.
3. “Harvesting assets” by closing down under-performing divisions and either
re-investing the proceeds in other divisions or returning cash to
shareholders as a dividend.
4. Increasing the debt to equity ratio to reduce the WACC. Though clearly the
company should not become over-geared.

5.6.3 Use as a Divisional Performance Measure

EVA can also be used as a performance evaluation tool for divisional managers. In
decentralised organisations, divisions are effectively companies in their own right,
with the head office acting as a parent. EVA therefore encourages divisional
managers to maximise the wealth of their divisions.
37

Although divisional managers may not have sufficient autonomy to make decisions
about financing or gearing (so will not be able to change the WACC), using EVA
should ensure that divisional managers only invest in projects whose return exceeds
the company’s cost of capital.

10.5.7 Advantages and Disadvantages of Using EVA

5.7 Advantages and Disadvantages of Using EVA

5.7.1 Advantages of Using EVA

 Maximising EVA is consistent with maximising the wealth of shareholders,
since it takes into account not only the profit, but also the finance charge
associated with producing that profit.
 Companies that use EVA as a performance evaluation tool have increased
their performance compared to companies that do not, according to Stern
Stewart & Co. This is particularly the case where managers' remuneration
packages are linked to the reported EVA.
 It is conceptually easy for non-financial managers to understand.
 It leads to goal congruence in the same way as residual income.
 It encourages managers to take a longer-term view since expenditure that
brings long-term benefits is not treated as an expense, but capitalised.
 Profits are based on economic profits (i.e. cash) rather than accounting
profits which can be manipulated (e.g. in the selection of accounting
policies).
 EVA can be used as a single performance measure that replaces the
confusion of multiple goals, such as revenue growth and profits growth.

5.7.2 Disadvantages of Using EVA

 The adjustments required may become complicated in practice.
 Estimating WACC can be difficult (e.g. the capital asset pricing model is
not universally accepted for determining the cost of equity).
 As an absolute measure it is not so easy to compare divisions of different
sizes.
 It is a short-term measure, so may still encourage managers to take a
shorter-term view.

10.6.1 Evaluation of Methods

6.1 Evaluation of Methods

6.1.1 Types of Measures

 ROI is a relative measure, so it is useful for comparing the performance of
different divisions of different sizes.
 Because residual income and EVA are absolute measures, using these to
compare divisions of different sizes is more difficult. (Two divisions could
have identical values for EVA or residual income, but if one were much
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larger than the other, it would be incorrect to conclude that both were
performing equally well.)
 Calculating residual income or EVA as percentages of capital employed
can overcome this weakness (by converting them to relative measures).
Exam advice

Be able to compare and evaluate ROI, RI and EVA rather than merely know their advantages and
disadvantages.

6.1.2 Goal Congruence

 ROI may lead to decisions that are not congruent with the goal of
maximising shareholder wealth. For example, deciding not to invest in
projects that reduce ROI even if they return more than the cost of capital
(see Activity 1).
 Residual income and EVA over the longer term should lead to decisions
that are congruent with maximising shareholder wealth, because projects
that return more than the cost of capital also increase residual income and
EVA.
 In the short term, however, there still may be goal incongruence if a
project yields negative residual income or EVA in its early years
(see Activity 4).

6.1.3 Overcoming Problems

ROI and residual income are based on accounting profits which suffer from the
following problems:
 Managers may avoid investments in intangibles (research, marketing, etc)
that cannot be capitalised under GAAP to achieve targets.
 Excessive cost-cutting to improve short-term ROI may weaken future
competitiveness or store up costs for the future:
o Reducing employee numbers may damage product
quality or levels of customer service.
o Deferring training may later require costly recruitment of
more skilled employees.
 Profit has several definitions and may be impacted by accounting policies.
EVA seeks to overcome these problems by making the adjustments
detailed previously (see s.6.4).
.2 Differences Between Residual Income and EVA

EVA is calculated similarly to residual income but constructed in such a way that
maximising EVA can be set as a target. There are two main differences when
calculating EVA and standard residual income:
 Residual income is accounting profit before interest and tax, less the
finance charge. EVA is NOPAT less the finance charge.
 For residual income, the finance charge is based on the book values of
equity and debt at the start of the year. For EVA, the finance charge is
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based on the adjusted values of equity and debt at the start of the year
(i.e. after adjusting for EVA adjustments of prior years).
Exhibit 1 EVA Management

Kao Corporation is a chemical and cosmetics company headquartered in Japan. EVA is its principal
management metric.
"Continuous growth in EVA is linked to increased corporate value, which means long-term profits not only
for shareholders, but for all Kao Group stakeholders as well. The Kao Group views EVA growth as a
primary focus of operating activity that expands business scale by making the maximum use of assets,
and raising asset efficiency. The Kao Group also uses this metric to determine the direction of long-term
management strategies, to assess specific businesses, to make evaluations on investment in facilities,
acquisitions and other items, and to develop performance targets for each fiscal year. By remaining
conscious of invested capital with EVA, the Kao Group strives to continuously increase corporate value
through profitable growth from a long-term perspective."
Source: www.kao.com

10 Summary and Quiz

Summary and Quiz

 Organisations may be broken down into autonomous divisions, whereby
the managers run the divisions with little interference from the centre.
 Divisional performance measures must take into consideration the issues
that can arise when an organisation has a divisional structure:
o Goal congruence
o Co-ordination
o Controllability
o Inter-dependence of divisions
o Head office costs
o Transfer prices
 When assessing the performance of a manager, only the costs and
revenues that the manager can control should be taken into account −
controllable profits.
 When assessing the performance of a division, all controllable and
uncontrollable costs that relate directly to the division should be taken into
account − traceable profits.
 ROI is a commonly used measure of divisional performance. It is
calculated as divisional profits divided by divisional net assets.
 Where managers are evaluated based on ROI, this may lead to
dysfunctional behaviour, if divisional managers reject projects with a return
in excess of the company's cost of capital, but which have a return below
the manager's current ROI without the investment.
 Residual income is an absolute measure which is calculated as the net
profit of the division less an imputed interest charge, calculated by
multiplying the divisional net assets by the company's cost of capital. It
should overcome the weakness of ROI in that all projects that generate a
return in excess of the company's cost of capital will generate positive
residual income.
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 Where projects span many years, the effect of depreciation is to show

more favourable ROI and residual income in later years of the project, as a
lower asset base is used. This can lead to projects being rejected if
managers take a short-term view. A solution to this is to use annuity
depreciation.
 EVA was developed as a more sophisticated version of residual income.
The calculation of EVA is similar to residual income, but adjustments are
made to accounting profits so that they reflect the real economic profits.