L3 - Performance Measurements 1

Question 1

Why are firms measuring their financial performance?

Answer 1

• It helps investors (stakeholder) formulate their expectations concerning future earning potentials of firms
• It supplies a plausible feedback (control & motorisation) on how well the company has achieved its goals
• It furnishes the basis of an adequate bonus plan that gives incentives to achieve the firm’s goals and reward the results of proper decisions.

Question 2

Why do many managers feel that traditional accounting-based measurement systems are no longer adequate?

Answer 2

• Traditional financial measures does not take cost of capital into account
• Traditional financial measures are regulated by accounting conventions (i.e. laws, standards and norms)

Question 3

What are the criticisms of accounting-based measures of performance?

Answer 3

• Inaccuracy and subjectivity of the accounting numbers (not reliable, manipulations of accounting numbers, distorted by inflation)
• Nonalignment with the organizational goal of maximizing shareholder wealth
• Short term-ism of managerial decision-making

Question 4

What are the “improved” (new) financial metrics?

Answer 4

• Residual income (RI)
• Economic Value Added (EVATM)
• Cash Flow Return on Investments (CFROI)
• Shareholder Value Added (SVA)

Question 5

Describe Return on Investment (ROI), what are the advantages and limitations of this performance measure?

Answer 5

• ROI = profit/ invested cap.
• ROI = Return on sales x Investment turnover

Advantages
* Encourages managers to focus on both profits and the assets required to generate those profits
* ROI can be used to evaluate the relative performance of investment centres

Limitations
* ROI can encourage managers to focus on short-term financial performance, at the expense of the long term
* ROI can encourage managers to defer asset replacement
* ROI may discourage managers from investing in projects that are acceptable from the total organisation’s point of view (suboptimization)

Question 6

Describe Residual Income (RI), what are the advantages and limitations of this performance measure?

Answer 6

Residual income = Profit – (Invested capital x Cost of capital)

Advantages
* Different cost of capital can be used for different assets
* Reduce dysfunctional behaviour (encourage managers to invest in projects that are acceptable from the total organisation’s point of view)

Limitations
* Difficult to use when evaluating the performance of investment centres of different sizes
* Residual income can also encourage a short-term orientation

Question 7

Describe Economic Value Added (EVA) TM (Trademark)

Answer 7

EVA = Net operating profit after tax - (Capital invested x WACC)
* EVA is a modified version of RI where the modifications consist of accounting adjustments for various accounting amounts and for the cost of capital. An absolute measure of value that reflects the value-added during a period.
* EVA calculates how much value an investment adds to the business for one year (each financial year). Value is created when the return on the firm’s economic capital employed exceeds the cost of that capital.

Described well in Venanzi D. (2010).

Question 8

Describe Cash Flow Return on Investment (CFROI)

Answer 8

CFROI = (Gross Cash Flow – Economic Depreciation) / Gross Investment
* Cash-flow return on investment (CFROI) is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings.
* CFROI is defined as the average economic return on all of a company’s investment projects in a given year. It is a modified version of internal rate of return (IRR).
* Compare CFROI with cost of capital to valuate whether assets in place are value creating or value destroying.
* GCF: Gross cash flow (EBIT x (1 – Tax rate) + Depreciation and Amortization)
* CFROI includes sunk costs. IRR includes only future cash flows
* CFROI > Cost of capital, to satisfy both the debt financing and the investors expected return.

Question 9

Explain Shareholder Value Added (SVA)

Answer 9

Shareholder value = Gross corporate value – The market value of debt
* Shareholder Value Added (SVA) is a value based management performance measure of a company’s worth to shareholders compared to the WACC.
* Value is added when the overall net economic cash flow of the business exceeds the economic cost of all the capital employed to produce the operating profit.
* Gross corporate value: Net present value of operating cash flows and terminal value of the business
The mathematical model behind SVA is based on the thought that the value of the company is comparable with the belief of its future generation of cash or dividends and not historical earnings (consistent with DCF approach).

Question 10

What internal and external influences does Kraus & Lind (2010) claim explains the low impact of CBSC on corporate control?

Answer 10

internal:
- simplicity (it gets too complex with too many measures with CBSC)
- comparability (they need to be easy enough to be comprehend by all employees and also management to learn from them)

external:
- capital market pressure
(managers decisions are influenced by how the stock prices move, as it is so carefully monitored)