FMu9xR-ch32 - 1 CHAPTER 32 VALUE ENHANCEMENT EVA CFROI AND OTHER TOOLS The traditional discounted cash flow model provides for a rich and thorough

FMu9xR-ch32 - 1 CHAPTER 32 VALUE ENHANCEMENT EVA CFROI AND...

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1 CHAPTER 32 VALUE ENHANCEMENT: EVA, CFROI AND OTHER TOOLS The traditional discounted cash flow model provides for a rich and thorough analysis of all the different ways in which a firm can increase value; but it can become complex, as the number of inputs increases. It is also very difficult to tie management compensation systems to a discounted cash flow model, since many of the inputs need to be estimated and can be manipulated to yield the results management wants. If we assume that markets are efficient, we can replace the unobservable value from the discounted cash flow model with the observed market price and reward or punish managers based upon the performance of the stock. Thus, a firm whose stock price has gone up is viewed as having created value, whereas one whose stock price has fallen has destroyed value. Compensation systems based upon the stock price, including stock grants and warrants, have become a standard component of most management compensation package. While market prices have the advantage of being up to date and observable, they are also noisy. Even if markets are efficient, stock prices tend to fluctuate around the true value and markets sometimes do make mistakes. Thus, a firm may see its stock price go up and its top management rewarded, even as it destroys value. Conversely, the managers of a firm may be penalized as its stock price drops, even though the managers may have taken actions that increase firm value. The other problem with stock prices as the basis for compensation is that they are available only for the entire firm. Thus, stock prices cannot be used to analyze the managers of individual divisions of a firm or for their relative performance. In the last decade, while firms have become more focused on value creation, they have remained suspicious of financial markets. While they might understand the notion of discounted cash flow value, they are unwilling to tie compensation to a value that is based upon dozens of estimates. In this environment, new mechanisms for measuring value that are simple to estimate and use, do not depend too heavily on market movements and do not require a lot of estimation, find a ready market. The two mechanisms that seem to have made the most impact are:
2 1. Economic Value Added , which measures the dollar surplus value created by a firm on its existing investment, and 2. Cash Flow Return on Investment , which measured the percentage return made by a firm on its existing investments In this chapter, we look at how each is related to discounted cash flow valuation. We also look at the conditions under which firms using these approaches to judge performance and evaluate managers may end up making decisions that destroy value rather than create it.

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