Performance Evaluation Flashcards
When evaluating a manager vs a division, what do you need to consider ?
Functional structure- per function
Divisional structure - Divisions per product
Evaluate only on controllable items
Formula for EVA ?
Net Operating Profit after Taxes (NOPAT) - Capital * cost of capital
Ie. Operating income after tax - WACC*(TA-CL)
Residual income formula ?
Net income - (Cost of equity capital)
Return on Investment formula?
Net income/ Equity capital
ROI considerations
- ROI for manager = controllable contribution / Controllable assets
- ROI = Accounting rate of return (Acc no’s)
- It considers profit alone, not size of investment
4, Generally use profit after interest, before tax - TP. Always consider ROI Relevant to both division ROI and Group ROI to ensure that goal congruency is maintained.
What is the investment ?
Total assets available
Includes all assets, regardless of their
particular purpose.
What is the investment ?
Total assets employed
includes total assets available minus the
sum of idle assets and assets purchased for future expansion.
What is the investment ?
Total assets employed minus current liabilities
excludes that portion of total assets employed that are financed by short-term
creditors.
What happens when Carrying value is used in ROI and RI/ EVA ?
investment value decreases as asset is used
(depreciation). Thus even if profit and original investment remain constant, ROI and RI/EVA will increase over time
What should you use in calculations of ROI and RI/ EVA ?
Use market values/original cost
ROI advantages
Simple to calculate
Relative measure and easy to compare
ROI disadvantages
- Ignores risk
- easy to manipulate
- can lead to incorrect decisions
- Accounting based measure of profit
RI advantages
- Considers risk
(through WACC) - Usually motivates
correct decisions - Considers income
earned relative to
investment made
RI disadvantages
- Absolute number
- Accounting based
measure of profit
Important points on EVA
- Converts accounting profit into economic profit
- Economic measure of performance closer to CF’s
- Profit after tax, excludes interest* (double counted)
- Add back any costs related to long term funding
Accounting adjustments for EVA?
- Amounts expensed under IFRS, that have enduring benefits
- Purely accounting entries (ie, no physical cash flows)
- Profits and losses on sale of unusual items not normally sold by the business if Controllable (Ie. once off items)
EVA advantages
AWE OTP
1. Absolute measure
2. Working capital management rewarded (CL)
3. Economic measure - based on NPV principles (Cash over acc)
- Operating income limits manipulation
- Taxes are considered
- Proper calculated WACC (ie, Gearing and allows different risk levels to be taken into account through different costs of capital)
EVA disadvantages
- Not a percentage therefore cannot compare across different size investments.
- Complexities in calculation.
Similarities between EVA and NPV
- NPV and EVA = same decision being made. EVA is trying to get back to cash flow principles
2.The discounted EVA’s for a five year project should give you the same result as an NPV for the same project.
Differences between EVA and NPV
NPV is a tool used to evaluate multiple year projects, while EVA is usually used to evaluate manager/ divisional performance on an annual basis.
What issue will you have with an EVA which is viewed in isolation and how can you fix it ?
Issue : result in the an incorrect decision being taken in year 1, where straight line economic depreciation is used. (accounting depreciation would be removed)
Result: This can be prevented by evaluating managers over the long term, or including non-financial measures in the evaluation
Market value added (MVA) formula
Market value added = MV of company - Invested capital
What if MVA is negative ?
If negative: management’s actions and investments are less than the
capital contributed and wealth has been destroyed
What is an MVA ?
A calculation that shows the difference between the MV of a company and capital contributed
Approaches for reducing short term focus ?
- Divisional performance evaluated on the basis of economic income
(PV of future cash flows). - Adopt EVA™ incorporating many accounting adjustments.
- Lengthen the measurement period.
- Do not rely excessively on financial measures and incorporate non-financial
measures that measure those factors that are critical to the long-term success
of the organization. (i.e. adopt a Balanced Scorecard Approach) - Delayed reward model, share incentives that vest.
Approaches for reducing short term focus ?
Formula for RI =
Income - (required rate of return x Investment)
RI considerations
Maximizing ROI may induce managers of highly profitable divisions to reject projects that should be accepted.
Goal congruence is more likely to be promoted by using residual income rather than ROI.
Purpose of balanced scorecard ?
Simple : The balanced scorecard translates an organization’s mission and strategy into
performance measures from four perspectives
Fancy : A method of implementing a business strategy by translating it into a set of performance measures derived from strategic goals that allocate rewards to executives and managers based on their success at meeting or exceeding the performance measures.
Why use a balanced score card ?
- Focus on traditional financial accounting measures such as ROA, ROE, EPS gives misleading signals to executives with regards to quality and innovation. It is important to look at the means used to achieve outcomes such as ROA, not just focus on the outcomes themselves.
- Executive performance needs to be judged on success at meeting a mix of both financial and non-financial measures to effectively operate a business.
- Some non-financial measures are drivers of financial outcome measures which give managers more control to take corrective actions quickly.
- Too many measures, such as hundreds of possible cost accounting index measures, can confuse and distract an executive from focusing on important strategic priorities. The balanced scorecard disciplines an executive to focus on several important measures that drive the strategy.
Why use a balanced score card ?
- Focus on traditional financial accounting measures such as ROA, ROE, EPS gives misleading signals to executives with regards to quality and innovation. It is important to look at the means used to achieve outcomes such as ROA, not just focus on the outcomes themselves.
- Executive performance needs to be judged on success at meeting a mix of both financial and non-financial measures to effectively operate a business.
- Some non-financial measures are drivers of financial outcome measures which give managers more control to take corrective actions quickly.
- Too many measures, such as hundreds of possible cost accounting index measures, can confuse and distract an executive from focusing on important strategic priorities. The balanced scorecard disciplines an executive to focus on several important measures that drive the strategy.
Components of a balanced scorecard ?
- Financial performance
- Customer satisfaction
- Internal Business Processes
- Learning and growth
