Economic value added economic value added eva yes

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Unformatted text preview: the importance of measures. Are all measures equally important? Or are some more important than the others? When constructing a Balanced Scorecard, it needs to be unique meaning that measures should not be too simplistic. In this sense, all stakeholders should be provided for as well on the scorecard. However, identifying all your stakeholders and providing a measure for them is very difficult. Management Accounting 2 – Semester 2 2010 15 Managing Shareholder Value Managing Shareholder Value Background Up until now, we have been doing things that are meant to increase shareholder value. Shareholder value is created when returns are greater than the cost of capital. Rappaport’s 10 Ways to Create Shareholder Value 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) Do not manage earnings or provide guidance for earnings. Choose strategic decisions that maximise value, even if it lowers short ­term value. Make acquisitions that maximise value, even if it lowers short ­term value. Only hold assets that maximise value. Give cash back to shareholders (dividends) when there are no value ­creating opportunities to invest that cash in. Reward executives for delivering long ­term returns. Reward operating unit executives for adding to multi ­year value. Reward middle management and frontline staff for delivering on key targets they can influence directly. Make senior management bear the risks of ownership. Provide investors with value ­relevant information. Note that points 6 to 9 are designed to align the interests of management and shareholders, thereby lowering agency costs. Traditional Measures of Shareholder Value Traditional measures of shareholder value are hard to rely on since they are highly subject to distortion. It is also problematic in that it relies on a lot of accounting assumptions. Some traditional measures are: • • • • • • Return on Equity (ROE) Du Pont Analysis Earnings per Share (EPS) Residual Income Profitability Index Net Present Values (NPV), Internal Rates of Return (IRR) These are beneficial in that they can be calculated very quickly and easily. However, they do not consider the time value of money, ignores business and finance risk and also encourages management to adopt a short ­term focus. Economic Value Added™ Economic Value Added™ (EVA™) – yes it is trademarked – is a variant of the residual income method. However, it includes up to 164 adjustments to reflect the “real economic reality”. However, in this course, we will only use 3 adjustments. Management Accounting 2 – Semester 2 2010 16 Managing Shareholder Value EVA™ is calculated as follows: EVA = Adjusted NOPAT – WACC x CE Where: NOPAT WACC CE = = = Net Operating Profit After Tax Weighted Average Cost of Capital Capital Employed in the Business EVA™ Adjustments We adjust EVA™ so as to: • • • Remove the effects of gearing from NOPAT Include other financing factors Eliminate accounting distortions. In our case with 3 adjustments, these would be: • • • Adding back interest expense and subtracting the tax shield associated with it from NOPAT. Adding back research and development expense and deducting amortization expense from NOPAT and associated tax effects. Adding or subtracting allowance for doubtful debts and associated tax effect. In adjusting NOPAT, in this course, we only consider the Bottom ­Up approach in that we begin adjusting from net profit after tax. When calculating capital employed, we only consider the Sources of Financing approach. This means that we begin with equity, add back interest ­bearing debts and then adjust accordingly. For the WACC, we calculate the after ­tax cost of debt, using the yield to maturity on outstanding debts or the long ­term bonds of companies with equivalent credit ratings, and the cost of equity. We then weight these according to the relative proportion of debt and equity we have. EVA™ Adjustments Summary Abbreviations used here are listed as follows: • • • • • • ADD – Allowance for Doubtful Debts R/D – Research and Development CE – Capital Employed = Equity + LTD + STD + Net Capitalised R/D + Closing Balance of ADD LTD – Interest Bearing Long ­Term Debt STD – Interest Bearing Short ­Term Debt NOPAT – Net Operating Profit After Tax Management Accounting 2 – Semester 2 2010 17 Managing Shareholder Value NOPAT Net Profit After Tax + [Interest Expense – Tax shield on Inter...
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