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Chapter 12 App

# Chapter 12 App - Chapter 12 12A-1 Economic Value Added and...

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Chapter 12 Risk, Cost of Capital, and Capital Budgeting 12A-1 Economic Value Added and the Measurement of Financial Performance Chapter 12 shows how to calculate the appropriate discount rate for capital budgeting and other valuation problems. We now consider the measurement of fi nancial performance. We introduce the concept of economic value added, which uses the same discount rate developed for capital budgeting. We begin with a simple example. Many years ago, Henry Bodenheimer started Bodie’s Blimps, one of the largest high- speed blimp manufacturers. Because growth was so rapid, Henry put most of his effort into capital budgeting. His approach to capital budgeting paralleled that of Chapter 12. He fore- cast cash fl ows for various projects and discounted them at the cost of capital appropriate to the beta of the blimp business. However, these projects have grown rapidly, in some cases becoming whole divisions. He now needs to evaluate the performance of these divisions to reward his division managers. How does he perform the appropriate analysis? Henry is aware that capital budgeting and performance measurement are essentially mirror images of each other. Capital budgeting is forward-looking because we must estimate future cash flows to value a project. By contrast, performance measurement is backward-looking. As Henry stated to a group of his executives, “Capital budgeting is like looking through the windshield while driving a car. You need to know what lies farther down the road to calculate a net present value. Performance measurement is like looking into the rearview mirror. You fi nd out where you have been.” Henry fi rst measured the performance of his various divisions by return on assets (ROA), an approach that we treated in the appendix to Chapter 2. For example, if a divi- sion had earnings after tax of \$1,000 and had assets of \$10,000, the ROA would be: 1 \$1,000 _______ \$10,000 10% He calculated the ROA ratio for each of his divisions, paying a bonus to each of his division managers based on the size of that division’s ROA. However, while ROA was generally effective in motivating his managers, there were a number of situations where it appeared that ROA was counterproductive.

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