Performance Evaluation

Question 1

When evaluating a manager vs a division, what do you need to consider ?

Answer 1

Functional structure- per function
Divisional structure - Divisions per product
Evaluate only on controllable items

Question 2

Formula for EVA ?

Answer 2

Net Operating Profit after Taxes (NOPAT) - Capital * cost of capital

Ie. Operating income after tax - WACC*(TA-CL)

Question 3

Residual income formula ?

Answer 3

Net income - (Cost of equity capital)

Question 4

Return on Investment formula?

Answer 4

Net income/ Equity capital

Question 5

ROI considerations

Answer 5

1. ROI for manager = controllable contribution / Controllable assets
2. ROI = Accounting rate of return (Acc no’s)
3. It considers profit alone, not size of investment
   4, Generally use profit after interest, before tax
4. TP. Always consider ROI Relevant to both division ROI and Group ROI to ensure that goal congruency is maintained.

Question 6

What is the investment ?
Total assets available

Answer 6

Includes all assets, regardless of their
particular purpose.

Question 7

What is the investment ?
Total assets employed

Answer 7

includes total assets available minus the
sum of idle assets and assets purchased for future expansion.

Question 8

What is the investment ?
Total assets employed minus current liabilities

Answer 8

excludes that portion of total assets employed that are financed by short-term
creditors.

Question 9

What happens when Carrying value is used in ROI and RI/ EVA ?

Answer 9

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

Question 10

What should you use in calculations of ROI and RI/ EVA ?

Answer 10

Use market values/original cost

Question 11

ROI advantages

Answer 11

Simple to calculate
Relative measure and easy to compare

Question 12

ROI disadvantages

Answer 12

• Ignores risk
• easy to manipulate
• can lead to incorrect decisions
• Accounting based measure of profit

Question 13

RI advantages

Answer 13

• Considers risk
  (through WACC)
• Usually motivates
  correct decisions
• Considers income
  earned relative to
  investment made

Question 14

RI disadvantages

Answer 14

• Absolute number
• Accounting based
  measure of profit

Question 15

Important points on EVA

Answer 15

• 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

Question 16

Accounting adjustments for EVA?

Answer 16

1. Amounts expensed under IFRS, that have enduring benefits
2. Purely accounting entries (ie, no physical cash flows)
3. Profits and losses on sale of unusual items not normally sold by the business if Controllable (Ie. once off items)

Question 17

EVA advantages

Answer 17

AWE OTP
1. Absolute measure
2. Working capital management rewarded (CL)
3. Economic measure - based on NPV principles (Cash over acc)

4. Operating income limits manipulation
5. Taxes are considered
6. Proper calculated WACC (ie, Gearing and allows different risk levels to be taken into account through different costs of capital)

Question 18

EVA disadvantages

Answer 18

1. Not a percentage therefore cannot compare across different size investments.
2. Complexities in calculation.

Question 19

Similarities between EVA and NPV

Answer 19

1. 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.

Question 20

Differences between EVA and NPV

Answer 20

NPV is a tool used to evaluate multiple year projects, while EVA is usually used to evaluate manager/ divisional performance on an annual basis.

Question 21

What issue will you have with an EVA which is viewed in isolation and how can you fix it ?

Answer 21

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

Question 22

Market value added (MVA) formula

Answer 22

Market value added = MV of company - Invested capital

Question 23

What if MVA is negative ?

Answer 23

If negative: management’s actions and investments are less than the
capital contributed and wealth has been destroyed

Question 24

What is an MVA ?

Answer 24

A calculation that shows the difference between the MV of a company and capital contributed

Question 25

Approaches for reducing short term focus ?

Answer 25

1. Divisional performance evaluated on the basis of economic income (PV of future cash flows). 2. Adopt EVA™ incorporating many accounting adjustments. 3. Lengthen the measurement period. 4. 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) 5. Delayed reward model, share incentives that vest.

Question 26

Approaches for reducing short term focus ?

Question 27

Formula for RI =

Answer 27

Income - (required rate of return x Investment)

Question 28

RI considerations

Answer 28

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.

Question 29

Purpose of balanced scorecard ?

Answer 29

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.

Question 30

Why use a balanced score card ?

Answer 30

1. 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. 2. Executive performance needs to be judged on success at meeting a mix of both financial and non-financial measures to effectively operate a business. 3. Some non-financial measures are drivers of financial outcome measures which give managers more control to take corrective actions quickly. 4. 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.

Question 30

Why use a balanced score card ?

Answer 30

1. 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. 2. Executive performance needs to be judged on success at meeting a mix of both financial and non-financial measures to effectively operate a business. 3. Some non-financial measures are drivers of financial outcome measures which give managers more control to take corrective actions quickly. 4. 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.

Question 31

Components of a balanced scorecard ?

Answer 31

- Financial performance - Customer satisfaction - Internal Business Processes - Learning and growth