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Management control systems > Lektion 11 - Value based management and Economic value added > Flashcards

Lektion 11 - Value based management and Economic value added Flashcards

1
Q

Describe what is meant by net present value / NPV?

A

General:

  • Fundamental finance principle
  • Value creation if expected present value of future stream of net cash exceeds initial cash outlay
  • Present value is the money amount making owner indifferent between receiving sum today or getting
    expected future cashflow stream
  • Exceeding value goes to project owner
  • Immediate value increase for firm equal to NPV if stock market agrees on firms analysis
  • Initial cash outlay must be measured in cash
  • An appropriate discount rate is the cost of capital
  • Sum of discounted residual incomes (Manager view)
  • Does not account for qualitative aspects

____________

Equation:

NPV = PV future net cash benefits - Initial cash outlay

NPV = Sum^n_t=1(CF_t/(1-r^t))

r = discount rate (equals cost of capital)

____________

Influencing factors

  • Magnitude of cashflows
  • Timing
  • Future cashflows degree of uncertainty

____________

Implication:

  • NPV > 0 = Value created
  • NPV < 0 = Value destroyed
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2
Q

Describe the difference between the standard balance sheet and the managerial balance sheet

A

The standard balance sheet:

  • From an accounting point of view
  • Assets: E.g. Cash, inventory, buildings
    Liabilities: Debt, owners equity

____________

The managerial balance sheet:

  • From an operation managers point of view
  • Operation manager accounts for both assets + liabilities: Accounts receivable, inventories , accounts payable
  • Invested capital, not assets financed by debt & equity
  • Includes WCR, invested capital & capital employed
  • Clearer structure between investment + financing capital

Operating working capital / working capital requirement:

  • The net investment in operations required to generate sales & profit from firms fixed assets
  • WCR = Trade receivables + inventories - Trade payable

Invested capital:
- Capital invested in cash, operations & net fixed assets

Capital employed:
- Sources of capital to fund investments

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3
Q

Describe the income statement

A

General:

  • Net profit amount generated in accounting period
  • Difference between revenues & expenses
Structure:
Sales
-   Operating expenses
Earnings before interest and tax / EBIT
-    Interest expense: Debt holders
Earnings before tax / EBT
-    Tax expense: Tax authorities
Earnings after tax / EAT
-     Dividend payment: Owners and shareholders
Addition to retained earnings
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4
Q

Describe the different equations for a firms profitability

A

Profitability of equity capital:

  • Return on equity / ROE
  • ROE = EAT / Owners equity

__________

Profitability of invested capital:

  • Return on invested capital / Return on capital employed: ROIC / ROCE
  • ROIC = After-tax operating profit / Invested capital
  • After-tax operating profit = EBIT · (1 - Tax rate)
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5
Q

Describe different sources and uses of cash

A

General

  • Profits generated by EBIT and EAT is not cash
  • Cash holding only increase when customer pay
  • Cash for operating activities is most important

___________

Sources of cash:

  • Operations: When customer pay invoices
  • Selling assets: Investment, divestment, asset disposal
  • Borrowing or issuing new shares: Financial decision

___________

Uses of cash:

  • Financing activities: Reimburse debt, dividends
  • Investment activities: Capex, new equipment
  • Operating activities: Supplier, employee or tax payment
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6
Q

Describe the statement of cash flows

A
  • Summarize reporting periods cash transactions
  • Integral part of annual report
  • Break down firms total net cash flows into three main corporate activities: Operating activities, investing activities and financing activities
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7
Q

Describe the different risks in a firm

A

General:
- Uncertain that sales figures actually is achieved

_____________

Business risk:

  • Sales fluctuations due to uncertain environment: Economic, political, social, competitive
  • Transmitted to EBIT

_____________

Financial risk:

  • Fixed interest expenses
  • Increases business risk

_____________

Total risk:

  • Sum of business risk & financial risk
  • Transmitted to firms EBIT
  • Owners require higher rate of return on equity to compensate higher risk-level: They are risk-averse
  • Borne by owners: Equity capital riskier than debt capital
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8
Q

Describe the measurement of value creation in a value based management system

A

Market value added / MVA:

  • Measure value at particular time-point
  • Value not only due to industry factors
  • Problematic performance measure: Interest rate determined by uncontrollable macroeconomic factors
  • Value in absolute not relative terms: Dollar amount, not value per dollar of capital employed
  • If not public traded, market value of capital cannot be observed & MVA not calculated. Unless offer to buy firm which can be used in estimating
  • If public traded, marked value of capital is obtained from financial markets
  • Equity capital includes allowance for bad debt, impairment of goodwill & R&D expenses. Different from standard accounting.
  • Only value creating growth matter
  • Reward based on return spread performance not ROIC
  • Created value if positive return spread

Equation:

  • MVA = Market value of capital - Capital employed
  • Market value of capital = Equity capital + debt capital
  • Capital employed = Invested capital from equity holders and debt holders from balance sheet and notes

MVA = ( (Return spread) · Invested capital) / (WACC - g)
Return spread = ROIC - WACC

MVA = EVA / (WACC - Growth rate)

Comments:

  • MVA > 0 = Value created
  • MVA < 0 = Value destroyed

Interpretation:

  • Maximizing MVA = Maximizing shareholder value
  • MVA = Equity MVA + Debt MVA
  • Equity MVA = MV equity - Adjusted book value
  • Debt MVA = MV debt - reported book value
  • Maximizing MV not equals value creation
  • MVA increase if undertaking positive NPV projects
  • MVA is the sum of NPV´s for all projects undertaken
  • Higher MVA equals investing in positive NPV projects
  • Maximizing NPV = Maximizing MVA
  • NPV take nonfinancial transactions into account while MPV has direct relation to EVA understood by accountants

Advantages of value focus:

  • Closer attention to expense control
  • More effective use of firms assets
  • Awareness of needed higher returns on invested capital
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9
Q

Describe the three factors of value creation

A

The firms operating profitability:

Return on invested capital / ROIC:

General:

  • Invested capital measured at periods beginning
  • Possible increase if higher operating profit, higher capital turnover or lower tax rate

Equation:

  • ROIC = (EBIT · (1 - Tax rate)) / Invested capital
  • ROIC = NOPAT / Invested capital
  • NOPAT = Net operating profit after tax
  • EBIT = Earnings before interest and taxes
  • Invested capital = Cash + WCR + Net fixed assets
  • After tax ROIC = Operating profit margin · Capital turnover · (1 - Tax rate)
  • Operating profit margin = EBIT / Sales
  • Capital turnover = Sales / Invested capital

_______________

The firms cost of capital:

Weighted average cost of capital / WACC:

General:

  • When a project is funded both by debt & equity
  • Should be calculated with market value weights
  • Opportunity cost reflect returns investors expect from other investments of similar risk
  • Different financing carry different risks & costs

Equation:

  • WACC = (After-tax cost of debt * % of debt capital) + (Cost of equity * % of equity capital)
  • WACC = S/S + B * r_s + B/B+S * r_B * (1- tax rate)
  • S = Market value of equity
  • B = Market value of debt
  • r_S = Cost of equity
  • r_B = Cost of debt

_______________

The firms ability to grow:

  • Expected to grow forever at constant annual rate
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10
Q

Describe the difference between economic profit and accounting profit

A

Economic profit:

General:

  • Economic added value / EVA
  • Better performance measure than accounting profit
  • Penalizes over investment in working capital
  • Positive return spread equals positive EVA
  • Measure of performance
  • Base of managerial compensation
  • Adjust measures. E.g. R&D treated as asset investment

Equation:

  • EVA = NOPAT - Capital charge
  • NOPAT = EBIT * (1 - Tax rate)
  • Capital charge = WACC * Invested capital

Give incentives to:

  • Rapidly & efficiently implement these projects to create the expected cash flows as soon as possible
  • Use the acquired assets as efficiently as possible
  • Seek potential positive NPV investments creating competitive advantages

Advantages:

  • Help evaluating & selecting future projects
  • Help planning the required budgets
  • Allow measure, evaluate & reward past performance

Disadvantages:

  • Summarizes past transactions
  • Measures past performance
  • Objectivity problem with EVA accounting adjustments
  • Reduced understandability of complex adjustments

______________

Accounting profit:

  • When positive NOPAT or net profit
  • Not good as performance measure
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11
Q

Describe how to make managers act like owners focusing on value creation

A

Solutions:

  • Remunerate with ownership instead of profit-share
  • Partly remunerate managers with EVA-based bonus

Required conditions:

  • Keep EVA-based bonus for a certain period
  • No modification or reward cap after compensation plan established & accepted: Still rewards/punishment
  • Reward on EVA must be significant portion of salary
  • All possible managers should have EVA bonus plan
  • Values to calculate EVA must be restated to adjust for the distortions caused by accounting conventions, but not too many adjustments
  • Bonus plan consistent with capital budgeting process
  • Potential use of bonus banks
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12
Q

Describe the difference between the NPV and IRR rule

A

The NPV rule

  • Accept investment proposals with positive NPV
  • Discount all expected cashflows & deduct initial cash
  • Relevant discount rate representing risk: WACC

__________

The IRR rule:

  • Accept investment proposal if IRR > WACC
  • IRR is discount rate where NPV of investment = 0
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13
Q

Describe the financial strategy matrix

A

General:

  • Convenient business diagnostic tool
  • Used for value-based strategic
  • Used for financing decisions
  • Used for evaluating resulting performance
  • Firm of many businesses locate each to a quadrant

X-axis:
- Return spread = ROIC - WACC

  • EVA > 0 = Value creation
  • EVA < 0 = Value destruction

Y-axis:
- Growth in sales - self-sustainable growth rate
- Self-sustainable growth rate: Maximum rate of growth without changing financing policy or operating policy.
Equal to profit retention rate * return on equity
- Capacity to self-financing growth

  • G_Sales > SGR = Cash deficit (shortage)
  • G_Sales < SGR = Cash surplus

_______________

Strategies:

Value creation + Cash deficit (shortage):

  • Raise funds: If on stock market e.i. issue new equity
  • Cut dividends
  • Reduce growth in sales to sustainable level: If impossible issue equity. Compete in narrow segment

Value destruction + Cash deficit / shortage:

  • Worst situation: Immediate attention & action
  • Never fund with other businesses cash surplus
  • Attempt drastic restructuring: Sell assets to raise cash or scale down activities for short-term survival
  • Exit the business: If turnaround impossible

Value destruction + Cash surplus:

  • Fix before cash surplus runs out
  • Review capital structure policy: Modify D-E ratio
  • Sell the business: Only if other strategies fail
  • Return some surplus to owner. Rest to make profitability

Value creation + Cash surplus:

  • Preferable quadrant
  • Use surplus to grow faster: New investments + acquire related businesses
  • Distribute to cash surplus if growth not an option: Increase dividends payment or repurchase shares. Should be avoided
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14
Q

What is the difference between operating and financing policy?

A

Financing policy:

  • Debt-to-equity ratio
  • Dividend payout ratio
  • Issuing equity
  • Share repurchases

Operating policy:

  • Profit margin
  • Capital turnover
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15
Q

What is the objectives that performance measures in value based management needs to support?

A

Strategic planning:
- Support of the strategic decision-making

Providing incentives:
Management compensation tied to performance measure

Measuring performance at the divisional level:
- Adequate report of value creation within organization

Communicating value creation:
- Help communicate value creation internally to line managers as well as to the external capital markets

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16
Q

Describe the Capital asset pricing model / CAPM

A

General:

  • Estimate risky asset price in capital market: E.i Equity
  • Give expected return by capital markets for investing in a risky asset like a company’s stock

Equation for the expected return on a risky asset:

E(R_i) = R_f + β_i * (E(R_M) - R_f)

E(R_i) = Expected return on risky asset
R_f = return on a risk-free asset
E(R_M) = expected return on the stock market
β_i = measure of risk of asset i (company risk factor)

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