Chapter33 valuebasedmanagement

Chapter 33

VALUE BASED MANAGEMENT

Centre for Financial Management , Bangalore

OUTLINE

• What is value based management (VBM)

• Methods and key premises of VBM

• Marakon approach

• Alcar approach

• Mckinsey approach

• Stern Stewart approach

• BCG approach

• Lessons from the experiences of VBM adopters

• Potential and hurdles for VBM in India


WHAT IS VBM

VBM represents a synthesis of various business disciplines

Finance : Goal of shareholder value maximisation and the DCF model

Business : Value creation stems from exploiting strategy opportunities based on the firm’s comparative

advantage

Accounting : Structure of financial statements with some modification

Organisational : Notion that ‘you get what you measure and behaviour reward’


RISING INTEREST… VBM

• LARGE CORPORATION’S … VALUE CREATION.. CENTRAL OBJECTIVE

• GROWING CONCERN.. MGTS.. STOCK UNDERVALUED

• TRADITIONAL INDICATORS.. EPS NOT RELIABLE.. INDICATORS.. FUTURE RETURNS

• INCREASING ATTENTION…TO LINKING TOP MGT.. COMPENS’TN TO SHAREHOLDER RETURNS

• GREATER ATTENTION.. SHRR.. PERFORMANCE RATINGS.. (BW.. FORTUNE)

• DEV.. APPROACHES.. IMPLEMENTING VBP Centre for Financial Management , Bangalore

VALUE BASED MANAGEMENT

• VBM INSTILLS A MIND - SET WHERE EVERYONE IN THE ORGN … FOCUSES ON VALUE CREATION.

• A COMPREHENSIVE VBM PROGRAM …

STRATEGIC PLANNING

CAPITAL ALLOCATION

OPERATING BUDGETS

PERFORMANCE MEASUREMENT

MANAGEMENT COMPENSATION

INTERNAL COMMUNICATION

EXTERNAL COMMUNICATION Centre for Financial Management , Bangalore

METHODS OF VBM

Several methods have been used in VBM. The three principal methods of VBM are:

• The free cash flow method proposed by McKinsey and LEK/Alcar group.

• The economic value added / market value added (EVA/MVA) method pioneered by Stern Stewart and Company.

• The cash flow return on investment / cash value added (CFROI/CVA) method developed by BCG and Holt Value Associates.


KEY PREMISES… VBM

• FOR MANAGING SH VALUE, FIRMS SHOULD USE METRICS… LINKED TO VALUE CREATION & EMPLOY THEM CONSISTENTLY… ALL FACETS OF FINANCIAL MANAGEMENT.

• A WELL DESIGNED PERFORMANCE MEASUREMENT & INCENTIVE COMPENS’N ESSENTIAL… MOTIVATE EMPLOYEES FOCUS ATTENTION… CREATING SHV.


KEY DIFFERENCE

The key difference between these methods relates to VBM metrics. For example, the LEK/ Alcar method uses shareholder value added, the Stern Stewart method emphasises EVA and MVA, and the BCG method focuses on CFROI and CVA.

Each camp argues that its measures are the best and cites supporting evidence for the same. It is difficult to objectively assess the validity of these claims.

While the different methods to VBM have their own fan clubs, the EVA / MVA method seems to have received more attention and gained more popularity.


MARAKON APPROACH

The key steps in the Marakon approach are as follows:

• Specify the financial determinants of value

• Understand the strategic drivers of value

• Formulate higher value strategies

• Develop superior organisational capabilities

James M.McTaggart, Peter W.Kontes, and Michael C.Mankins The Value Imperative, Free Press, 1994


FINANCIAL DETERMINANTS OF VALUE

According to the Marakon model, the market-to-book values ratio is a function of the return on equity, the growth rate of dividends (as well as earnings), and the cost of equity:

M r – g

B k – g

where M = market value of equity

B = book value of equity

r = return on equity

g = growth rate in dividends

k = cost of equity

= (33.1)


Source: James M. McTaggart, Peter W. Kontes, and Michael C. Mankins, The Value Imperative

Market economics

Structural factors and

trends

Average equity spread and growth of

market(s) over time

Competitive position

Differentiation and economic cost position and trends

Relative equity spread and growth over

time

Financial determinants

Value creation

Average equity spread over

time

Average growth over

time

STRATEGIC DETERMINANTS OF VALUE CREATION


DETERMINANTS OF MARKET ECONOMICS (OR PROFITABILITY)

Intensity of indirectcompetition Threat of entry

Supplier pressures Regulatory pressures

Intensityof direct

competition

Customerpressures

Market profitability

Limitingforces

Directforces

Source: James M.McTaggart, Peter W.Kontes, and Michael C.Mankins, The Value Imperative.


Participationstrategy options

Competitive strategy options

Entry strategyoptions

Exit strategyoptions

Alternativestrategy

development

In which markets

should weparticipate?

How should we compete

in each market?

Product offeringstrategy options

Cost and assetstrategy options

Pricing strategyoptions

HIGHER VALUE STRATEGIES

Source : James M.Mc Taggart, Peter W.Kontes, and Michael C.Mankins, The Value Imperative.


SUPERIOR ORGANISATIONAL CAPABILITIES

Superior organisational capabilities overcome the internal barriers to value creation. They are:

• A competent and energetic chief executive who is fully committed to the goal of value maximisation.

• A corporate governance mechanism that promotes the highest degree of accountability for creation or destruction of value.

• A top management compensation plan which is guided by the principle of “relative pay for relative performance”.


SUPERIOR ORGANISATIONAL CAPABILITIES

• A resource allocation system which is based on four principles: (i) the principle of zero-based resource allocation, (ii) the principle of funding strategies, not projects, (iii) the principle of no capital rationing, and (iv) the principle of zero tolerance for bad growth.

• A performance management process (the high-level strategic and financial control process) which is founded on two basic principles: (i) The performance targets are driven by the plans, rather than the other way around. (ii) The process should have integrity implying that the performance contract must be fully honored by both sides, the chief executive and each business unit head.


ALCAR APPROACHAlfred Rappaport Creating Shareholder Value : A Guide for Managers and Investors, Free Press 1998

According to Rappaport the following seven factors – he calls them “value drivers” – affect shareholder value:

• Rate of sales growth

• Operating profit margin

• Income tax rate

• Investment in working capital

• Fixed capital investment

• Cost of capital

• Value growth duration Centre for Financial Management , Bangalore

Creating shareholder value Shareholder return

• Dividends • Capital gains

Cash flow from operations Discount rate Debt

• Value growth duration • Sales growth

• Operating profit margin• Income tax rate

• Working capital investment• Fixed capital investment

• Cost of capital

Operating Investment Financing

Corporate objective

Valuationcomponents

Value drivers

Management decisions

Source : Alfred Rappaport, Creating Shareholder Value : A Guide for Managers and Investors.

SHAREHOLDER VALUE CREATION NETWORK


ASSESSMENT OF THE SHAREHOLDER VALUE IMPACT OF THE BUSINESS

UNIT (STRATEGY)

1. Forecast the operating cash flow stream for the business unit (strategy) over the planning period.

2. Discount the forecasted operating cash flow stream using the WACC.

3. Estimate the residual value of the business unit (strategy) at the end of the planning period and find its present value.

4. Determine the total shareholder value.

5. Establish the pre-strategy value

6. Infer the value created by the strategy


ILLUSTRATIONThe income statement for year 0 (the year which has just ended) and the balance sheet at the end of year 0 for Ventura Limited are shown in the first column of the exhibit shown next.

Ventura Limited is debating whether it should maintain the status quo or adopt a new strategy. If it maintains the status quo:

• The sales will remain constant at 1,000• The gross margin and selling, general, and administrative expenses will remain unchanged at 25 percent and 10 percent respectively• Depreciation charges will be equal to new investments• The asset turnover ratios will remain constant• The discount rate will be 16 percent.• The income tax rate will be 40 percent.

If Ventura Limited adopts a new strategy its sales will grow at a rate of 10 percent per year for five years. The margins, the turnover ratios, the capital structure, the income tax rate, and the discount rate, however, will remain unchanged. Depreciation charges will be equal to 10 percent of the net fixed assets at the beginning of the year.

What value will the new strategy create? As computed in Exhibit 33.5, the value created by the new strategy is 58.


Current Income Statement Projections Residual Values Value (year 0) 1 2 3 4 5 5+

Sales 1000 1100 1210 1331 1464 1611 1611 Gross margin (25%) 250 275 303 333 366 403 403 S & G.A. (10%) 100 110 121 133 146 161 161 Profit before tax 150 165 182 200 220 242 242 Tax 60 66 73 80 88 97 97 Net profit 90 99 109 120 132 145 145 Balance Sheet Projections Fixed assets 300 330 363 399 439 483 483 Current assets 200 220 242 266 293 322 322 Total assets 500 550 605 667 732 805 805 Equity 500 550 605 667 732 805 805


DETERMINATION OF THE VALUE CREATED BY A NEW STRATEGY

Exhibit 33.5

Cash Flow Projections Profit after tax 99 109 120 132 145 145 Depreciation 30 33 36 40 44 48

Capital expenditure 60 66 72 80 88 48 Increase in current assets

20 22 24 27 29 0

Operating cash flow 49 54 60 65 72 145

Present value factor 0.862 0.743 0.641 0.552 0.476 (at 16% discount) Present value of the

operating cash flow 42 40 38 36 34

Present value of the operating cash flow stream = 190 Residual value = 145/0.16 = 906

Present value of the residual value = (0.476)906 = 431 Total shareholder value = 190 + 431 – 0 = 621

Pre-strategy value = 90/0.16 = 563 Value of the strategy = 621 – 563 = 58


SHAREHOLDER VALUE MANAGEMENT CYCLE

Strategicplanning

Incentivecompensation

Performanceevaluation

Investorcommunications

Portfolio reviewand resource allocation

Source: Alfred Rappaport, Creating Value for Shareholders : A Guide for Managers and Invetsors


MCKINSEY APPROACHMcKinsey & Company, a leading international consultancy firm, has developed an approach to VBM which has been very well articulated by Tom Copeland, Tim Koller, and Jack Murrin of McKinsey & Company5. According to them:

“Properly executed, value based management is an approach to management whereby the company’s overall aspirations, analytical techniques, and management processes are all aligned to help the company maximize its value by focusing decision-making on the key drivers of value.”

The key steps in the McKinsey approach to VBM are as follows:

• Ensure the supremacy of value maximisation

• Find the value drivers

• Establish appropriate managerial processes

• Implement value-based management properly

5 Tom Copeland, Tim Koller, and Jack Murrin, Valuation : Measuring and Managing the Value of Companies, Second Edition, New York : John Wiley & Sons Inc., 1994. Centre for Financial Management , Bangalore

AREAS OF ACTIVITY FOR MAKING VALUE HAPPEN


ShareholderValue

Aspirationsand targets

Portfolio management

Organisational design

Value driver definition

Business Individualperformance performancemanagement management

Metrics Value thinking Mindset

Source: Tom Copeland et.al Valuation Measuring and Managing the Value of Companies, 3rd Edition.

STERN STEWART APPROACH (EVA® APPROACH)

EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It

may be calculated in any of the following, apparently different but essentially equivalent, ways:

EVA = NOPAT - c* x CAPITAL (33.8)

EVA = CAPITAL ( r- c*) (33.9)

EVA = [PAT + INT (1-t)] – c* CAPITAL (33.10)

EVA = PAT- ke EQUITY (33.11)

where EVA = economic value added

NOPAT = net operating profit after tax

c* = cost of capital

CAPITAL = economic book value of the capital employed in the firm

r = return on capital = NOPAT/CAPITAL

PAT = profit after tax

INT = interest expense of the firm

t = marginal tax rate of the firm

ke = cost of equity

EQUITY = equity employed in the firm


BALANCE SHEET AND PROFIT AND LOSS ACCOUNT

BALANCE SHEET AS ON 31.03.2000 PROFIT & LOSS STATEMENT FOR THE YEAR ENDING 31.03.2000

LIABILITIES ASSETS NET SALES 300

EQUITY 100 FIXED ASSETS 140 COST OF GOODS SOLD 258

DEBT 100 NET CURRENT 60 PBIT 42

ASSETS INTEREST 12

200 200 PBT 30

TAX 9

PAT 21

COE = 18% COD = 12 (1 - 3) = 8.4% WACC = 13.2%

NOPAT = PBIT (1 - TAX RATE) = 42 (1 - 0.3) = RS.29.4 MILLION

CAPITAL = RS.200 MILLION ROCE = 29.4 / 200 = 14.7%

FOUR WAYS OF COMPUTING EVAEVA = NOPAT - c* x CAPITAL = 29.4 - (0.132) x 200 = RS.3 MILLION

EVA = CAPITAL x (r - c*) = 200 (0.147 - 0.132) = RS. 3 MILLION

EVA = [PAT + INT (1-t)] - c* CAPITAL = [21 + 12 (0.7)] - 0.132 x 200 = RS.3 MILLION

EVA = PAT - ke EQUITY = 21 - 0.18 x 100 = RS.3 MILLION

NUMERICAL ILLUSTRATION OF VALUE CREATING STRATEGIES

BASE CASECAPITAL : 10,000NOPAT : 2,000c* : 15%r : 20%

EVA = CAPITAL x (r - c*) = 10,000 (0.20 - 0.15) = 500

STRATEGY 1 : IMPROVEMENT IN OPERATING PERFORMANCENOPAT INCREASES FROM 2000 TO 2250, DUE TO GREATER OPERATING EFFICIENCIES. THIS RAISES r TO 22.5%. AS A RESULT EVA RISES TO 750

EVA = CAPITAL x (r - c*) = 10,000 (0.225 - 0.150) = 750

STRATEGY 2 : PROFITABLE INVESTMENTA NEW PROJECT REQUIRING 10,000 IS EXPECTED TO EARN A RETURN OF 18% THEREBY ADDING 1800 TO NOPAT. THIS PROJECT WILL INCREASE EVA, EVEN THOUGH THE CONSOLIDATED RETURN WILL DECLINE TO 19% (THE AVERAGE OF 20% AND 18%)

EVA = CAPITAL x (r - c*) = 20,000 (0.19 - 0.15) = 800

NOTE THAT MAXIMISING EVA IS MORE IMPORTANT, NOT MAXIMISING RETURN ON CAPITAL. HENCE THE PROJECT SHOULD BE ACCEPTED

STRATEGY 3 : WITHDRAWAL OF UNPRODUCTIVE CAPITAL1000 OF WORKING CAPITAL CAN BE LIQUIDATED WITH ONLY A MARGINAL DECLINE OF NOPAT. NOPAT WILL FALL BY JUST 50. WITHDRAWING THIS WORKING CAPITAL WOULD INCREASE THE RATE OF RETURN TO 21.67% (2000 - 50) / (10000 - 1000) AND EVA TO 600

EVA = CAPITAL x (r - c*) = 9,000 (0.2167 - 0.150) = 600

STRATEGY 4 : REDUCTION IN THE COST OF CAPITALTHE CAPITAL STRUCTURE OF THE FIRM IS ALTERED AND THIS CHANGE LOWERS THE COST OF CAPITAL TO 13%, WITHOUT AFFECTING ANYTHING ELSE. AS A RESULT EVA RISES FROM 500 TO 700

EVA = CAPITAL x (r - c*) = 10,000 (0.20 - 0.13) = 700

MEASURING NOPAT AND CAPITAL : ADJUSTING FOR THE DISTORTIONS OF GAAP

The gap between GAAP-based accounting information and economic reality stems from the extreme conservatism characterising accounting practice

To calculate EVA that is a reliable guide to value creation, several adjustments are required to accounting earnings and accounting book value. The purpose of these adjustments is to derive a NOPAT figure that reflects economic performance and a capital figure that measures the capital contributed by shareholders and lenders.

Stern Stewart have identified more than 160 potential adjustments. These relate to things like intangible assets, strategic investments, market promotion outlays, goodwill, timing of expense and revenue recognition, off- balance sheet financing, passive investments in marketable securities, restructuring charges, bad-debt recognition, inventory valuation, foreign currency translation, depreciation, taxes, and non- interest bearing liabilities

In most real life situations, however, 10 to 15 adjustments suffice. The more important ones tend to relate to the following.


MEASURING NOPAT AND CAPITAL EMPLOYED :ADJUSTING FOR THE DISTORTIONS OF GAAP

1. CAPITALIZE R & D INVESTMENTS & WRITE THEM OFF OVER AN APPR. PERIOD

2. CAPITALIZE MARKET DEVELOPMENT COSTS & AMORTIZE THEM OVER A PERIOD . . TIME

3. HOLD BACK THE OUTLAYS ON STRATEGIC INVESTMENT IN A SPECIAL SUSPENSE ACCOUNT

4. DON’T FLOW RESTRUCTURING CHARGES THRU THE INCOME STAT’T; INSTEAD ADD RESTR’G INVESTMENT TO THE B/S.

5. REPLACE STRAIGHT-LINE DEPR’N WITH SINKING FUND DEPR’N, IF NECESSARY

6. EXCLUDE PASSIVE INVEST’TS & . . INCOME THEREFROM

7. MAKE ADJUSTT’S FOR GOODWILL WRITEOFFS, DEFERRED TAXES, BAD DEBT RESERVES, & SO ON (QUASI EQUITY)

8. MOVE ALL OFF-BALANCE SHEET ITEMS, SUCH AS UNCAPITALIZED LEASES, BACK TO THE B/S


RESTRUCTURING CHARGESAPEX LTD . . RS.100 MN FACTORY NIL OP. PROFIT

COC : 12%

GAAP : BREAK-EVEN … EVA … -12 MN

APEX CAN SELL THE FACTORY FOR RS.60 MN RS.60 MN DIV

UNDER GAAP . . EARNINGS 40 MN . . B / S 100 MN

UNDER EVA . . INSTEAD OF MAKING A RS.40 MN CHARGE TO ITS INCOME STATT . . APEX ADDS A RS.40 MN RESTR’G INVT . . B/S CAP. DECLINES NOT BY RS.100 MN, BUT BY RS.60 MN, AMOUNT PAID TO SHs. EVA RISES FROM - 12 TO - 4.8

DEPRECIATION

SLM 1 2 3 4 5CAPITAL 100000 80000 60000 40000 20000DEPR’N 20000 20000 20000 20000 20000CAP. CHARGE 15000 12000 9000 6000 3000SUM 35000 32000 29000 26000 23000

SFM SINKING FUND DEPR’N (AMORT’N DEPR’N)CAP. CHARGE 15000 12775 10216 7273 3890DEPR’N 14833 17058 19617 22559 25943 (PRINCIPAL AMORT’N)SUM 29833 29833 29833 29833 29833

A x PVIFA (5, 15%) = 100000 A x 3.352 = 100000 A = 29833


EVA APPLICATIONS TRADITIONAL FIN. MGT EVA BASED FIN. MGT

• FIRM GOALS REVENUES PROFITS, EPS EVA

• BUSINESS PLANS - DO - EVA

• DIVISIONAL PERF. DIVISIONAL PROFITS EVA

MEASUR’T ROI

• CAPITAL BUDGETING DCF EVA

• PERFORMANCE TARGET NEGOTIATED PROFIT FORMULA-LINKED EVA TARGET

• INCENTIVE COMPEN’N SMALL & RANGE UNLIMITED & EVA- BOUND LINKED

• FINANCIAL STR’RE STATIC DYNAMIC

WHY EVATIES DIRECTLY WITH SHW CREATIONCONVERTS ACCTG INF’N . . ECONOMIC REALITY . . READILY GRASPEDPROVIDES A SINGLE UNIFIED MEASURE FOR ALL PURPOSESMAKES MANAGERS INTO OWNERSSERVES AS AN ANCHOR FOR CORPORATE GOVERNANCE


EVA APPROACH TO VALUATION

1 2 3 4 5 6 7

NOPAT 6.0 7.2 8.6 10.4 11.6 13.0 14.1BEG. CAP 50 60 72 86.4 96.8 108.4 117.1X C* 11% 11% 11% 11% 11% 11% 11%CAP. CHARGE 5.5 6.6 7.9 9.5 10.6 11.9 12.9EVA 0.5 0.6 0.7 0.9 1.0 1.1 1.2PV FACTOR .901 .812 .731 .659 .593 .535PV OF EVA .45 .49 .51 .59 .59 .59GROWTH (%) 20 20 20 12 12 8 8

VALUE OF THE COMPANY = BEG. CAPITAL + PV OF EVA STREAM

6 EVAt EVA7 PV OF EVA STREAM = + = 1.2 / [0.03 x (1.11)6] = 21.4

t=1 (1+k)t (K-G)(1+K)6

VALUE OF THE COMPANY = 50 + 24.6 = 74.6


EVA & MVAEVA TIES DIRECTLY TO THE INTRINSIC MARKET VALUE OF ANY COMPANY. WHEN IT IS PROJECTED AND DISCOUNTED TO A PRESENT VALUE, EVA ACCOUNTS FOR THE MARKET VALUE THAT MANAGEMENT ADDS TO, OR SUBTRACTS FROM, THE CAPITAL IT HAS EMPLOYED.

MVA = MARKET VALUE - CAPITAL

MVA = PRESENT VALUE OF ALL FUTURE EVA

PREMIUM VALUE EVA1 + EVA2 +…… (1+c*)1 (1+c*)2

+ …

MAR KET VALUE

M V A C A P I T A L

C A P I T A L

MV Lost

Market Value

EVA2

(1+c*)2

EVA1 + (1+c*)1


CAPITAL BUDGETING WITH EVAINVESTMENT : 100 EQUITY FINANCING : 100

DEPR’N : ST. LINE COST OF EQUITY : 15%

PROJECT LIFE : 4 YRS TAX RATE: 50%

SALVAGE VALUE : NIL

1 2 3 4 REVENUES 200 200 200 200 COSTS 135 135 135 135 PBIDT 65 65 65 65 DEPR’N 25 25 25 25 PBIT 40 40 40 40 NOPAT 20 20 20 20 CAP. AT CHARGE 100 75 50 25 CAP. CHARGE 15 11.25 7.5 3.75 EVA 5 8.75 12.5 16.25 CASH FLOW (PAT + DEP) 45 45 45 45

CFt

NPV = - I = 128.475 - 100 = 28.475(1+k)t

EVA t

NPV = = 28.475 (1+k)t


EVA AND INCENTIVE COMPENSATION

The centre piece of the EVA financial management system is a unique bonus plan that overcomes these limitations and aligns the interest of managers with shareholders. The key elements of the EVA bonus plan are:

• Bonus is linked to increases in EVA

• There is no floor or ceiling on the bonus

• The target bonus is generous

• Performance targets are set by formula, not negotiation

• A bonus bank is established.


A : Traditional bonus plan B : EVA bonus plan

Bonus

80% 100% 120%

Bonus

Target EVA

BONUS BEHAVIOUR



BONUS BANK SYSTEM

NORMAL YEAR GOOD YEAR BAD YEAR

BONUS EARNED 50 200 -100

BEGINNING BANK 100 100 200

CUMULATIVE BALANCE 150 300 100

PAYOUT RATIO 1/3 1/3 1/3

BONUS PAID 50 100 33 1/3

BONUS FORWARD 100 200 66 2/3

BONUS = a1 . CHANGE IN EVA + a2 . EVA

IF EVA . . - a2 = 0 a1 > > a2 . . INCENTIVE

LINKED . . EVA NO CAP / FLOOR FORMULA BANK


THE TWO FINANCIAL PARADIGMSEPS BASED FINANCIAL MANAGEMENT EVA BASED FINANCIAL MANAGEMENT

SYSTEM SYSTEMMANAGEMENT TRIES TO MANAGEMENT TRIES TO REPORT STEADY INCREASES IN EPS ACHIEVE IMPROVEMENT IN EVA DIVERSIFY TO ACHIEVE STABILITY STRIVE FOR FOCUS TIGHTLY CONTROL THE ALLOCATION OF DECENTRALIZE INVESTMENT DECISION CAPITAL MAKING BALANCE THE CLAIMS OF VARIOUS ACCORD PRIMACY TO SHAREHOLDER STAKEHOLDERS BUY COMPANIES WITH LOWER P/E MULTIPLES ACQUIRE COMPANIES THAT AUGMENT VALUE TO BOOTSTRAP EPS NEGOTIATE DIVISION PROFIT TARGETS DEFINE EVA TARGETS BY FORMULA AWARD MODEST TARGET LINKED BONUSES MAKE BONUS VARIABLE BOTH WAYS

MADE SENSE IN MAKES SENSE IN IN THE STABLE BUSINESS ENVIRONMENT THAT IN THE VOLATILE BUSINESS ENVIRONMENT,

PREVAILED TILL THE MID 1970s WHEN THE TOP CHARACTERISED BY INFORMATION REVOL’N

MANAGEMENT WAS TO ACHIEVE ECONOMIES AND RAPID TECHNOLOGICAL DEVELOPMENTS

OF SCALE IN MFRG AND MARKETING AND FIND CALLING FOR A CHANGE IN THE STRUCTURE

GROWTH OPPORTUNITIES IN THE SAME / OF INTERNAL CONTROL SYSTEMS OF LARGE

RELATED BUSINESSES ORGANISATION


IMPLEMENTING THE EVA SYSTEM

• DEVELOP TOP MANAGEMENT COMMITMENT

• CUSTOMISE THE DEFINITIONS OF EVA

• IDENTIFY EVA CENTRES

• ANALYSE THE DRIVERS OF EVA

• TAILOR AN INCENTIVE COMPENSATION SYSTEM

• TRAIN ALL THE EMPLOYEES

PROBLEMS IN USING EVA

• Disincentive for collaborative relationship

• Imperfect measure

• Underinvestment

• Difficulties in divisional performance measurement


BCG APPROACH

• Boston Consulting Group (BCG), an international consulting organisation, has developed an approach to shareholder value management.

• Two concepts are at the foundation of the BCG approach : total shareholder return and total business return.

• For applying these concepts, two performance metrics are used : cash flow return on investment and cash value added


TOTAL SHAREHOLDER RETURNTotal shareholder return (TSR) is the rate of return shareholders earn from owning a company’s stock over a period of time:

The TSR for a single holding period is computed as follows:

Dividend Ending market value – Beginning market valueTSR = + Beginning market value Beginning market value

The TSR for a multiple holding period is computed using the conventional internal rate of return computation

Dividend1 Dividend2 Dividend n

+ + + …. (1 + TSR)1 (1 + TSR)2 (1 + TSR)n

Ending market value in year n +

(1 + TSR)n

Beginningmarket value =


WHY TSR IS DEEMED THE MOST USEFUL MEASURE OF VALUE CREATION

• TSR is comprehensive

• TSR is widely used by the investment community.

• TSR can be easily benchmarked

• TSR is not biased by size

• TSR is difficult to manipulate


TOTAL BUSINESS RETURNThe total business return (TBR) is the internal counterpart of TSR. The link between TSR, TBR, and value drivers is shown below.

Total Business Return

Total Shareholder

Return

Capital gains

Free cash flows

Growth in new investments

Return on invested capital

Measured as Cash flow return on investment


TBRThe TBR for a single holding period is computed as follows:

Free cash flow Ending value – Beginning valueTBR = + Beginning value Beginning value

The TBR for a multiple holding period is measured using the conventional internal rate of rate computation:

Beginning Free cash flow1 Free cash flow2

value = + + …… (1 + TBR) (1 + TBR)2

Free cash flown Ending value in yearn + +

(1 + TBR)n (1 + TBR)n

The beginning and ending values are estimates of market values of the firm or business unit at the beginning and end of the period. They are estimated using one or more of the following:

Value = Earnings x P/E multiple Value = Book value x M/B multiple Value = Free cash flow cost of capital Value = NPV of expected cash flow

USES OF TBR

BCG uses TBR for

• Strategic planning

• Resource allocation

• Incentive compensation


Positive

Current CFROI vs cost of capital 0 Negative Negative 0 Positive TBR of business plan versus target TBR

Question High priority for reinvestment

Do not fund Question

RESOURCE ALLOCATION PERSPECTIVE


CASH FLOW RETURN ON INVESTMENT (CFROI)TBR incorporates the returns (CFROIs) both for the assets in place and the assets to be created. Thus CFROI has an important bearing on TBR.

What is CFROI and how is it measured? BCG defines CFROI as “the sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firm’s assets”. Sustainable cash flow is gross cash flow less economic depreciation. Thus,

Cash flow - Economic depreciationCFROI =

Cash invested

Note that economic depreciation is the amount of annual sinking fund payment earning capital cost required to replace assets.

9To illustrate the calculation of economic depreciation, consider a plant that has an economic life of 14 years and costs Rs 250,000 to replace.

Economic depreciation x FVIFA (14, 10%) = Rs. 250,000

Rs 250,000 Rs 250,000Economic depreciation = = = Rs 8,937

FVIFA (14, 10%) 27.975

ILLUSTRATION OF CFROITo illustrate the calculation of CFROI , let us consider an example . A new plant entails an initial investment of Rs. 300,000, Rs. 250,000 toward fixed assets and the balance toward net working capital. The plant has an economic life of 14 years.

At the end of 14 years, fixed assets will fetch nothing but net working capital will be recovered in full. The annual depreciation charge on fixed assets will be Rs.250,000/14 = Rs. 17,857. The plant is expected to produce a NOPAT of Rs.21,080 each year. The cost of capital is 10 percent. It will cost Rs.250,000 to replace the fixed assets.

Exhibit 33.20 shows the CFROI of the project for three sample years, assuming that the actual performance is in line with forecast performance. It also shows two other return measures popularly used, viz:

NOPATReturn on capital employed (ROCE) =

Book capital

Cash flowReturn on gross investment (ROGI) =

Cash invested Centre for Financial Management , Bangalore

ACCURACY OF VARIOUS MEASURES OF RETURN

How accurate are the various measures of return? To judge the accuracy of these measures, they may be compared with the internal rate of return (IRR), the measure most commonly employed to assess investment projects. The IRR for the project is the value of r in the following equation.

38,937 38,937 38,937 + 50,000300,000 = + + ….. +

(1 + r) (1 + r)2 (1 + r)14

r works out to 10 percent.Comparing the three measures with IRR we find that:

• ROCE understates IRR in the initial years and overstates IRR in the later years. ROCE shows a rising trend over time, though the project is a constant cost-of-capital performer.• Unlike ROCE, ROGI does not show a rising trend. However, it has a constant upward bias of about 3 percent as it does not take into account what must be withheld to replace the asset at the end of its economic life.• CFROI equals IRR throughout. It takes into account the replacement need and provides the correct signal each year.


CASH VALUE ADDED (CVA)

The CFROI is the key metric used by BCG for measuring performance and valuing a company. However, BCG has also developed a measure of economic profit: cash value added (CVA). BCG claims that CVA is superior to EVA because it removes the accounting distortion that may bias EVA.

CVA is measured as operating cash flow less economic depreciation less a capital charge on gross investment. Thus,

Cash Economic Capital charge on gross flow depreciation investment

CVA = – –


EVA AND CVA CALCULATIONS INVESTMENT = FIXED ASSET (250000) + NET WORKING CAPITAL(50000)

LIFE : 14 YRS SALVAGE VALUE (FIXED ASSETS) = 0

ECONOMIC DEPR’N = 250000 / FVIFA(14,10%) = 250000 / 27.975 = RS. 8937

PANEL A : EVA RS. IN MILLION

YEAR 1 YEAR 6 YEAR 12

1. NOPAT 21,080 21,080 21,0802. BOOK CAPITAL (BEG.) 300,000 210,715 103,5733. COST OF CAPITAL 10% 10% 10%4. CAPITAL CHARGE 30,000 21,072 10,357

EVA (1 - 4) (8,920) 8 10,732

PANEL B : CVA

1. NOPAT 21,080 21,080 21,080

2. DEPRECIATION 17,857 17,857 17,8573. CASH FLOW 38,937 38,937 38,9374. ECONOMIC DEPR’N 8,937 8,937 8,9375. CASH INVESTED 300,000 300,000 300,0006. COST OF CAPITAL 10% 10% 10%7. CAPITAL CHARGE 30,000 30,000 30,000

CVA = (3 - 4 - 7) 0 0 0

CVA = OPERATING CASH FLOW - ECONOMIC DEPR’N - CAPITAL CHARGE ON THE FULL CASH INVESTED


LESSONS… EXPERIENCES OF VBM ADOPTERS

• TOP MGMT. SUPPORT

• INCENTIVE PLAN

• EDUCATION

• CHOICE OF METRIC

• CONDUCIVE CIRCUMSTANCES

• UNPRODUCTIVE ASSETS

• PELL-MELL DIVERSIFICATION

• PHYSICAL ASSETS VS. INTELLECTUAL ASSETS

• NEED FOR CUSTOMISATION Centre for Financial Management , Bangalore

POTENTIAL

• MOST COMPANIES…. SUBSTANTIAL

PHYSICAL ASSETS… LOW PDY… CAP

• PELL MELL DIVERSIFICATION

• DISMAL DECADE (1992-2002) FOR EQUITIES


HURDLES

• LACK OF A GENUINE COMMITMENT…

PROMOTE WELFARE… SHS.

• FINANCIAL LITERACY… EMPLOYEES NOT HIGH

• ACCOUNTING MODEL DOMINATES

CORPORATE THINKING

• DEGREE… OF DECENTRAL’N... NOT HIGH.

• RELUCTANCE… MANY MGMTS. … GIVE UP

DISCRETION.

• MGR. USED… HIGH PROP’N OF FIXED COMPENS’N


FUTURE

• MANY MGMTS… HAVE BEGUN TO REALISE .. NEED… CREATE…SHV. THE FORCES OF GLOBALISATION, LIBERALISATION,DEREGULATION, AND COMPETITION… NOW SWEEPING THE INDIAN CORPORATE LANDSCAPE WILL PROD COMPANIES TO EXPLORE WAYS AND MEANS TO ENHANCE SHV.

• I EXPECT VBM TO BE A DOMINANT BUSINESS THEME IN INDIA IN THE YEARS TO COME. IT IS A TOOL OF REAL VALUEAND NOT A FAD OF EPHEMPERAL ATTRACTION.


SUMMING• To facilitate value creation, value-based management (VBM) systems have been developed.

• Several approaches to value based management (VBM) have been developed. The importance ones are the Marakon approach, the Alcar approach, the Mckinsey approach, and the BCG approach.

• The key steps in the Marakon approach are as follows : (i) Specify the financial determinants of value. (ii) Understand the strategic drivers of value. (iii) Formulate higher value strategies. (iv) Develop superior organisational capabilities

• The Alcar approach is based on discounted cash flow analysis. According to this appraoch, the following seven factors-called “value drivers” – affect shareholder value: rate of sales growth, operating profit margin, income tax rate, investment in working capital, fixed capital investment, cost of capital, and value growth duration.


• As per the Alcar approach, the key phases of shareholder value management cycle are: strategic planning, performance review and resource allocation, performance evaluation, incentive compensation, and investor communication.• The key steps in the Mckinsey approach are : (i) Ensure the supremacy of value maximisation (ii) Find the value drivers. (iii) Establish appropriate managerial processes. (iv) Implement VBM properly.• EVA is the surplus left after making an appropriate charge for the capital employed in the business.

• The EVA approach to VBM is based on the premise that EVA provides a single, unified, and accurate measure of value as well as performance. It links well forward looking valuation and capital budgeting analysis with actual performance measurement. For these reasons and more, EVA is regarded as the right measure for goal setting and business planning, performance evaluation, incentive compensation, investor communication, capital budgeting, and valuation.


• Two concepts are at the foundation of the Boston Consulting Group’s approach to shareholder value management : total shareholder return (TSR) and total business return (TBR). For applying the TSR and the TBR, two performance metrics are used : cash flow return on investment (CFROI) and cash value added (CVA).

• While the scope and need for applying VBM in India is enormous, there are some hurdles in doing that which arise mainly from certain attitude, beliefs, values, and practices that are inimical to VBM. Notwithstanding these hurdles, I believe that companies in India will introduce VBM programmes with vigour and commitment.
