This document discusses methods for evaluating manager performance and value creation for shareholders, including total shareholder return (TSR), market value added (MVA), and residual income (RI). It defines these terms and provides examples of how to calculate them. The key points are that RI is a better measure than profit alone because it considers the cost of capital; a project can be profitable but destroy value if returns are below the cost of capital; and while the present value of RI over time equals NPV, individual period RIs can be biased estimates of value creation.

1. Residual Income
and NPV
The ex-post evaluation of
project selection

2. Two important questions
 How do we motivate managers to create
shareholder value?
 How do we evaluate their performance in
terms of value creation.

3. TOTAL SHAREHOLDER RETURN (TSR)
TSR= Dividend per share + (share price at end of period – initial share price)
Initial share price
A share rises in price over a year from 1 to £1.10 and a 4p dividend is paid at the end of the year:
110 − 100 + 4
TSR = = 14%
100

4. Issues to be borne in mind when making use of
TSR:
1 Relate return to risk class
2 It measures in percentage not absolute terms
3 TSR is dependant on the time period chosen

5. Illustration of TSR
Year TSR Value of €1m investment at t0
1 +6% 1.06m
2 -40% 0.636m
3 +50% 0.954m
4 +4.822% 1.0m
Sum of Annual 20.8%
Returns
Holding Period 0%
Return 1.06 x 0.6 x 1.5 x 1.04822 = 1.0

6. MARKET VALUE ADDED (MVA)
MVA = Market value – Capital
Market value = Current value of debt, preference shares or ordinary shares.
Capital = All the cash raised from finance providers or retained from earnings
to finance new investment in the business, since the company was founded.

7. Illustration of MVA
Spiggle plc was founded 10 years ago.
Equity finance was £15m.
It has no debt or preference shares.
All earnings have been paid out as dividends.
The shares are now valued at £40m.
The MVA is therefore £25m:
MVA = Market Value – Capital
MVA = £40m – £15m = £25m
MVA = Ordinary shares market value – Capital
supplied by ordinary shareholders

8. Creating Shareholder Wealth -
Performance Evaluation
 Stock Market Returns
 Affected by more than manager’s
performance
 Not useful at divisional level or when a
company’s stock is not publicly traded
 Cannot be used for the performance of a
division in the company

9. Call in the Accountant
 Earnings Per Share
 Rob the future to pay the present
 The cost of funds is ignored
 The level of investment ignored
 Accounting Rate of Return
 Same problems as above
 Scale difference can cause problems

10. The Solution ?
Economic Profit

11. The Terms
• Economic Profit
• Residual Income
• Abnormal Earnings
• EVA®
are more or less synonymous

12. Residual Income is:
RIt = Xt - rBVt-1
RIt = Residual Income
Xt = Equity Profit
r = Cost of Equity Capital

13. Alternative Formula
 Xt 
RI t =
 BV −r BVt −
 1
 t−1 
=( ROE −r )BVt −1

14. RI is important because
 The Present Value of the Residual income
of a project is equal to its NPV
 The equity value of business can be
expressed as the sum of its Book Value
plus the PV of its future Residual income.
Vt = BVt + PV(RI)
 It can be used to evaluate managers
performance.

15. Time 0 1 2 3 4
Cash Flows -1000 400 400 400 400
Depreciation (1000/4) 250 250 250 250
Profit 150 150 150 150
NPV of Cash Flows @ 10% IR£267.95
BVt-1 1000 750 500 250
Residual Income 50 75 100 125
NPV of RI @ 10% IR£267.95
RI computed assuming S.L. Depreciation

16. RI with Economic Depreciation
Time 0 1 2 3 4
Cash Flows -1000 400 400 400 400
Value of project 995 694.21 363.64 0
Depreciation 5 300.5 330.6 363.6
Profit 395 99 69 36
NPV of Cash Flows @ 10% 267.95
BVt-1 1,000.00 994.741 694.215 363.6 0
Residual Income 294.741 0 0 0
NPV of RI @ 10% 267.95

17. Illustration of why Profitable
Projects don’t always create value
 Let us assume that a company needs to
invest €500M in a project that lasts 5
years. The table below shows the
project to be profitable. However, the
ROR is just equal to the cost of capital and
RI is therefore zero. This means that the
project just earns a fair rate of return and
its NPV is zero.

18. Time 0.00 1.00 2.00 3.00 4.00 5.00
Cash Flows -500.00 145.00 136.00 127.00 118.00 109.00
Depreciation (1000/5) 100.00 100.00 100.00 100.00 100.00
Profit 45.00 36.00 27.00 18.00 9.00
NPV of Cash Flows @ 9%0.00
BVt-1 500.00 400.00 300.00 200.00 100.00
ROI 0.09 0.09 0.09 0.09 0.09
Residual Income 0.00 0.00 0.00 0.00 0.00
NPV of RI @ 9% 0.00

19. A profitable profit that destroys
value!
 The next slide shows how a profitable
project may destroy value.
 If the profits are not sufficient to cover the
cost of capital NPV will be <0.
 Take the previous example and reduce
profits – note no losses are made. ROE is
sometimes < cost of capital

20. Time 0.00 1.00 2.00 3.00 4.00 5.00
Cash Flows -500.00 140.00 130.00 120.00 110.00 101.00
Depreciation (1000/5) 100.00 100.00 100.00 100.00 100.00
Profit 40.00 30.00 20.00 10.00 1.00
NPV of Cash Flows @-25.91
9%
BVt-1 500.00 400.00 300.00 200.00 100.00
ROI 0.08 0.08 0.07 0.05 0.01
Residual Income -5.00 -6.00 -7.00 -8.00 -8.00
NPV of RI @ 9% -25.91

21. Advantages of RI
 It is clearly linked to value creation (NPV)
 It makes managers aware that capital is
not free

22. Limitations of RI
 Book values are not equal to market values so the
anticipated RI will be greater than zero. Thus if a
positive RI is achieved it could mean that book value
understates true value or that wealth is created. Put
another way RI suffers from the same allocation
problems as Accounting. How do you accurately
measure value created over a short period of when value
depends on what is going to happen over a much longer
time frame.

23. Limitations Continued
 Thus, while the PV of all the RI s over a
period is the measure of wealth created.
RI s for any individual period can be
seriously biased.