Bus 424 eighth lecture presentation

Bus 424 eighth lecture presentation - 8. Financial...

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Unformatted text preview: 8. Financial Performance Measures 1. 2. 3. 4. Outline Market­based performance measures Accounting­based performance measures ROI, RI, EVA Asset­valuation and performance measures Bus 424 eighth lecture presentation 1 Summary measures Summary, single­number, aggregate, bottom­line financial measures of performance. Reflect the aggregate or bottom­line impacts of multiple performance areas. – e.g., accounting profits reflect the aggregate effects of both revenue­ and cost­related decisions. Two types: – Market measures Reflect changes in stock prices or shareholder returns. – Accounting measures Defined in either residual terms (net income after taxes, operating profit, residual income, economic value added) or ratio terms (return on investment, return on equity, or return on net assets). Bus 424 eighth lecture presentation 2 Market measures Timely — measured in short time periods Precise — in well­functioning capital markets Objective — not manipulable by the managers whose performances are being evaluated Congruent — the most direct manifestation, or closest proxy, of the theoretical notion of firm value Cost effective — do not require any company measurement expense Understandable — in terms of what the measures represent (changes in market value of the firm) Bus 424 eighth lecture presentation 3 Limitations Feasibility – Market measures are not available either for privately­held firms or wholly­owned subsidiaries or divisions, and they are not applicable to non­profit organizations. Controllability – Market measures can generally be influenced to a significant extent only by the top few managers in the organization, those who have the power to make decisions of major importance. Realized performance – Market measures are heavily influenced by future expectations, but these expectations might not be realized. Bus 424 eighth lecture presentation 4 Limitations (Continued) Congruence? – For competitive reasons, markets are not always fully informed about a company’s plans and prospects, and hence, its future cash flows and risks – Market valuations can be affected by “carefully timed” or “managed” disclosures which are not always in the company’s long­term interest – Other “anomalies” Bus 424 eighth lecture presentation 5 Limitations (Continued) These limitations of market measures cause organizations to look for surrogate measures of performance. – Accounting measures are the most important surrogates used, particularly at management levels below the very top management team. Bus 424 eighth lecture presentation 6 Accounting measures Timely — measured in short time periods Precise — subject to extensive accounting rules Objective — audited by independent auditors Congruent In for­profit firms, accounting profits or returns are relatively congruent with the true firm goal of maximizing shareholder value. Positive correlations between accounting profits and changes in stock prices. Cost effective — already required for financial reporting Understandable Bus 424 eighth lecture presentation 7 Limitations (Continued) Accounting income does not reflect economic income perfectly, because accounting measures: – Are transactions oriented – Are dependent on the choice of measurement method – Are conservatively biased – Ignore intangibles – Ignore the cost of equity capital – Ignore risk – Focus on the past The change in the value of the entity over a given period, where “value” is obtained by discounting future CFs. 8 Bus 424 eighth lecture presentation Myopia The motivational effect of these measurement limitations can be perverse because managers who are motivated to produce accounting profits or returns can (in the short­term) do so by: – Not making investments, even worthwhile ones Investment myopia – Making operational decisions to shift income across periods, even when harmful long­term Operational myopia Bus 424 eighth lecture presentation 9 ROI performance measures Return on Investment ROI is a ratio of the accounting profits earned by the business unit divided by the investment assigned to it. ROI = profits ÷ investment base Residual Income RI is a dollar amount obtained by subtracting a capital charge from the reported accounting profits. RI = profits ­ capital charge Bus 424 eighth lecture presentation 10 Problems caused by ROI­measures Numerator Accounting profits, hence, ROI contains all problems associated with these profit measures. Denominator How to measure the fixed assets portion? Suboptimization ROI­measures can lead division managers to make decisions that improve division ROI even though the decisions are not in the corporation's best interest. Bus 424 eighth lecture presentation 11 An example - Assume corporate cost of capital = 15% - Division investment of $25,000 that generates 5,000 annual profit (=20%) New Division Asset Alone WITHOUT WITH Profit Assets ROI 25,000 100,000 25% 30,000 125,000 24% 5,000 25,000 20% Bus 424 eighth lecture presentation 12 Another example Entity Cash Receivables Inventories Fixed Assets $ 10 20 15 5 10 Profit $ 24.0 14.4 10.5 3.8 (1.8) $ 20 20 40 10 5 $ 30 30 40 20 10 $ 60 50 10 40 10 Total Invest. $ 120 120 105 75 35 Required Earn. $ 6.0 5.0 1.0 4.0 1.0 Profit $ 24.0 14.4 10.5 3.8 (1.8) ROI 20 % 12 10 5 (6) A B C D E Entity ROI Cur. Assets Req. Earn. Fixed Assets $ 60 70 95 35 25 $ 2.4 2.8 3.8 1.4 1.0 $ 60 50 10 40 10 Res. Income $ 15.6 6.6 5.7 (1.6) (3.8) A B C D E RI 4% 10% Bus 424 eighth lecture presentation 13 Suboptimization – ROI provides different incentives for investments across organizational entities. Entity manager will not invest if Entity manager will invest if Corporate Cost of Capital Corporate Cost of Capital < IRR of Project IRR of Project < Entity ROI > > Entity ROI Hence, if corporate cost of capital is 10%, IRR of project is 11%, then A and B are unlikely to invest IRR of project is 9%, then D and E are still likely to invest Bus 424 eighth lecture presentation 14 Suboptimization (Continued) Assume Corporate cost of capital = 10% Investment of $10 to earn $1.1 per year DOES NOT INVEST Base situation Profit Before tax Investment base ROI New situation Profit before tax Investment ROI Entity A $ 24 $ 120 20 % New situation $ 25.1 $ 130 19.30 % INVESTS Entity C $ 10.5 $ 105 10 % New situation $ 11.6 $ 115 10.08 % INVESTS Entity D $ 3.8 $ 75 5% New situation $ 4.9 $ 85 5,76% Bus 424 eighth lecture presentation 15 Suboptimization (Continued) Assume Corporate cost of capital = 15% Investment of $10 to earn $1.1 per year DOES NOT INVEST Base situation Profit Before tax Investment base ROI New situation Profit before tax Investment ROI Unit A $ 24 $ 120 20 % New situation $ 25.1 $ 130 19.30 % INVESTS Unit C $ 10.5 $ 105 10 % New situation $ 11.6 $ 115 10.08 % INVESTS Unit D $ 3.8 $ 75 5% New situation $ 4.9 $ 85 5.76% Bus 424 eighth lecture presentation 16 Other issues Suboptimization is not an issue with residual income (RI) measures when the capital charge is set at or above the cost of capital. ROE measures induce managers to use debt financing (if they have financing authority). This is not the case with RI if the capital charge is equal to the weighted average cost of debt and equity. ROA measures induce managers to lease assets (again, if they have authority over such decisions). Bus 424 eighth lecture presentation 17 The fixed assets portion Net Book Value Both ROI and RI get better merely to passage of time Both ROI and RI are usually overstated if the division includes a relatively large number of older assets Example – Invest $100; Cash flow $27 per year; Depreciation $20 (5 years) Yr 1 2 3 4 5 NBV 100 80 60 40 20 Incremental Income 7 7 7 7 7 (=27-20) 10 % 18 Capital Charge 10 8 6 4 2 RI -3 -1 1 3 5 ROI 7% 9% 12% 18% 35% Bus 424 eighth lecture presentation Misleading performance signals Division managers are encouraged to retain assets beyond their optimal life and not to invest in new assets. Corporate managers may be induced to over­allocate resources to divisions with older assets. Combined with the suboptimization issue, managers of entities with older assets, and hence a higher ROI, are likely to be more reluctant to invest in “desirable” projects with an IRR higher than the corporate cost of capital. Bus 424 eighth lecture presentation 19 EVA: after tax operating income - [WACC x {TA-CL}] E D WACC = k e + kd D +E D +E k e = cost of equity k d = cost of debt (after tax) E = market value proportion of D+E equity in funding mix Bus 424 eighth lecture presentation 20 •Cost of Equity: •ri = rf +βi (rm – rf) •βi = σim/ σm2 (standard risk measure for individual security) security) •rf = risk free rate of interest (T-Bill rate of interest) risk •σim = covariance between stock i’s return and market return •σm2 =variance of the market return Bus 424 eighth lecture presentation 21 •Company A has two sources of financing for project A: Long term bond $2,000,000 paying 9% interest Common shares $6,000,000. T-Bill interest rate: 6%. Company A’s Beta: 1.5. Expected return on market: 12%. The project will generate annual operating income of 1,800,000 (income tax is 40%). The total asset – current liability is 12,000,000. What is the annual Economic Value Added of the project. Bus 424 eighth lecture presentation 22 ...
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This note was uploaded on 05/23/2010 for the course BUS 424 taught by Professor Joe during the Spring '10 term at Skidmore.

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