Value based divisional performance Flashcards
(5 cards)
Cash v Profit
Managers are motivated and incentivised by profit whilst shareholders are motivated by growth in market value of shares
Profit is short term so focus is on ROI/RI whilst shareholders dividend is stimulated by cash.
Shareholders are motivated by growth in market value of shares. Dividend and growth are stimulated and need cash. focus is on long-term.
Shareholder value added -
definition,
drivers - ROTCICP
Target evaluation
Value based techniques are of the idea to set targets for managers that align with shareholders interest,
SVA suggests 7 value drivers and the business would set targets in each area that would be specific, measurable, achievable, controllable and measurable.
These drivers are the components of a typical NPV calculation hence linking targets to cashflow and NPV and so Market value of shares. The targets need to be evaluated based on controllability and usefulness
Drivers/Comments
1. Revenue - controllable and a good target area
2. Operating Margin - margin is important and controllable
3. Tax rate - exogenous as tax planning is carried by H/O and govt
sets rate
4. Capital expenditure - poor cheap and poor quality assets might be desirable
5. Investment in working capital - good working capital management is good for cashflow
6. Cost of capital - cheap borrowing is desirable, raising finance is
mostly carried out by H/O
7. Period of growth in new projects - Longevity is not overly useful,
growth is positive
Value based management
Four steps of VBM - STOP
Implementation Issues
when should a business implement VBM
Changes needed to implement VBM
Exam notes
Value is shareholder value or value in the businesses. it is the management of the company to create more value. shareholder value is created by cash and growth over the long term.
shareholder value is determined by the P.V of cashflows generated by a business discounted at the cost of money into perpetuity
VBM is an approach to performance management that increases shareholder value whilst EVA is a performance metric that measures shareholder value.
VBM is about setting targets for the things that drive value in the business.
value drivers are activities linked to shareholder value which managers can influence and is cascaded down o managers and employee objectives. Individual employee objectives is linked to shareholder value
The main thing is managers have to ask themselves how to generate cash and grow the business in the long term.
Four steps of VBM
1. Strategic development - strategy, business objectives and high
level drivers
2. Target agreed and set - For each driver a target is set, consistency
is key. short and long term must be considered - excessive focus
on long term can leave org short of cash and failure
3. operational ownership - each target is allocated to a responsible
individual, driven all the way to every employee
4. Performance is measured in the PMS
The big shift is emphasis on the creation of long term shareholder value as the focus of measures and there must be consistency between all four steps.
Implementation issues
1. cultural shift will be required which people may resist
2. New systems might be needed to capture and report KPI
3. New KPI’s will be needed for each driver, which may be difficult to get right.
Exam Slide - Evaluation for if VBM is ideal for the company
1. Check if Performance, share price, shareholder value is down-
VBM can turn it around by bringing focus on shareholder value.
2. Is the current performance metric is ROCE or Net profit then
shareholder value is not aligned with org’s main objective. ROCE is
profit based, companies should use value based metrics instead.
3. If Net profit margin is how business unit managers performance
are assessed or as primary objective
Changes a business should make to adopt VBM
1. Company will need to change its performance metrics - EVA
2. Company will need to create a framework for value drivers - give an example of value drivers and link to company
3. Company will need to assign new targets and KPI’s.
4. Company will need new information - New info systems to capture
the data required to move from profit based measures.
Economic value added -
Definition
Objectives
proforma,
adjustments
WACC formula
Positives
Negatives
EVA is theoretically the increase in market value of the business due to action of directors in managing the businesses results, it ignores M.V changes due to exogenous factors. it is a measure of performance in last 12 months not a decision making tool
Objectives - last 12 months
1. To provide a measure of returns more consistent with cashflows
2. to encourage a long term view
3. to reduce focus on book value of asset used in ROI/RI and move
towards M.V
Proforma
Cash profit (NOPAT) X
WACC on MV of assets (X)
EVA X
Use M.V of assets at the beginning of the year, positive value = value added, negative value -= value destroyed
Adjustments - Two adjustments for NOPAT and capital employed
1. Economic depreciation is used instead of depreciation (cost)
2. add tax relief from debt interest (cost)
3. Tax paid deducted
4. Any tax relief on interest added to above tax paid (show
separately)
5. Provisions are not allowed, add them back to capital employed
and P&L. Use closing balance to find P&L. OB - CB = P&L
6. Brand based marketing can be capitalised and amortised .
Advertising is expensed
7. Research is capitalised and amortised (amortisation is based on year end numbers and product must be complete for it to begin).
Adjustments to asset values - Capital employed
1. Opening asset values to be used
2. Replace BV of NCA with MV
3. Remove opening provisions
4. Capitalise brand based marketing and R&D for previous periods not opening period, as only treating opening balance
WACC calculation
=Equity % * Ke + Debt % * Kd(1-t)
Positives
1. Provides a cash focussed return, reconciles profit motivations to cash motivations
2. Removes the shortermist temptations around marketing and
R&D
3. Moves from B.V to M.V
4.more closely aligns performance appraisal to shareholders needs
5. Clear positive is good and negative is bad
Negatives
1.Very complicated to calculate
2. Information not always readily available
3. Trademarked by Mckinsey
4. Economic depreciation is difficult to estimate
5. EVA is an absolute number so it is difficult to compare with other companies or divisions
Exam Slide
- Attempts to align divisional performance measurement to
shareholders needs. - Increase the cash focus and the focus on drivers of performance
- Long term emphasis stressed
- EVA is the primary focus in exams
- If an EVA adjustment is not mentioned by examiner, then ignore
it - Some EVA adjustments try to adjust profit into cash
- Some adjustments try to focus on long term rather than short
term
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