Corporate Performance Measurement
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Corporate Performance Measurement Strategic Analysis Series Primer July 2010. Agenda. Executive Summary Objectives Background Performance Measurement Framework Market Value Added (MVA) Economic Profit (EP) Cash Flow Return on Investment (CFROI) Exercises MVA Economic Profit

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Corporate performance measurement strategic analysis series primer july 2010

Corporate Performance Measurement

Strategic Analysis Series

Primer

July 2010


Agenda

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Executive summary 1 of 2

Executive Summary (1 of 2)

  • Corporate performance evaluation has evolved from the 1960s focus on ROE to the current variations of economic profit that measure impact on shareholder value

    • many firms have devised their own variations of economic profit

    • Stern Stewart’s Economic Value Added (EVA)TM is best known of these measures

    • Holt/BCG’s Cash Flow Return on Investment (CFROI) is a similar concept presented in % return format

  • Both ROE and EP are business metrics, tools used to measure the performance of the business

    • separate from fundamental business drivers, the actual factors that influence shareholder value, and output measures the backward-looking records of overall company performance

  • Focusing on EP instead of ROE decreases the likelihood of destructive behavior by managers

    • By evaluating managers based on EP, manager behavior can be altered such that only projects that add value (with NPV>0) are undertaken, which does not always occur with ROE

CorporatePerformanceMeasurement


Executive summary 2 of 2

Executive Summary (2 of 2)

  • End goal of EPexercises is consistent with traditional XXX focus of maximising shareholder value

    • XXX has measured historical performance with Total Shareholder Return

    • Stern Stewart devised Market Value Added (MVA)TM as means of measuring market expectations of EP that managers will add in the future

    • managers’ objective should be to maximise MVA

  • All economic profit measures deduct charge for use of equity capital from accounting’s typical net income or profit after tax to reflect the opportunity cost associated with equity investments

    • Stern Stewart has trademarked EVATM by specifying adjustments to make to EP

CorporatePerformanceMeasurement


Agenda1

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Objectives

Objectives

There are three objectives of the Corporate Performance Measures Module:

  • To define the most popular measures of corporate performance

  • To explain the significance of these measures in the corporate environment and potential applications in XXX’s strategy work

  • To outline calculations of each performance measure

CorporatePerformanceMeasurement


Agenda2

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Corporate performance evaluation

Background

Corporate Performance Evaluation

Corporate performance evaluation has evolved from the 1960s focus on ROE to the current variations of economic profit (EP) that measure impact on shareholder value

1960s/70s

  • With the rise of conglomerates, most companies focused on Return on Equity, or ROE, as their primary measure of performance

    • led most managers to undertake acquisitions solely to manipulate accounting figures

1980s/90s

  • With the increased focus on delivering shareholder value, managers have accepted systems that measure the change in value

    • managers realised equity is not free

    • economic profit (EP) meets these needs by telling managers where value has been created and where it has been destroyed

  • As aligning interests between owners and managers has become more important, tying management compensation to EP provided a popular solution

CorporatePerformanceMeasurement


Relevance to xxx

Background

Relevance to XXX

  • XXX was the first of major consulting firms to focus on creating shareholder value

  • To achieve this, XXX has used the output measure of Total Shareholder Return and the accounting measures of ROE and ROI

  • Modified accounting measures, such as EP, provide an alternative means of measuring the creation of shareholder value

CorporatePerformanceMeasurement


Link to strategy

Background

Link to Strategy

Marakon has made economic profit (EP) the central focus of the ‘program’ they apply to every case

  • To illustrate the role of corporate performance measures and resource allocation to strategy work, an examination of Marakon’s “program” is useful

  • Marakon applies the following program, which can take several years to complete, to all of its clients:

    • assess the economic profit of all customer segments and product lines

    • compare company performance to industry performance

    • investigate three or more strategies for each business every planning cycle

    • shift resource allocation from economically unprofitable products/customers to economically profitable

    • leads to yield loss for Marakon and clients since additional scenarios frequently evaluated

CorporatePerformanceMeasurement


Economic value added

Background

Economic Value Added

EVATM is one variation of EP

How new is Economic Value Added (EVA)?

  • A century ago, Alfred Marshall explained that for a company to have genuine profits, the profits must be sufficient to cover the cost of capital as well as the firm’s operating costs

  • Stern Stewart has re-packaged the concept into EVA, which is essentially a more palatable form of the same idea

  • McKinsey has been using economic profit for many years

  • BCG uses Cash Flow Return on Investment (CFROI) for a similar analysis

  • To avoid infringing upon Stern Stewart’s trademark, many consulting firms have developed their own terms for the same concept

CorporatePerformanceMeasurement

EVA is a registered trademark of Stern Stewart


Agenda3

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Measures

Framework

Measures

EVA/MVA,EP,and CFROI are modified accounting measures used to measure the performance of the business

Fundamental Business Drivers

Business Metrics

Output Measures

Description:

  • Primary business-specific factors influencing shareholder value

  • Tools used to measure performance of business

  • Backward-looking measures of overall company performance as viewed by market

Inputs/ Measures:

  • Operating profits

    • volume

    • price

    • costs

  • Financial Cost of Capital Employed

    • fixed assets

    • working capital

    • WACC*

  • Accounting

    • ROE

    • ROA

  • Modified accounting

    • EVA/MVA

    • EP

    • CFROI

    • CVA

  • Total Shareholder Return (TSR)

  • Total Business Return (TBR)

CorporatePerformanceMeasurement

* For a discussion of WACC and discount rates, please see the Investment Appraisal Module in the BVU


Fundamental business drivers

Framework

Fundamental Business Drivers

The fundamental business drivers provide a framework for identifying the sources of shareholder value creation or destruction

Shareholder Value Creation/Destruction

Cost of Capital

Operating Profit

Fixed Assets

Working Capital

Volume

Price

Costs

+

WACC

X

X

Components:

  • # of units sold

  • Average selling price

  • Direct costs

    • material

    • labour

  • Indirect costs

    • SG & A

    • Depreciation

  • Property, plant & equipment

  • Intangibles

  • Current assets less current liabilities

  • Weighted average cost of capital based on market values of debt and equity

  • Use after-tax cost of debt

  • LIFO vs FIFO

  • Depreciation estimates

  • Intangible measurement

  • Cost of equity for private firms

Issues:

CorporatePerformanceMeasurement


Accounting business metrics

Framework

Accounting Business Metrics

ROE measures returns to shareholders, while ROA measures returns to investors of all forms of capital

Return on Assets (ROA)*

Return on Equity (ROE)

Formula:

Net Income

Net Income

ROA

=

ROE

=

Assets

Equity

Measures:

Profitability of all capital employed, including debt

Profitability of equity invested in business (net equity issued plus retained earnings)

Uses:

Returns of enterprise as a whole

Returns to shareholders

CorporatePerformanceMeasurement

* Sometimes referred to as Return on Investment (ROI)


Accounting business metrics dupont formula

Framework

Accounting Business Metrics - DuPont Formula

The DuPont formula is used to separate ROE into its components in order to assess the performance of the business

Net Income

Net Income

Sales

Assets

ROE

=

=

X

X

Equity

Sales

Assets

Equity

ROS

Asset Turnover

Leverage

ROA

ROE

=

=

Profitability

X

Asset Turnover

X

Leverage

CorporatePerformanceMeasurement


Modified accounting business metrics

Framework

Modified Accounting Business Metrics

Many consulting companies attempt to brand the modified accounting business metrics they use

Measure

Consulting Companies

  • Economic Profit

  • XXX

  • McKinsey

  • Marakon (through Value-Based Management)

  • LEK

  • EVA  / MVA 

  • Stern Stewart

  • AT Kearney

  • Accounting firms

  • Cash Value Added* (CVA)

  • BCG

  • Cash Flow Return on Investment (CFROI)

  • Holt

  • BCG

CorporatePerformanceMeasurement

* EVA=EVA with depreciation added back


Role in organisation

Framework

Role in Organisation

The modified accounting business metrics, which include EP, enable relatively accurate levels of corporate performance measurement at lower levels of decision making in the organisation

High

TSR*

MVA

Modified Accounting Business Metrics

Accuracy as Measure of Corporate Performance

EP/EVA/CFROI

ROE/ROA

Fundamental Business Drivers

Low

Low

High

Level of Decision Making

CorporatePerformanceMeasurement

* only backward -looking


Output measures

Framework

Output Measures

While TSR calculates return to shareholders for publicly-listed companies, BCG’s TBR calculation estimates equivalent returns for privately-held firms

1

Market value of share at end of period *

number of years

Total Shareholder Return (TSR) in CAGR Format

1

=

Market value of share at beginning of period

1

Estimated market value of shares of privately-held company at end of period*

number of years

1

Total Business Return (TBR)

=

Estimated market value of shares of privately-held company at beginning of period*

CorporatePerformanceMeasurement

* Adjusted for all stock splits and assuming all dividends reinvested


Output measures1

Framework

Output Measures

XXX’s client stock performance slide is calculated using TSR, which is used to measure the shareholder value created

CorporatePerformanceMeasurement


Agenda4

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Definition 1 of 2

Market Value Added

Definition (1 of 2)

XXX’s focus has always been to help the management of the firm to maximise shareholder value, which is equivalent to maximising MVA

Goal of Managers should always be to create more shareholder value, or maximise MVA

Market Value Added (MVA)

Invested Capital

Total Market Value of Firm(includes all debt and equity)

CorporatePerformanceMeasurement


Definition 2 of 2

Market Value Added

Definition (2 of 2)

MVA equals the total market value of the company less invested capital or net assets. Either the Operating or Financing Approach can be used, but XXX typically uses the Operating approach

Operating Approach (Typically used by XXX)

Financing Approach

CorporatePerformanceMeasurement

Note: *Short-term non-interest bearing liabilities


Operating approach excess cash

Market Value Added

Operating Approach - Excess Cash

The first step required to calculate Net Assets with the Operating Approach is to identify excess cash, which is total cash less cash required in the operating cycle

Amount ($)

CorporatePerformanceMeasurement

Note: *Short-term non-interest bearing liabilities


Operating approach working capital requirements

Market Value Added

Operating Approach - Working Capital Requirements

Next, The working capital requirements are the firm’s net investments in the operating cycle, or the net amount of short-term investment required to fund operations

Amount ($)

WorkingCapitalRequirements

CorporatePerformanceMeasurement


Operating approach net fixed assets

Market Value Added

Operating Approach - Net Fixed Assets

When calculating MVA, Net Fixed Assets is defined as Net PP&E plus other Investment (tangible and intangible). The third and final step to calculate Net Assets is Net PP&E, which is the amount of long-term investment required to fund operations

Amount $

Net PP&E

CorporatePerformanceMeasurement


Link to ep

Market Value Added

Link to EP

Market value added (MVA) reflects the markets expectations of the EP managers will add in the future

MVA is the market’s expectation of discounted future EPs

Percent of Total

CorporatePerformanceMeasurement


Link to ep example

Market Value Added

Link to EP - Example

After extensive work by a diligent XXX team, Acme Industries is expected to generate $25M in economic profits next year, which is expected to grow at 3% forever. If the cost of capital is 13% and the invested Capital is $100M, what is the MVA and the market value of the company?

CorporatePerformanceMeasurement


Link to ep solution

Market Value Added

Link to EP - Solution

After extensive work by a diligent XXX team, Acme Industries is expected to generate $25M in economic profits next year, which is expected to grow at 3% forever. If the cost of capital is 13% and the invested Capital is $100M, what is the MVA and the market value of the company?

Market Value of

the Company

MVA = PV of EPs

= MVA + Invested Capital

= $ 25 M

= $ 250 M + $100 M

13% - 3%

= $350M

= $ 250 M

CorporatePerformanceMeasurement


Link to ep 1 of 2

Market Value Added

Link to EP (1 of 2)

EP measures managers’ performance in the past, since it represents the market value added created over one year

Note: *Assumes Invested Capital Constant

CorporatePerformanceMeasurement


Link to ep 2 of 2

Market Value Added

Link to EP (2 of 2)

EP is used to evaluate manager performance because the change in MVA over a period of time is measured

  • Goal of company’s managers should always be to maximise MVA

  • When managers make any investment decisions, if the project is:

    • value-creatingNPV >0MVA increases

    • value-destroyingNPV <0MVA decreases

  • Reason that EP is the focus of most attention is because MVA is a stock or wealth measure, so MVA will show how much value has been added at that point in time

    • EP measures the amount of value added over a period of time, which is far more useful when measuring manager performance

CorporatePerformanceMeasurement


Actual performance

Market Value Added

Actual Performance

  • Which UK sectors would you expect to have the highest market value added?

    • and the lowest?

  • Which UK companies would you expect to have the highest market value added?

    • and the lowest?

CorporatePerformanceMeasurement


Uk sector performance 10 best

Market Value Added

UK Sector Performance - 10 Best

Banks, integrated oil and drugs were the UK sectors with the highest market value added

Sector Market Value Added (Sept 98)

Source: Stern Stewart, Sunday Times

CorporatePerformanceMeasurement


Uk sector performance 10 worst

Market Value Added

UK Sector Performance - 10 Worst

Distributors, print and packaging and construction had the lowest market value added in the UK

Sector Market Value Added (Sept 98)

Source: Stern Stewart, Sunday Times

CorporatePerformanceMeasurement


Uk company performance 10 best

Market Value Added

UK Company Performance - 10 Best

Shell’s £69.5B of market value added is the largest in the UK

Company Market Value Added (Sept 98)

1998 EVA (£B)

(1.506)

0.416

0.803

0.710

0.402

(0.024)

1.400

0.231

n/a

0.098

Source: Stern Stewart, Sunday Times

CorporatePerformanceMeasurement


Uk company performance 10 worst

Market Value Added

UK Company Performance - 10 Worst

British Steel’s £3B of market value destroyed was the worst of Britain’s 200 largest companies

Company Market Value Added (Sept 98)

1998 EVA (£B)

(0.071)

(0.012)

(0.054)

(0.087)

(0.050)

(0.108)

(0.120)

(0.320)

(0.284)

(0.352)

Source: Stern Stewart, Sunday Times

CorporatePerformanceMeasurement


Agenda5

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Agenda6

Economic Profit

Agenda

  • Definition

  • Advantages/Disadvantages

  • Framework

  • Use in Strategy Work

CorporatePerformanceMeasurement


Definition 1 of 21

Economic Profit

Definition (1 of 2)

Economic Profit (EP) is a residual profit concept accounting for the opportunity cost of holding capital

Traditional accounting concept of profits

Amount ($)

CorporatePerformanceMeasurement

Note: Economic Profit (EP) =Operating Profit - (Cost of Capital * Amount of Equity Capital Invested)


Definition 2 of 21

Economic Profit

Definition (2 of 2)

Economic Profit determines a company’s value creation or destruction

  • Easy to use, based on accounting records (for historical values)

  • Not prisoners of GAAP

  • Can be used to show relative performance of products, segments, regions, etc. in a given year

  • Can be calculated for future years and discounted to show value creation

  • When Economic Profits are positive over time

    • value creation is positive

    • market price per share is more than book value per share

    • growth creates value

Gross Profit

OperatingProfit

A&P

NOPAT

EffectiveTaxation

Overheads

EP

Net WorkingCapital

InvestedCapital

$ Charge forCapitalEmployed

Net FixedAssets

WACC

CorporatePerformanceMeasurement

Note: NOPAT = Net Operating Profit After Tax (See Appendix for details)

WACC = Weighted Average Cost of Capital


Key principles access to company earnings

Economic Profit

Key Principles: Access to Company Earnings

In order to understand EP it is important to go back to the basic income statement

Observations

Interest

  • Debt providers have first access to the interest payments due on money lent

$100

$100

Tax

  • Governments tax corporate profits

Income Statement (%)

EBIT

  • Shareholders (equity providers) have access to all residual profits (after paying interest and tax)

PAT

What did we earn?(using what we own)

Who gets access to these earnings?

CorporatePerformanceMeasurement

Note: Economic Profit (EP) = Operating Profit - (Cost of Capital * Amount of Capital Invested)


Understanding the balance sheet

Economic Profit

Understanding the Balance Sheet

The balance sheet separates what is owned by the firm from how it was paid for

Balance Sheet Makeup

Key Observations

  • Assets are a company’s economic resources, items which have the potential to provide future benefits to the organisation

  • NIBLs represent a free source of funds to the company. It is money lent to a firm with no charge or expected return

  • Debt is any interest bearing capital, including preferred stock

  • Shareholder's Equity is the accountant's estimate of the value of the shareholder's investment in the company

    • total assets less total liabilities

$500

$500

100%

NIBLs

Balance Sheet

Debt

Assets

Shareholder's Equity

How did we pay for it?

What do we own?

CorporatePerformanceMeasurement

Note: NIBL = Non-interest bearing liabilities


Economic profit balance sheet

Economic Profit

Economic Profit Balance Sheet

In order to develop the EP balance sheet, short-term non-interest bearing liabilities must be removed and adjustments for accounting distortions must be made

  • Short-term NIBL are removed from the EP balance sheet since capital returns are not expected on the amounts owed (e.g. wages payable)

  • EP Balance Sheet Net Assets amount may be much larger than the traditional accounting value after adjustments for accounting distortions (e.g., adding internally-generated intangible assets) are made

Operating

Approach

Financing

Approach

Regular Balance Sheet

EP Balance Sheet

CorporatePerformanceMeasurement

Note: NIBL= Non-interest bearing liabilities


Income statement and balance sheet traditional link 1 of 2

Economic Profit

Income Statement and Balance Sheet Traditional Link (1 of 2)

The traditional linkage of the Income Statement and Balance Sheet is the connection between net income and retained earnings or dividends

Reinvest it in the Company

Dividend Policy

Retained Earnings

  • Cash “out” from shareholders perspective

Management Decision

Net Income

  • Income attributable to shareholders (EBIT - Interest - Tax)

Distribute it to Shareholders

Dividends

  • Cash “in” from shareholders perspective

CorporatePerformanceMeasurement


Income statement and balance sheet traditional link 2 of 2

Economic Profit

Income Statement and Balance Sheet Traditional Link (2 of 2)

The traditional linkage of the Income Statement and Balance Sheet is the connection between net income and retained earnings or dividends

Balance Sheet

Income Statement

Economic Consequence

Assets

Liabilities

Revenue

- Costs

NIBLs

CurrentAssets

= Net Income

Debt

- Dividends

Net FixedAssets

= Retained Earnings

Equity

OtherAssets

CorporatePerformanceMeasurement


Break even example 70 debt 30 equity revisited

Economic Profit

Break-Even Example - 70% Debt / 30% Equity Revisited

  • If you could buy the same factory for £100K, but could only finance 70% with debt and required equity for the remaining 30%, how much after-tax profit would you require to break-even?

    • assume tax rate = 40%

    • assume cost of equity = 15%

CorporatePerformanceMeasurement


Break even example 70 debt 30 equity solution

Economic Profit

Break-Even Example - 70% Debt / 30% Equity - Solution

  • If you could buy the same factory for £100K, but could only finance 70% with debt and required equity for the remaining 30%, how much after-tax profit would you require to break-even?

    • assume tax rate = 40%

    • assume cost of equity = 15%

Debt:

£70K @ 7%

£4.9K

(cover interest payments)

Equity:

(£30 @ 15%)

(1 -40%)

£7.5K

(cover equity charge, which is not tax-deductible)

£12.4K

  • Therefore £12.4K is required to break-even with 30% equity, compared to £7K with 100% debt financing

  • Any after-tax profits beyond £12.4K will be economic profits

CorporatePerformanceMeasurement


Agenda7

Economic Profit

Agenda

  • Definition

  • Advantages/Disadvantages

  • Framework

  • Use in Strategy Work

CorporatePerformanceMeasurement


Advantages

Economic Profit

Advantages

EP is more successful than other measures in explaining shareholder returns

TM

CorporatePerformanceMeasurement

Source: Stern Stewart


Advantages 1 of 3

Economic Profit

Advantages (1 of 3)

A manager with high ROE will not undertake projects with ROE greater than required but lower than current ROE, creating missed opportunities

  • Managers are typically evaluated based on maximising ROE

  • A manager with ROE level of R will not undertake any projects with ROE < R1

  • Any projects with ROE > R0 but ROE < R, will still have positive NPV but will not be undertaken by manager

    • creates missed opportunities

NPV

0

R0(after equity charge)

0

R1

EP > 0

ROE

CorporatePerformanceMeasurement


Advantages 2 of 3

Economic Profit

Advantages (2 of 3)

A manager with low ROE will undertake any project that increases ROE, even if it is below required level. If project ROE is below required level, value is destroyed

NPV

  • A manager with ROE level of R2 will undertake any project that increases ROE

  • If any projects with ROE < Ro are undertaken, value is destroyed

0

Ro

(After equity Charge)

0

R2

EP >0

ROE

CorporatePerformanceMeasurement


Advantages 3 of 3

Economic Profit

Advantages (3 of 3)

By evaluating managers based on EP, their incentives will be to focus on all projects that create value

EP <0 Do not undertake project*

EP >0 Under take project

NPV

  • By evaluating managers based on EP, manager behaviour can be altered such that only projects with NPV > 0 are undertaken

0

0

Ro

(After equity Charge)

ROE

CorporatePerformanceMeasurement

Note: * Some projects may have negative EP in early years but large positive EP in later years. To adjust for this, MVA, or PV and EP can be used


Disadvantages

Economic Profit

Disadvantages

Critics of EP cite under-investment by managers and size bias as reasons to use different measures to evaluate managers

Under-investment by Managers

  • EP discourages new investments that do not generate positive returns in initial phases because manager will be charged for any capital used from the start of project

    • solution is to under-charge capital at start of project

Size Bias

  • EP generally rewards larger divisions because performance measured by $ generated, not %

  • Divisional managers argue that % return is better measure of their skills than $ return

    • $ return is the important measure for shareholders

    • Diageo looks at Operating Economic Profit per case of spirits to normalise

      • ROCE basis

CorporatePerformanceMeasurement


Beware capital is in the ratio formula

Economic Profit

Beware: Capital is in the Ratio Formula

Even measures that tie in the asset side of a company's financial performance need to be understood carefully...

  • Asset revaluations (especially in Australia)

  • In general accounting ratios will tend to bias performance upwards in relation to true economic returns because they ignore inflation, asset life and asset mix

  • ROE tends to increase due to inflation, which may be contrary to actual economic performance in real terms

  • Furthermore, the other issue to be aware of is that older PPE assets tend to generate higher returns (RONA, ROC, even ROE) because they are more fully depreciated

  • One consequence of this is that companies growing assets quickly will appear to have a lower return than those with slow growth

CorporatePerformanceMeasurement


Common pitfalls

Economic Profit

Common Pitfalls

By avoiding common pitfalls with EP, managers can prevent significant over or under-investment

  • Looking at absolute EP levels instead of changes in EP

    • business with high EP may under invest and/or become complacent

  • Focusing on current EP levels in highly cyclical businesses

    • may lead to significant over or under investment

  • Ignoring natural trends in EP that occur in certain businesses

    • e.g. high-tech startup would have low or negative initial EP that increases over time

CorporatePerformanceMeasurement


Agenda8

Economic Profit

Agenda

  • Definition

  • Advantages/Disadvantages

  • Framework

  • Use in Strategy Work

CorporatePerformanceMeasurement


Framework

Economic Profit

Framework

Both the Operating and Financing Approaches can be applied to the EP framework. These approaches will give identical EP figures, but XXX typically uses the Operating Approach

CalculateNOPAT

Adjust BalanceSheet

Estimate Costof Capital

Calculate EP

  • Adjust Operating Income (EBIT)

  • Calculate Net Assets

  • Estimate Weighted Average Cost of Capital (WACC)

  • EP = NOPAT - (Net Assets & WACC*)

Operating Approach:

  • Adjust Net Income

  • Calculate Capital Employed or Invested Capital

  • Estimate Weighted Average Cost of Capital

  • EP = NOPAT - (Invested Capital WACC*)

Financing Approach:

Note: *Net Operating Profit After Tax

CorporatePerformanceMeasurement


Nopat

Economic Profit

NOPAT

The Operating and Financing Approaches adjust different income figures to calculate the same level of NOPAT

NOPAT

Calculation

Operating Approach

Financing Approach

  • NOPAT = Operating income (EBIT)

    • + Non-operating income/(loss)

    • + Accounting adjustments*

    • - Cash operating taxes

  • NOPAT = Net income

    • + After-tax interest expense

    • + Financing adjustments

    • + Accounting adjustments

CorporatePerformanceMeasurement

Note: *Adjustment discussed in Accounting Adjustments section


Discount rates framework

Economic Profit

Discount Rates - Framework

EP can be calculated beginning with either profits, NOPAT, or returns, ROIC, depending on the availability of data. The NOPAT method is more commonly used

EP Calculation

Using NOPAT

Using ROIC

EP = (ROIC - WACC) * Invested Capital

EP = NOPAT - Capital Charge

Invested Capital * WACC

Spread between what is achieved and what is required

Note: NOPAT = Net operating profit after tax; Invested capital = All debt equity invested in format at book value; WACC = Weighted average cost of capital ROIC = Return on invested capital = (NOPAT / invested capital) also known as: Return on Net Assets (RONA) or Return on Capital employed (ROCE)

CorporatePerformanceMeasurement


Discount rates two different definitions of ep

Economic Profit

Discount Rates - Two Different Definitions of EP

There are two different frames of reference for calculating the “economic value” of any business - analogous to the perspectives used in ROI and ROE analysis

Total Capital Perspective

Equity Capital Perspective

Stakeholder:

Banks and Shareholders

Shareholders

EP definition:

EP = NOPAT - (Assets x WACC)

Return on Assets (ROA)*

Return on Equity (ROE)

Key Ratio:

Perspective:

... the "profitability" of the business from the frame of reference of the debt and equity holders

"... profitability" of the business from the frame of reference of the equity holders

Opportunity cost of the equity capital

. . . given that, what is the frame of reference?

Opportunity cost of the (blended) debt and equity capital

Accordingly:

"Profitability" is measured as income earned less the opportunity cost of total capital invested

"Profitability" is measured as income earned less the opportunity cost of equity capital invested

Performance Measurement Linkages:

- Ratio:

- EP:

Equity Capital Spread = ROC - Ke

EP = Equity Capital * (ROC-Ke)

Total Capital Spread = ROA - WACC EP = Total Capital * (ROC-WACC)

CorporatePerformanceMeasurement

* May be referred to as Return on Capital (ROC) or Return on Investment (ROI)


Discount rates

Publicly traded:

Use Published Estimates of b

  • Take average of highest quality sources

  • For US firms BARRA publishes estimates of b

Determine Appropriate Risk-Free Rate

Determine Appropriate Market Risk Premium

Determine Appropriate Cost of Debt, KD

Determine Market Value of Debt and Equity

Calculate Firm Tax Rate

Calculate WACC

( )

( )

E

D+E

D

D+E

KD (I-T)

Ke +

Non-publicly traded:

  • Use 10 year T-Bond or 30 Year T-Bond less liquidity premium (of 1.7% for US) for appropriate country

  • Only use government bonds if little or no risk of default for country in question

  • Use long-term average of difference between expected market rate of return and risk-free rate E(Rm) - Rf

  • For US, Copeland, Koller and Murrin recommend 5% to 6% based on geometric average from 1926-1993

  • KD is not necessarily equal to coupon rate of bond (e.g. IBM 2005 7.5% does not necessarily have KD = 7.5%

  • Must calculate or obtain yield on outstanding debt

  • If not available, use KD of firms with similar rating from agencies such as Moody’s or S&P

  • Book value of debt can generally be used a proxy for market value of debt

  • Market value of equity = current share price multiplied by # of shares outstanding**

  • If firm not publicly traded use P/E ratios of comparable firms

  • Divide income tax payable (not income tax expense) by net earnings

  • Use WACC formula:

  • Where :

  • E = market value of equity

  • D = market value of client

  • KE = cost of equity

  • KD = cost of debt

  • T = corporate tax rate

Calculate Industry Average for Unlevered b

Re-Lever Target Leverage for your Firm to Calculate Ke

  • Find comparable firms for industry in question and unlever b based on formula*

  • Use average of bu of comparable firms

  • Use target leverage in formula* to calculate bL

  • Once bLcalculated, use CAPM formula Ke = Rf + bL [E(Rm) - Rf] to calculate Ke

Economic Profit

Discount Rates

*Bu = Unlevered Beta = BL

1 + (1 tax rate) (market value ÷ of debt market value of equity)

CorporatePerformanceMeasurement

Note: ** Since invested capital is calculated based on book value of debt + equity, WACC can be calculated for EVA purposes with book value weighting


Accounting adjustments

Economic Profit

Accounting Adjustments

EVA and MVA measures differ from other more standard Economic Profit and Market/Book measures primarily due to adjustments to book capital and earnings advocated by Stern/Stewart ...

Stern Stewart’s Stated Objective

Key Adjustments

  • Make NOPAT a more realistic measure of the actual cash yield from recurring business activities

  • Turn capital into a more accurate measure of the base upon which investors expect returns

  • Convert from accrual accounting to cash accounting

    • Reserves, deferred taxes

  • Convert from successful efforts to full-cost accounting

    • Cumulative unusual items

  • Do not discriminate between tangible and intangible assets

    • Capitalize R&D

    • Value brand equity

  • Capitalize goodwill (never write off)

  • Convert off balance sheet financing to debt

Source: The Quest for Value

CorporatePerformanceMeasurement


Accounting adjustments stern stewart

Economic Profit

Accounting Adjustments - Stern Stewart

For instance, certain adjustments to capital and earnings may be necessary to normalise industry-specific accounting treatments and may make comparisons across industries more meaningful.

Key Adjustments

Highest Impact Industries

  • High inventory industries

  • Consumer goods and services (bad debt)

  • Industries with large deferred tax reserves (eg. natural resources companies)

  • Industries with short product life cycles (inventory obsolescence)

Reserves

Goodwill

  • Acquisitive industries

  • R&D intense industries

  • Industries with large upfront marketing investments (eg. development of geographic markets)

Capitalisation of Outlays

  • Discovery industries (natural resources, research - intense industries, entertainment, etc.)

Full-cost Accounting

  • Restructuring industries

  • Cyclical industries

Unusual Items

Capitalisation of Leases

  • Capital intense industries

CorporatePerformanceMeasurement


Accounting adjustments stern stewart s mechanics

Economic Profit

Accounting Adjustments - Stern Stewart’s Mechanics

Equity equivalent reserves gross up the standard accounting book value for common equity; the period-to-period change flows through the income statement

Additions to Book Capital:

Equity equivalents

Additions to NOPAT:

Change in Equity Equivalents

Deferred Tax Reserve

LIFO Reserve

Other Reserves

Cumulative Goodwill Amortisation

Unrecorded Goodwill

(Net) Capitalised Intangibles

Full-Cost Reserve

Cumulative Unusual Loss (Gain) after Tax

Increase (decrease) in Reserves

Eliminate Goodwill Amortisation

Increase in (net) capitalised intangibles

Increase in full-cost reserve

Unusual loss (gain) after tax

Non-capitalised leases are capitalised and form debt equivalents; the interest expense is added back to NOPAT

Note: NOPAT is net of depreciation; depreciation is considered a true conomic expense because assets need to be replenished

Source: ‘The Quest for Value’

CorporatePerformanceMeasurement


Accounting adjustments selection criteria

Economic Profit

Accounting Adjustments - Selection Criteria

The following five criteria should be used to determine whether an adjustment should be made

Basic Principle: Eliminate distortions to the extent that it is practical to do so

  • Is it likely to have a material impact on EP?

  • Can managers influence the outcome?

  • Can operating managers understand it?

  • Is the required information relatively easy to track or derive?

  • If the adjustment is made, will manager behaviour improve ?

CorporatePerformanceMeasurement

Source: INSEAD


Short cut approach excludes adjustments

Economic Profit

Short-Cut Approach (Excludes Adjustments)

The following short-cut approach provides a quick means of calculating EP, but does not include the appropriate adjustments

Operating Income (EBIT)

+Interest Income

+Equity Income (or - equity loss)

+Other Investment Income

-Cash operating taxes

-Tax shield on interest*

=Net Operating Profit After Tax (NOPAT)

Total Assets

-Short-Term Non-Interest Bearing Liabilities (ST NIBL)**

=Invested Capital (IC)

Average IC = (IC Beginning + IC End) ÷ 2

Note: Sometimes IC Beginning, not IC Average used

NOPAT

-Capital Charges (Average IC * Cost of Capital)

=EP

* Operating income x marginal statutory tax rate (gives no credit for tax shield on interest)

** STNIBL = Current liabilities less all interest bearing liabilities, such as short-term notes payable

Source: INSEAD

CorporatePerformanceMeasurement


Agenda9

Economic Profit

Agenda

  • Definition

  • Advantages/Disadvantages

  • Framework

  • Use in Strategy Work

CorporatePerformanceMeasurement


Use in strategy work

Economic Profit

Use in Strategy Work

EP works effectively for manufacturing companies, but is generally not appropriate for service firms

Use of EP/MVA

Manufacturing Sector

Service Sector

  • Capital - intensive industries benefit most from EP

    • forces managers to consider capital invested in business

  • e.g. Coca-Cola spinning off bottlers

    • UDV spinning off wine production assets to focus on blending

  • EP generally not appropriate due to difficulty in measuring human capital (typically most valuable asset)

  • Structure of balance sheet precludes use of EP in Financial Services sector

CorporatePerformanceMeasurement


Optimum information level

Economic Profit

Optimum Information Level

An organisation needs to establish the optimum level of information complexity in order to create the most value

Maximum value to organisation from 'economic value-added'

Value to the Organisation*

Optimum level of adjustment and analysis will be determined by:

  • Absolute sensitivity of value measures to adjustments

  • Level of the organisation that is using the (economic value added) information

  • Strategic use of information

  • Ability of management to make decisions on the information

Organisation below full potential as a result of too simplistic a measurement/decision making process

Diminishing value to organisation as cost of adjustment/analysis Outweighs incremental gain on decisions made

Optimal Adjustments and Analysis

Level of Complexity (Adjustment and Analysis)

Note: Value defined as incremental value created from management decision less cost of the information base/decion making process

CorporatePerformanceMeasurement


Use in strategy work1

Economic Profit

Use in Strategy Work

EP can be improved in a number of ways

Improving EP

Raising the efficiency of current operations

Achieving economically profitable growth

Exiting uneconomic activities

  • Generating incremental gains in EP from existing capital investments

  • Generating incremental positive EPs from new capital investments

  • Immediate exit from activities generates proceeds > subsequent cash flow foregone

CorporatePerformanceMeasurement


Guidelines

Economic Profit

Guidelines

The following guidelines should be considered when setting up EP

Link to Compensation

  • Senior Managers should be both evaluated and compensated based on their EP results

  • Aligns incentives of Shareholders and Management

  • Use change in EP as basis for evaluation to incent managers to create additional value

  • The more complex the EP system is, the less likely it is to be used

  • Accounting adjustments must be sufficient to eliminate major distortions from economic value, but not too complicated for management to understand or utilise on long-term basis

Keep it Simple

CorporatePerformanceMeasurement


Agenda10

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Definition

CFROI

Definition

CFROI is an adjusted IRR that is compared to the firm’s WACC

  • Cash Flow Return on Investment (CFROI), also known as the Holt method, is a return on investment measure that adjusts for deficiency in typical IRR calculations

    • CFROI uses cash flows and investments stated in constant monetary units

  • Once calculated, CFROI compared to benchmark, the firm’s cost of capital to evaluate management performance

  • Two firms use the Holt Method

    • Holt Value Associates, LP for portfolio management

    • BCG/Holt for Corporate Management

CorporatePerformanceMeasurement


Cash flow return on investment cfroi framework 1 of 6

CFROI

Cash Flow Return on Investment - CFROI Framework (1 of 6)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Calculate CFROI

  • Determine average life of firms assets

  • Approximate by median of Gross Plant Depreciation Expense over last 3 years

CorporatePerformanceMeasurement


Cash flow return on investment cfroi framework 2 of 6

CFROI

Cash Flow Return on Investment - CFROI Framework (2 of 6)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Calculate CFROI

  • Start with Net Income (after taxes)

  • Add back non cash operating expenses

  • Add back financing expenses

  • Use monetary inflation adjustment to restate in current dollars

CorporatePerformanceMeasurement


Cash flow return on investment cfroi framework 3 of 6

CFROI

Cash Flow Return on Investment - CFROI Framework (3 of 6)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Calculate CFROI

  • Gross up book assets with accumulated depreciation of value of operating bases

  • Discount operating leases over life of assets period using real rate of interest of firms’ debt

CorporatePerformanceMeasurement


Cash flow return on investment cfroi framework 4 of 6

CFROI

Cash Flow Return on Investment - CFROI Framework (4 of 6)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Calculate CFROI

  • Terminal value consists of non depreciating assets, including:

    • land

    • net working capital

    • investments in marketable securities

  • Use inflation adjustment to restate in current dollars

CorporatePerformanceMeasurement


Cash flow return on investment cfroi framework 5 of 6

CFROI

Cash Flow Return on Investment - CFROI Framework (5 of 6)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Calculate CFROI

  • Calculate CFROI using IRR methodology:

    • Present Value = Gross Cash Investment

    • Payments = Gross Cash Flow

    • Future Value = Sum of Nondepreciating assets

    • Number of Periods = Life of Assets

CorporatePerformanceMeasurement


Cash flow return on investment cfroi framework 6 of 6

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Calculate CFROI

CFROI

Cash Flow Return on Investment - CFROI Framework (6 of 6)

  • Use firms cost of capital (WACC) for benchmark

  • Must restate WACC in real terms to be able to compare to CFROI

CorporatePerformanceMeasurement


Cash flow return on investment ep cfroi differences 1 of 2

CFROI

Cash Flow Return on Investment - EP/CFROI Differences (1 of 2)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Target Audience

Calculate CFROI

Methodology

EP

  • Management

  • External Investors

  • NPV

  • Add back goodwill amortisation

  • Adjust tax expense to actual cash taxes

  • Add back interest portion of operating rental expenses

  • Add back accumulated goodwill

  • Only use assets net of depreciation

  • WACC in nominal terms

CorporatePerformanceMeasurement


Cash flow return on investment ep cfroi differences 2 of 2

CFROI

Cash Flow Return on Investment - EP/CFROI Differences (2 of 2)

Calculate Sum of Non Depreciating Assets

Calculate Life of Assets

Calculate Gross Cash Flow

Calculate Gross Cash Investment

Compare CFROI to Benchmark

Target Audience

Calculate CFROI

Methodology

  • External Investors

  • IRR

  • Add back goodwill amortisation + depreciation

  • No tax expense adjustment

  • Add back operating rental expenses

  • Accumulated goodwill is normally not added back

  • Assets grossed up for accumulated depreciation

  • WACC restated in real terms

CFROI

CorporatePerformanceMeasurement


Agenda11

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Market value added exercise 1 of 3

MVA Exercise

Market Value Added Exercise (1 of 3)

Exercise:

Calculate Harnischfeger’s MVA at October 31, 1996

Information

Required:

  • 47,598,340 common shares outstanding

  • Market Value of common shares: $40

  • Since Market Value of debt and minority interest not reported assume market value = book value

  • Assume operating cash equal to 1% of total sales

CorporatePerformanceMeasurement

Source: Harnischfeger’s 1996 Annual Report, INSEAD


Market value added exercise 2 of 3

MVA Exercise

Market Value Added Exercise (2 of 3)

Harnischfeger Industries Inc.Consolidated Balance Sheet - Year Ended 31 October 1996

Dollars amounts in thousands

1996

1995

Assets

Current Assets

Cash and cash equivalents

36,936

239,043

667,786

Accounts receivable – net

499,953

Inventories

547,115

416,395

Business held for sale

-

26,152

Other current assets

132,26

57,999

1,213,390

1,410,250

Property, plant and equipment

Land and improvements

48,371

31,571

Buildings

301,010

233,788

Machinery and equipment

776,332

676,546

1,125,713

941,905

Accumulated depreciation

(491,668)

(454,249)

634,045

487,656

Investments and other assets

Goodwill

512,693

147,943

Intangible assets

39,173

66,796

Other assets

93,868

124,982

645,734

339,721

$2,690,029

$2,040,767

CorporatePerformanceMeasurement

Source: Harnischfeger’s 1996 Annual Report, INSEAD


Market value added exercise 3 of 3

MVA Exercise

Market Value Added Exercise (3 of 3)

Harnischfeger Industries Inc.Consolidated Balance Sheet - Year Ended 31 October 1996

Liabilities and Shareholders’ Equity

Current Liabilities:

Short-term notes payable

49,633

22,802

Trade accounts payable

346,056

263,750

Employee compensation and benefits

160,488

100,041

154,401

Advance payments and progress billings

155,199

43,801

Accrued warranties

50,718

315,033

138,508

Other current liabilities

1,077,127

723,303

Long-term obligations

459,110

657,765

Other Liabilities:

78,814

101,605

Liability for post retirement benefits

39,902

52,237

Accrued pension and related costs

20,820

14,364

Other liabilities

34,805

Deferred income taxes

54,920

209,467

188,000

Minority Interest

93,652

89,611

Shareholders Equity:

51,407

Common stock

51,118

Capital in excess of par value

615,089

603,712

Retained earnings

148,175

53,560

Cumulative translation adjustments

(37,584)

(42,188)

(61,350)

Less:Stock Employee CompensationTrust Treasury Stock

(60,483)

(42,242)

(46,513)

673,485

559,276

$

2,040,767

2,690,029

CorporatePerformanceMeasurement

Source: Harnischfeger’s 1996 Annual Report, INSEAD


Market value added solution market value

MVA Exercise

Market Value Added - Solution (Market Value)

Harmishfeger’s market value at 31 October, 1996 was $2,704.984 M

Market Value($ M)

CorporatePerformanceMeasurement


Market value added solution excess cash

MVA Exercise

Market Value Added - Solution (Excess Cash)

Harnishfeger’s excess cash at October 31, 1996 was $8,296 M

Amount($ K)

CorporatePerformanceMeasurement


Market value added solution working capital requirements

MVA Exercise

Market Value Added - Solution (Working Capital Requirements)

Harnischfeger’s working capital requirements at October 31, 1996 were $374.46 M

Amount ($ K)

WorkingCapitalRequirements

CorporatePerformanceMeasurement


Market value added solution net fixed assets

MVA Exercise

Market Value Added - Solution (Net Fixed Assets)

Harnischfeger’s net fixed assets at October 31, 1996 were $1.28 B

Net PP&E

Amount ($ Thousands)

CorporatePerformanceMeasurement


Market value added solution invested capital

MVA Exercise

Market Value Added - Solution (Invested Capital)

Harmishfeger’s invested capital at 31 October, 1996 was $1,662.535 M

Invested Capital ($ M)

CorporatePerformanceMeasurement


Market value added solution market value added

MVA Exercise

Market Value Added - Solution (Market Value Added)

Harnischfeger’s market value added at October 31, 1996 was $1042.44 M

CorporatePerformanceMeasurement


Agenda12

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Economic profit exercise

EP Exercise

Economic Profit Exercise

Exercise:

Calculate Harnischfeger’s EP for the year ended October 31, 1996

Information Required:

Interest income $6.505 million

WACC equals 12%

CorporatePerformanceMeasurement


Economic profit exercise1

EP Exercise

Economic Profit Exercise

Harnischfeger Industries Inc.Consolidated Balance Sheet - Year Ended 31 October 1996

Assets

1996

1995

Current Assets:

$239,043

$36,936

Cash and cash equivalents

667,786

499,953

Accounts receivable - net

547,115

416,395

Inventories

Business held for sale

-

26,152

132,261

57,999

Other current assets

1,410,250

1,213,390

Property, Plant and Equipment:

Land and improvements

Buildings

Machinery and equipment

Accumulated depreciation

48,371

301,010

776,332

1,125,713

(491,668)

634,045

31,571

233,788

676,546

941,905

(454,249)

487,656

Investment and Other Assets:

147,943

66,796

124,982

339,721

$2,040,767

512,693

39,173

93,868

645,734

$2,690,029

Goodwill

Intangible assets

Other assets

Source: Harnischfeger’s 1996 Annual Report; INSEAD

CorporatePerformanceMeasurement


Economic profit exercise2

EP Exercise

Harnischfeger Industries Inc.Consolidated Balance Sheet - Year Ended 31 October 1996

Economic Profit Exercise

Liabilities and Shareholders’ Equity

1996

1995

$22,802

263,750

100,041

154,401

43,801

138,508

723,303

459,110

Current Liabilities:

$49,633

Short-term notes payable

346,056

Trade accounts payable

Employee compensation and benefits

160,488

Advance payments and progress billings

155,199

Accrued warranties

50,718

Other current liabilities

315,033

101,605

52,237

20,820

34,805

209,467

89,611

1,077,127

Long-term Obligations

657,765

Other Liabilities:

78,814

Liability for post-retirement benefits

Accrued pension and related costs

39,902

14,364

Other liabilities

54,920

Deferred income taxes

51,118

603,712

53,560

(42,118

(60,483

(46,513

559,276

$ 2,040,767

)

)

)

188,000

Minority Interest

93,652

Shareholders’ Equity:

51,407

Common stock

Capital in excess of par value

615,089

Retained earnings

148,175

Cumulative translation adjustments

(37,584)

Less: Stock Employee Compensation Trust

(61,360)

Treasury Stock

(42,242)

673,485

Source: Harnischfeger’s 1996 Annual Report; INSEAD

CorporatePerformanceMeasurement

$ 2,690,029


Economic profit exercise3

EP Exercise

Economic Profit Exercise

Harnischfeger Industries Inc.Consolidated Balance Sheet - Year Ended 31 October 1996

Dollar amounts in thousands

Sales

Cost of Sales

Product Development, Selling and Administration Expenses

Restructuring Charge

$2,887,570

2,166,775

433,776

43,000

Operating Income

Interest Expense - Net

244,019

(62,258)

Income before Taxes and Minority Interest

Provision for Income Taxes

Minority Interest

181,761

(63,600)

(3,944)

Net Income

$114,217

Source: Harnischfeger’s 1996 Annual Report; INSEAD

CorporatePerformanceMeasurement


Economic profit exercise solution

EP Exercise

Economic Profit - Exercise Solution

Harnischfeger’s 1996 NOPAT was $162.857 M

$ M

Operating Income

+ Interest Income

+Equity Income

+ Other Investment Income

- Income Taxes

- Tax shield on interest*

= Net Operating Profit After Tax (NOPAT)

$244.019

6.505

0

0

(63.600)

(24.067)

$162.857

*Tax shield on interest =

Provision for income taxes

Income before taxes and minority interest

Net Interest Expense + Interest Income

63.600

181.761

62.258

+6.505

CorporatePerformanceMeasurement

x

=

x

=

24.067


Economic profit exercise solution1

EP Exercise

Economic Profit - Exercise Solution

Harnischfeger’s 1996 average Invested Capital was $1,501.40 M

$ M

1996

1995

Total Assets

- ST NIBL*

= Invested Capital

2,690.029

(1,027.494)

1,662.535

2,040.767

(700.501)

1,340.266

Average Invested Capital

1,501.401

1996

1995

* ST NIBL = Current Liabilities - Short-Term Notes Payable =

1,077.127

(49.633)

1,027.494

723.303

(22.802)

700.501

CorporatePerformanceMeasurement


Economic profit exercise solution2

EP Exercise

Economic Profit Exercise Solution

Harnischfeger’s 1996 EP was ($17.311 M)

$ M

NOPAT

- Capital Charges*

EP

162.857

(180.168)

(17.311)

Harnischfeger was approximately value-neutral in 1996, which contrasts sharply with the $1 billion MVA (see MVA section). The discrepancy indicates that despite adding no value in 1996, the market expects management to deliver value in the future. The large MVA implies that future EPs will be much higher than 1996.

Note: * Capital Charges = Average IC * WACC = 1,501.401 x 12% = 180.168

CorporatePerformanceMeasurement


Agenda13

Agenda

  • Executive Summary

  • Objectives

  • Background

  • Performance Measurement Framework

  • Market Value Added (MVA)

  • Economic Profit (EP)

  • Cash Flow Return on Investment (CFROI)

  • Exercises

    • MVA

    • Economic Profit

  • Case Study - Diageo

CorporatePerformanceMeasurement


Drivers of value

Case Study - Diageo

Drivers of Value

The success of New World wine producers can be attributed to three initiatives, of which the reduction in capital intensity was most closely linked to the EP analysis

New World Wine

Economics

Premium Positioning andVarietal Dominance

Decreased Importanceof Appellation

Reduction inCapital Intensity

  • Lower grape costs

    • purchasing on spot market

    • long-term contractual supply contracts

  • Blending techniques used to ensure consistent quality

  • Wider range of outsourcing opportunities

    • third-party grape sourcing and production reduces need to own and operate vineyards and production facilities

  • New technology enabling reduction in stock holding time

  • More premium the wine, higher the returns

  • Scale achieved through varietal dominance leads to higher returns

Link to EP Analysis

  • Low

  • High

  • Low

CorporatePerformanceMeasurement


Brand performance

Case Study - Diageo

Brand Performance

By focusing solely on bottling, only Glen Ellen generated positive economic profits for the wine produced

As a vertically integrated Vintner with vineyard and crushing facilities, BV has a large asset base and capital charge

Cost perCase ($)

As a non-vertically integrated Vintner with bottling facility only, Glen Ellen maintains a low asset base and capital charge

$ EP/Case:

$1.00

($1.80)

($0.80)

($6.60)

($2.38)

($16.28)

CorporatePerformanceMeasurement

Source: HWG Strategic Position Assessment


Asset utilisation

Case Study - Diageo

Asset Utilisation

The Glen Ellen system is more efficient than the BV system

1.5

Total Inventory Turns

Maturing Stock as % of NSV

73%

1.0

51%

Maturing Stock as % of NSV

Maturing Stock as % of NSV

TotalInventoryTurns

TotalInventoryTurns

Glen Ellen System

Beaulieu Vineyard

CorporatePerformanceMeasurement

Source: HWG Strategic Position Assessment


Components of roce

Case Study - Diageo

Components of ROCE

Analysis of the components of ROCE highlights the different economics of the two systems

ROCE

Capital Employed

NOPAT

¸

Cash Operating Taxes

Other Net Working Capital

Net Fixed Assets

Other Adjustments

Other Adjustments

Operating Profit

-

+/-

+

+

+/-

Inventory

Drivers:

  • Margins

    • price

    • mix

    • grape costs

    • production costs

    • selling/ distribution costs

  • Volume

  • Tax rate

  • Accounting policies

  • Degree of vertical integration

  • Wine mix

    • colour

    • quality

    • dry vs. sweet

  • Ageing technology

  • Trade relation-ships

  • Accounting policies

CorporatePerformanceMeasurement


Breakthrough strategies change the rules

Case Study - Diageo

Breakthrough Strategies: Change the Rules

The traditional wine making process is very capital intensive. Through selective outsourcing, New World wine producers have been able to significantly reduce their asset base

Vineyard

Vinification

Ageing Process

Grapes Culture & Production

Alcoholic Fermen- tation

Malolactic Fermen- tation

Bottle Stock Keeping

Grapes Crushing

Matur- ation

Distri-

bution

Harvest

Ageing¹

Blending

Bottling

Traditional old world wine producer activities

Vertically integrated New World wine producer activities (Robert Mondavi)

(Outsourced activities)

Non vertically integrated wine producer activities (Glen Ellen)

Activities systematically performed

Activities performed only for super/ultra premium wines

Notes: ¹ Ageing can be done in oak barrels or in stainless steel vats

CorporatePerformanceMeasurement

Source: Literature search, Expert interviews


Lessons learned

Case Study - Diageo

Lessons Learned

  • Ignoring the capital requirements necessary under different business models can mask the true profitability of each product

    • the only wine that was economically profitable was the Glen Ellen product that Diageo bottled but did not grow from the vineyard

  • A fresh approach to the business may be necessary in order to devise more economically profitable business models

    • less prestige in only performing bottling, but many vineyards driven by non-economic factors

CorporatePerformanceMeasurement


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