Chapter33 valuebasedmanagement

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Chapter33 valuebasedmanagement

  1. 1. Chapter 33 VALUE BASED MANAGEMENT © Centre for Financial Management , Bangalore
  2. 2. 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 © Centre for Financial Management , Bangalore
  3. 3. WHAT IS VBM VBM represents a synthesis of various business disciplines Finance : Goal of shareholder value maximisation and the DCF model Business strategy : Value creation stems from exploiting 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’ © Centre for Financial Management , Bangalore
  4. 4. 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
  5. 5. 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 EXTERNALFinancial Management , Bangalore COMMUNICATION © Centre for
  6. 6. 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. © Centre for Financial Management , Bangalore
  7. 7. 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. © Centre for Financial Management , Bangalore
  8. 8. 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. © Centre for Financial Management , Bangalore
  9. 9. 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 © Centre for Financial Management , Bangalore
  10. 10. 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 B = r–g 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 © Centre for Financial Management , Bangalore (33.1)
  11. 11. STRATEGIC DETERMINANTS OF VALUE CREATION Market economics Structural factors and trends Average equity spread and growth of market(s) over time Financial determinants Average equity spread over time Value creation Competitive position Differentiation and economic cost position and trends Relative equity spread and growth over time Average growth over time Source:James M. McTaggart, Peter W. Kontes, and Michael C. Mankins, The Value Imperative © Centre for Financial Management , Bangalore
  12. 12. DETERMINANTS OF MARKET ECONOMICS (OR PROFITABILITY) Direct forces Threat of entry Supplier pressures Limiting forces Intensity of indirect competition Regulatory pressures Intensity of direct competition Market profitability Customer pressures Source: James M.McTaggart, Peter W.Kontes, and Michael C.Mankins, The Value Imperative. © Centre for Financial Management , Bangalore
  13. 13. HIGHER VALUE STRATEGIES Participation strategy options In which markets should we participate? Alternative strategy development Competitive strategy options How should we compete in each market? Entry strategy options Exit strategy options Product offering strategy options Cost and asset strategy options Pricing strategy options Source : James M.Mc Taggart, Peter W.Kontes, and Michael C.Mankins, The Value Imperative. © Centre for Financial Management , Bangalore
  14. 14. 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”. © Centre for Financial Management , Bangalore
  15. 15. 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. © Centre for Financial Management , Bangalore
  16. 16. ALCAR APPROACH Alfred 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
  17. 17. SHAREHOLDER VALUE CREATION NETWORK Creating shareholder value Corporate objective Valuation components Value drivers Cash flow from operations • Value growth duration Management decisions • Sales growth • Operating profit margin • Income tax rate Operating Shareholder return • Dividends • Capital gains Discount rate • Working capital investment • Fixed capital investment Investment Debt • Cost of capital Financing Source : Alfred Rappaport, Creating Shareholder Value : A Guide for Managers and Investors. © Centre for Financial Management , Bangalore
  18. 18. 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 © Centre for Financial Management , Bangalore
  19. 19. ILLUSTRATION The 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. © Centre for Financial Management , Bangalore
  20. 20. Exhibit 33.5 DETERMINATION OF THE VALUE CREATED BY A NEW STRATEGY Current Values (year 0) Sales Gross margin (25%) S & G.A. (10%) Profit before tax Tax Net profit Income Statement Projections 1 2 3 4 5 Residual Value 5+ 1000 250 100 150 60 1100 275 110 165 66 1210 303 121 182 73 1331 333 133 200 80 1464 366 146 220 88 1611 403 161 242 97 1611 403 161 242 97 90 99 109 120 132 145 145 Balance Sheet Projections Fixed assets Current assets 300 200 330 220 363 242 399 266 439 293 483 322 483 322 Total assets Equity 500 500 550 550 605 605 667 667 732 732 805 805 805 805 © Centre for Financial Management , Bangalore
  21. 21. Cash Flow Projections Profit after tax Depreciation Capital expenditure Increase in urrent assets c 99 30 60 20 109 33 66 22 120 36 72 24 132 40 80 27 145 44 88 29 Operating cash flow 49 54 60 65 72 Present value factor (at 16% discount) Present value of the operating cash flow 0.862 0.743 0.641 0.552 0.476 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- trategy value = 90/0.16 = 563 s Value of the strategy = 621 563 = 58 – © Centre for Financial Management , Bangalore 145 48 48 0 145
  22. 22. SHAREHOLDER VALUE MANAGEMENT CYCLE Strategic planning Investor communications Incentive compensation Portfolio review and resource allocation Performance evaluation Source: Alfred Rappaport, Creating Value for Shareholders : A Guide for Managers and Invetsors © Centre for Financial Management , Bangalore
  23. 23. MCKINSEY APPROACH McKinsey & 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 & Company 5. 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
  24. 24. AREAS OF ACTIVITY FOR MAKING VALUE HAPPEN Shareholder Value Aspirations and targets Portfolio management Organisational design Value driver definition Business performance management Metrics Individual performance management Value thinking Mindset Source: Tom Copeland et.al Valuation Measuring and Managing the Value of Companies, 3rd Edition. © Centre for Financial Management , Bangalore
  25. 25. 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 EVA = PAT- k EQUITY e (33.10) (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 © Centre for Financial Management , Bangalore
  26. 26. BALANCE SHEET AND PROFIT AND LOSS ACCOUNT BALANCE SHEET AS ON 31.03.2000 LIABILITIES ASSETS PROFIT & LOSS STATEMENT FOR THE YEAR ENDING 31.03.2000 NET SALES EQUITY 100 FIXED ASSETS 140 DEBT 100 NET CURRENT 60 300 COST OF GOODS SOLD 258 COE = 18% COD = 12 (1 - 3) = 8.4% PBT 30 9 PAT 200 12 TAX 200 42 INTEREST ASSETS PBIT 21 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 EVA EVA = 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
  27. 27. NUMERICAL ILLUSTRATION OF VALUE CREATING STRATEGIES BASE CASE CAPITAL : NOPAT : c* : r : 10,000 2,000 15% 20% EVA = CAPITAL x (r - c*) = 10,000 (0.20 - 0.15) = 500 STRATEGY 1 : IMPROVEMENT IN OPERATING PERFORMANCE NOPAT 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 INVESTMENT A 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 CAPITAL 1000 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 CAPITAL THE 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
  28. 28. 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, offbalance 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. © Centre for Financial Management , Bangalore
  29. 29. 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 © Centre for Financial Management , Bangalore
  30. 30. RESTRUCTURING CHARGES APEX 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 CAPITAL DEPR’N CAP. CHARGE SUM SFM 1 2 3 4 5 100000 20000 15000 35000 80000 20000 12000 32000 60000 20000 9000 29000 40000 20000 6000 26000 20000 20000 3000 23000 SINKING FUND DEPR’N (AMORT’N DEPR’N) CAP. CHARGE 15000 DEPR’N 14833 SUM 29833 A x PVIFA (5, 15%) = 100000 12775 10216 17058 19617 29833 29833 A x 3.352 = 100000 7273 3890 22559 25943 (PRINCIPAL AMORT’N) 29833 29833 A = 29833 © Centre for Financial Management , Bangalore
  31. 31. EVA APPLICATIONS • FIRM GOALS TRADITIONAL FIN. MGT EVA BASED FIN. MGT REVENUES PROFITS, EPS EVA • BUSINESS PLANS - DO - • DIVISIONAL PERF. DIVISIONAL PROFITS MEASUR’T EVA EVA ROI • CAPITAL BUDGETING DCF EVA • PERFORMANCE TARGET NEGOTIATED PROFIT FORMULA-LINKED EVA TARGET • INCENTIVE COMPEN’N SMALL & RANGE BOUND UNLIMITED & EVALINKED • FINANCIAL STR’RE STATIC DYNAMIC WHY EVA TIES DIRECTLY WITH SHW CREATION CONVERTS ACCTG INF’N . . ECONOMIC REALITY . . READILY GRASPED PROVIDES A SINGLE UNIFIED MEASURE FOR ALL PURPOSES MAKES MANAGERS INTO OWNERS SERVES AS AN ANCHOR FOR CORPORATE GOVERNANCE © Centre for Financial Management , Bangalore
  32. 32. EVA APPROACH TO VALUATION 1 2 3 4 5 6 7 NOPAT 6.0 7.2 8.6 10.4 11.6 13.0 14.1 BEG. CAP 50 60 72 86.4 96.8 108.4 117.1 X C* 11% 11% 11% 11% 11% 11% 11% CAP. CHARGE 5.5 6.6 7.9 9.5 10.6 11.9 12.9 EVA 0.5 0.6 0.7 0.9 1.0 1.1 1.2 PV FACTOR .901 .812 .731 .659 .593 .535 PV OF EVA .45 .49 .51 .59 .59 .59 GROWTH (%) 20 20 20 12 12 8 8 VALUE OF THE COMPANY = BEG. CAPITAL + PV OF EVA STREAM 6 PV OF EVA STREAM EVAt = Σ t=1 EVA7 + (1+k)t = 1.2 / [0.03 x (1.11)6] = 21.4 (K-G)(1+K)6 VALUE OF THE COMPANY = 50 + 24.6 = 74.6 © Centre for Financial Management , Bangalore
  33. 33. EVA & MVA EVA 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 M A R K E T V A L U E M V A C A P I T A L EVA1 + (1+c*)1 C A P I T A L MV Lost EVA2 +…… (1+c*)2 2 EVA + EVA 2 1 1 (1+c*) (1+c*) +… Market Value © Centre for Financial Management , Bangalore
  34. 34. CAPITAL BUDGETING WITH EVA INVESTMENT : 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 20 100 75 50 25 • CAP. AT CHARGE • CAP. CHARGE 15 • CASH FLOW (PAT + DEP) 7.5 3.75 5 • EVA 11.25 8.75 12.5 16.25 45 45 45 45 CFt NPV = Σ - I = 128.475 - 100 = 28.475 (1+k) t EVA t NPV = Σ = 28.475 (1+k)t © Centre for Financial Management , Bangalore
  35. 35. 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. © Centre for Financial Management , Bangalore
  36. 36. BONUS BEHAVIOUR A : Traditional bonus plan B : EVA bonus plan Bonus Bonus 80% 100% 120% Target EVA © Centre for Financial Management , Bangalore
  37. 37. BONUS BANK SYSTEM NORMAL YEAR GOOD YEAR BAD YEAR 50 200 -100 BEGINNING BANK 100 100 200 CUMULATIVE BALANCE 150 300 100 PAYOUT RATIO 1/3 1/3 1/3 50 100 33 1/3 100 200 66 2/3 BONUS EARNED BONUS PAID BONUS FORWARD BONUS = a1 . CHANGE IN EVA + a2 . EVA IF EVA . . - a2 = 0 • LINKED . . a1 > > a2 . . INCENTIVE EVA • NO CAP / FLOOR • FORMULA © Centre for Financial Management , Bangalore • BANK
  38. 38. THE TWO FINANCIAL PARADIGMS EPS BASED FINANCIAL MANAGEMENT SYSTEM EVA BASED FINANCIAL MANAGEMENT SYSTEM MANAGEMENT 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 • ACQUIRE COMPANIES THAT AUGMENT VALUE STAKEHOLDERS • BUY COMPANIES WITH LOWER P/E MULTIPLES TO BOOTSTRAP EPS • NEGOTIATE DIVISION PROFIT TARGETS • AWARD MODEST TARGET LINKED BONUSES DEFINE EVA TARGETS BY FORMULA • MAKE BONUS VARIABLE BOTH WAYS • MADE SENSE IN • IN THE STABLE BUSINESS ENVIRONMENT THAT MAKES SENSE IN • 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 © Centre for Financial Management , Bangalore
  39. 39. 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 © Centre for Financial Management , Bangalore
  40. 40. PROBLEMS IN USING EVA • Disincentive for collaborative relationship • Imperfect measure • Underinvestment • Difficulties in divisional performance measurement © Centre for Financial Management , Bangalore
  41. 41. 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 © Centre for Financial Management , Bangalore
  42. 42. TOTAL SHAREHOLDER RETURN Total 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 value TSR = + Beginning market value Beginning market value The TSR for a multiple holding period is computed using the conventional internal rate of return computation Beginning market value Dividend1 Dividend2 + = (1 + TSR)1 + Dividend n + (1 + TSR)2 + …. (1 + TSR)n Ending market value in year n (1 + TSR)n © Centre for Financial Management , Bangalore
  43. 43. 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 © Centre for Financial Management , Bangalore
  44. 44. TOTAL BUSINESS RETURN The total business return (TBR) is the internal counterpart of TSR. The link between TSR, TBR, and value drivers is shown below. Total Shareholder Return Total Business Return Capital gains Return on invested capital Free cash flows Growth in new investments Measured as Cash flow return on investment © Centre for Financial Management , Bangalore
  45. 45. TBR The TBR for a single holding period is computed as follows: Free cash flow TBR = Beginning value Ending value – Beginning value + Beginning value The TBR for a multiple holding period is measured using the conventional internal rate of rate computation: Beginning value = Free cash flow1 + (1 + TBR) + Free cash flow2 (1 + TBR) 2 Free cash flown (1 + TBR) n + …… + Ending value in yearn (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 Value Value Value = = = = Earnings x P/E multiple Book value x M/B multiple Free cash flow ÷ cost of capital NPV of expected cash flow
  46. 46. USES OF TBR BCG uses TBR for • Strategic planning • Resource allocation • Incentive compensation © Centre for Financial Management , Bangalore
  47. 47. RESOURCE ALLOCATION PERSPECTIVE Positive Question Current CFROI vs cost of capital High priority for reinvestment 0 Do not fund Negative Negative Question 0 Positive TBR of business plan versus target TBR © Centre for Financial Management , Bangalore
  48. 48. 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, CFROI = Cash flow - Economic depreciation Cash invested Note that economic depreciation is the amount of annual sinking fund payment earning capital cost required to replace assets. 9 To 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 Economic depreciation = Rs 250,000 = FVIFA (14, 10%) = Rs 8,937 27.975
  49. 49. ILLUSTRATION OF CFROI To 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: NOPAT Return on capital employed (ROCE) = Book capital Return on gross investment (ROGI) = Cash flow Cash invested © Centre for Financial Management , Bangalore
  50. 50. 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. 38,937 300,000 = 38,937 + (1 + r) r works out to 10 percent. 38,937 + 50,000 + ….. + (1 + r)2 (1 + r)14 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. © Centre for Financial Management , Bangalore
  51. 51. 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, CVA = Cash – Economic – Capital charge on gross flow depreciation investment © Centre for Financial Management , Bangalore
  52. 52. 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 21,080 300,000 10% 30,000 21,080 210,715 10% 21,072 21,080 103,573 10% 10,357 8 10,732 21,080 21,080 21,080 17,857 38,937 8,937 300,000 10% 30,000 17,857 38,937 8,937 300,000 10% 30,000 17,857 38,937 8,937 300,000 10% 30,000 0 EVA (1 - 4) YEAR 12 (8,920) 1. NOPAT 2. BOOK CAPITAL (BEG.) 3. COST OF CAPITAL 4. CAPITAL CHARGE YEAR 6 0 0 PANEL B : CVA 1. NOPAT 2. DEPRECIATION 3. CASH FLOW 4. ECONOMIC DEPR’N 5. CASH INVESTED 6. COST OF CAPITAL 7. CAPITAL CHARGE CVA = (3 - 4 - 7) CVA = OPERATING CASH FLOW - ECONOMIC DEPR’N - CAPITAL CHARGE ON THE FULL CASH INVESTED © Centre for Financial Management , Bangalore
  53. 53. 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
  54. 54. POTENTIAL • MOST COMPANIES…. SUBSTANTIAL PHYSICAL ASSETS… LOW PDY… CAP • PELL MELL DIVERSIFICATION • DISMAL DECADE (1992-2002) FOR EQUITIES © Centre for Financial Management , Bangalore
  55. 55. 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 © Centre for Financial Management , Bangalore
  56. 56. 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. © Centre for Financial Management , Bangalore
  57. 57. 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. © Centre for Financial Management , Bangalore
  58. 58. • 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. © Centre for Financial Management , Bangalore
  59. 59. • 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. © Centre for Financial Management , Bangalore

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