Author: Patrick Cote
Contributors: Kate McGreevy
Julian Critchlow
�bc
Corporate Performance
Measurement
April 1999
Copyright© 1999 Bain & Company,
Inc.
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•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
Agenda
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•Corporate performance evaluation has evolved from the 1960s focus on ROE to
the current variations of economic profit that measure impact on shareholder
value
–many firms have devised their own variations of economic profit
–Stern Stewart’s Economic Value Added (EVA)TM is best known of these
measures
–Holt/BCG’s Cash Flow Return on Investment (CFROI) is a similar concept
presented in % return format
•Both ROE and EP are business metrics, tools used to measure the performance
of the business
–separate from fundamental business drivers, the actual factors that influence
shareholder value, and output measures the backward-looking records of
overall company performance
•Focusing on EP instead of ROE decreases the likelihood of destructive behavior
by managers
–By evaluating managers based on EP, manager behavior can be altered such
that only projects that add value (with NPV>0) are undertaken, which does not
always occur with ROE
Executive Summary (1 of 2)
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Executive Summary (2 of 2)
•End goal of EP exercises is consistent with traditional Bain
focus of maximising shareholder value
–Bain has measured historical performance with Total
Shareholder Return
–Stern Stewart devised Market Value Added (MVA) TM as
means of measuring market expectations of EP that
managers will add in the future
–managers’ objective should be to maximise MVA
•All economic profit measures deduct charge for use of
equity capital from accounting’s typical net income or profit
after tax to reflect the opportunity cost associated with
equity investments
–Stern Stewart has trademarked EVA TM by specifying
adjustments to make to EP
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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Objectives
There are three objectives of the Corporate
Performance Measures Module:
•To define the most popular measures of corporate
performance
•To explain the significance of these measures in the
corporate environment and potential applications in
Bain’s strategy work
•To outline calculations of each performance measure
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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•With the rise of conglomerates, most companies focused on
Return on Equity, or ROE, as their primary measure of
performance
–led most managers to undertake acquisitions solely to
manipulate accounting figures
1960 s/70s
1980 s/90s •With the increased focus on delivering shareholder value,
managers have accepted systems that measure the change in
value
–managers realised equity is not free
–economic profit (EP) meets these needs by telling managers
where value has been created and where it has been
destroyed
•As aligning interests between owners and managers has
become more important, tying management compensation to
EP provided a popular solution
Corporate performance evaluation has evolved from
the 1960s focus on ROE to the current variations of
economic profit (EP) that measure impact on
shareholder value
Background
Corporate Performance Evaluation
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•Bain was the first of major consulting firms to focus on
creating shareholder value
•To achieve this, Bain has used the output measure of Total
Shareholder Return and the accounting measures of ROE and
ROI
•Modified accounting measures, such as EP, provide an
alternative means of measuring the creation of shareholder
value
Background
Relevance to Bain
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•To illustrate the role of corporate performance measures and
resource allocation to strategy work, an examination of Marakon’s
“program” is useful
•Marakon applies the following program, which can take several years
to complete, to all of its clients:
–assess the economic profit of all customer segments and product
lines
–compare company performance to industry performance
–investigate three or more strategies for each business every
planning cycle
–shift resource allocation from economically unprofitable
products/customers to economically profitable
–leads to yield loss for Marakon and clients since additional
scenarios frequently evaluated
Marakon has made economic profit (EP) the
central focus of the ‘program’ they apply to
every case
Background
Link to Strategy
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EVA is a registered trademark of Stern Stewart
•A century ago, Alfred Marshall explained that for a company to
have genuine profits, the profits must be sufficient to cover
the cost of capital as well as the firm’s operating costs
•Stern Stewart has re-packaged the concept into EVA � , which is
essentially a more palatable form of the same idea
•McKinsey has been using economic profit for many years
•BCG uses Cash Flow Return on Investment (CFROI) for a similar
analysis
•To avoid infringing upon Stern Stewart’s trademark, many
consulting firms have developed their own terms for the same
concept
How new is
Economic
Value
Added �
(EVA � )?
EVA TM is one variation of EP
Background
Economic Value Added
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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Measures
* For a discussion of WACC and discount rates, please see the Investment Appraisal Module in the BVU
Descriptio
n:
EVA/MVA � ,EP,and CFROI are modified
accounting measures used to measure the
performance of the business
Inputs/
Measures:
Fundamental
Business
Drivers
Business Metrics Output Measures
•Primary business-
specific factors
influencing
shareholder value
•Tools used to
measure
performance of
business
•Backward-looking
measures of overall
company
performance as
viewed by market
•Operating profits
–volume
–price
–costs
•Financial Cost of
Capital Employed
–fixed assets
–working capital
–WACC*
•Accounting
–ROE
–ROA
•Modified
accounting
–EVA � /MVA �
–EP
–CFROI
–CVA
•Total Shareholder
Return (TSR)
•Total Business
Return (TBR)
Framework
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The fundamental business drivers provide a
framework for identifying the sources of
shareholder value creation or destruction
Shareholder Value
Creation/Destruction
Operatin
g Profit
Cost of
Capital
Volume Price Costs Workin
g
Capital
WACCFixed
Assets
X + X
•Direct costs
–material
–labour
•Indirect costs
–SG & A
–Depreciatio
n
•Average
selling
price
•# of
units
sold
•Weighted
average cost of
capital based on
market values of
debt and equity
•Use after-tax
cost of debt
•Current
assets
less
current
liabilities
•Property,
plant &
equipmen
t
•Intangible
s
•LIFO vs FIFO
•Depreciation
estimates
•Cost of equity
for private
firms
•Intangible
measurement
Components:
Issues:
Framework
Fundamental Business Drivers
14CorporatePerformanceMeasurement
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ROE measures returns to shareholders, while
ROA measures returns to investors of all forms
of capital
Formula:
Measures:
ROA
Profitability of all capital
employed, including
debt
Uses:
Return on Assets
(ROA)*
Return on Equity
(ROE)
Net
IncomeAssets
= ROE
Net Income
Equity
=
Profitability of equity
invested in business (net
equity issued plus
retained earnings)
Returns of enterprise as
a whole
Returns to shareholders
Framework
Accounting Business Metrics
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The DuPont formula is used to separate ROE
into its components in order to assess the
performance of the business
ROE
Net
Income
Equity
=
Net
Income
Sales
=
Sales
Assets
Assets
Equity
X X
ROS Asset
Turnover
Leverage
ROE = Profitabilit
y
Asset
Turnover
LeverageX X=
ROA
Framework
Accounting Business Metrics - DuPont Formula
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Many consulting companies attempt to brand
the modified accounting business metrics they
use
•Economic Profit
Measure Consulting Companies
•Bain
•McKinsey
•Marakon (through Value-Based
Management)
•LEK
•EVA � / MVA � •Stern Stewart
•AT Kearney
•Accounting firms
•BCG
•Holt
•BCG
•Cash Value Added*
(CVA)
•Cash Flow Return on
Investment (CFROI)
Framework
Modified Accounting Business Metrics
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The modified accounting business metrics, which include EP,
enable relatively accurate levels of corporate performance
measurement at lower levels of decision making in the
organisation
Accuracy as
Measure of
Corporate
Performanc
e
Level of Decision Making
High
Low
Low High
MVA �
Modified
Accountin
g Business
Metrics
TSR*
ROE/ROA
Fundamental Business
Drivers
EP/EVA � /CFROI
Role in Organisation
Framework
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While TSR calculates return to shareholders for
publicly-listed companies, BCG’s TBR calculation
estimates equivalent returns for privately-held
firms
Total
Shareholder
Return (TSR)
in CAGR
Format
Market value of share
at end of period *
Market value of share
at beginning of
period
=
Total
Business
Return (TBR)
=
Estimated market value of
shares of privately-held
company at end of period*
numbe
r of
years
1
number
of
years
1
1
1
Estimated market value of
shares of privately-held
company at beginning of
period*
Framework
Output Measures
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Bain’s client stock performance slide is
calculated using TSR, which is used to
measure the shareholder value created
Framework
Output Measures
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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Market
Value
Added
(MVA)
Invested
Capital
Goal of Managers
should always be to
create more
shareholder value, or
maximise MVA
Total Market Value of Firm
(includes all debt and
equity)
Bain’s focus has always been to help the
management of the firm to maximise
shareholder value, which is equivalent to
maximising MVA
Market Value Added
Definition (1 of 2)
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MVA equals the total market value of the
company less invested capital or net assets.
Either the Operating or Financing Approach can
be used, but Bain typically uses the Operating
approach
Note: *Short-term non-interest bearing liabilities
Operating Approach (Typically used by Bain) Financing
Approach
Market Value Added
Definition (2 of 2)
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The first step required to calculate Net Assets with the
Operating Approach is to identify excess cash, which
is total cash less cash required in the operating cycle
Note: *Short-term non-interest bearing liabilities
Amount ($)
Market Value Added
Operating Approach - Excess Cash
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Next, The working capital requirements are the firm’s
net investments in the operating cycle, or the net
amount of short-term investment required to fund
operations
Amount ($)
Working
Capital
Requirements
Market Value Added
Operating Approach - Working Capital Requirements
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When calculating MVA, Net Fixed Assets is defined as Net
PP&E plus other Investment (tangible and intangible). The
third and final step to calculate Net Assets is Net PP&E,
which is the amount of long-term investment required to
fund operations
Amount $
Net PP&E
Market Value Added
Operating Approach - Net Fixed Assets
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Market value added (MVA) reflects the markets
expectations of the EP managers will add in the
future
P
e
r
c
e
n
t
o
f
T
o
t
a
l
MVA is the
market’s
expectation
of
discounted
future EPs
Market Value Added
Link to EP
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After extensive work by a diligent Bain team, Acme
Industries is expected to generate $25M in economic
profits next year, which is expected to grow at 3%
forever. If the cost of capital is 13% and the invested
Capital is $100M, what is the MVA and the market
value of the company?
Market Value Added
Link to EP - Example
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After extensive work by a diligent Bain team, Acme
Industries is expected to generate $25M in economic
profits next year, which is expected to grow at 3%
forever. If the cost of capital is 13% and the invested
Capital is $100M, what is the MVA and the market
value of the company?
MVA = PV of EPs
= $ 25 M
13% - 3%
= $ 250 M
= MVA + Invested Capital
= $ 250 M + $100 M
= $350 M
Market Value of
the Company
Market Value Added
Link to EP - Solution
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EP measures managers’ performance in the past,
since it represents the market value added created
over one year
Note: *Assumes Invested Capital Constant
Market Value Added
Link to EP (1 of 2)
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EP is used to evaluate manager
performance because the change in MVA
over a period of time is measured
•Goal of company’s managers should always be to
maximise MVA
•When managers make any investment decisions, if
the project is:
–value-creating NPV >0 MVA increases
–value-destroying NPV <0 MVA decreases
•Reason that EP is the focus of most attention is
because MVA is a stock or wealth measure, so MVA
will show how much value has been added at that
point in time
–EP measures the amount of value added over a
period of time, which is far more useful when
measuring manager performance
Market Value Added
Link to EP (2 of 2)
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•Which UK sectors would you expect to
have the highest market value added?
–and the lowest?
•Which UK companies would you expect to
have the highest market value added?
–and the lowest?
Market Value Added
Actual Performance
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Banks, integrated oil and drugs were the
UK sectors with the highest market value
added
Source: Stern Stewart, Sunday Times
Sector
Market
Value
Added
(Sept
98)
Market Value Added
UK Sector Performance - 10 Best
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Distributors, print and packaging and
construction had the lowest market
value added in the UK
Source: Stern Stewart, Sunday Times
Sector
Market
Value
Added
(Sept 98)
Market Value Added
UK Sector Performance - 10 Worst
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Shell’s £ of market value added is the largest in the UK
Source: Stern Stewart, Sunday Times
Company
Market
Value
Added
(Sept 98)
1998 EVA �
(£B)
() () n/a
Market Value Added
UK Company Performance - 10 Best
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British Steel’s £3B of market value destroyed
was the worst of Britain’s 200 largest
companies
Source: Stern Stewart, Sunday Times
Company
Market
Value
Added
(Sept 98)
1998 EVA �
(£B)
()()()()()()()()()()
Market Value Added
UK Company Performance - 10 Worst
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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•Definition
•Advantages/Disadvantage
s
•Framework
•Use in Strategy Work
Economic Profit
Agenda
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Definition (1 of 2)
Note: Economic Profit (EP) =Operating Profit - (Cost of Capital * Amount of Equity Capital Invested)
Economic Profit (EP) is a residual profit concept
accounting for the opportunity cost of holding
capital
A
m
o
u
n
t
(
$
)
Tradition
al
accountin
g concept
of profits
Economic Profit
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Definition (2 of 2)
Note: NOPAT = Net Operating Profit After Tax (See Appendix for details)
WACC = Weighted Average Cost of Capital
Economic Profit determines a company’s
value creation or destruction
•Easy to use, based on accounting
records (for historical values)
•Not prisoners of GAAP
•Can be used to show relative
performance of products,
segments, regions, etc. in a given
year
•Can be calculated for future years
and discounted to show value
creation
•When Economic Profits are
positive over time
–value creation is positive
–market price per share is more
than book value per share
–growth creates value
EP
NOPAT
$ Charge
for
Capital
Employe
d
Operating
Profit
Effective
Taxation
Invested
Capital
WACC
Gross Profit
A&P
Net Working
Capital
Net Fixed
Assets
Overheads
Economic Profit
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In order to understand EP it is important
to go back to the basic income statement
What did we earn?
(using what we
own)
I
n
c
o
m
e
S
t
a
t
e
m
e
n
t
(
%
)
Who gets access
to these
earnings?
$10
0
$10
0
EBIT
PAT
Tax
Interes
t
Observation
s
•Debt providers have first
access to the interest
payments due on money lent
•Governments tax corporate
profits
•Shareholders (equity
providers) have access to
all residual profits (after
paying interest and tax)
Note: Economic Profit (EP) = Operating Profit - (Cost of Capital * Amount of Capital Invested)
Key Principles: Access to Company Earnings
Economic Profit
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Note: NIBL = Non-interest bearing liabilities
•Assets are a company’s economic
resources, items which have the
potential to provide future benefits
to the organisation
•NIBLs represent a free source of
funds to the company. It is money
lent to a firm with no charge or
expected return
•Debt is any interest bearing
capital, including preferred stock
•Shareholder's Equity is the
accountant's estimate of the value
of the shareholder's investment in
the company
–total assets less total liabilities
Key ObservationsBalance Sheet Makeup
What do
we own?
Assets
NIBLs
Debt
Shareholder's
Equity
How did we
pay for it?
$500 $500
100%
Balance
Sheet
The balance sheet separates what is
owned by the firm from how it was paid
for
Understanding the Balance Sheet
Economic Profit
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Economic Profit Balance Sheet
Note: NIBL= Non-interest bearing liabilities
In order to develop the EP balance sheet, short-term
non-interest bearing liabilities must be removed and
adjustments for accounting distortions must be made
•Short-term NIBL
are removed from
the EP balance
sheet since capital
returns are not
expected on the
amounts owed
(. wages
payable)
•EP Balance Sheet
Net Assets amount
may be much
larger than the
traditional
accounting value
after adjustments
for accounting
distortions (.,
adding internally-
generated
intangible assets)
are made
Regular Balance Sheet
EP Balance Sheet
Financing
Approach
Operating
Approach
Economic Profit
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Dividend Policy
The traditional linkage of the Income Statement and
Balance Sheet is the connection between net income
and retained earnings or dividends
•Income attributable
to shareholders
(EBIT - Interest -
Tax)
•Cash “in”
from
shareholders
perspective
•Cash “out” from
shareholders
perspective
Net Income
Retained Earnings
Dividends
Management
Decision
Reinvest it in the Company
Distribute it to Shareholders
Income Statement and Balance Sheet Traditional Link (1 of 2)
Economic Profit
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Economic Consequence
The traditional linkage of the Income Statement and
Balance Sheet is the connection between net income
and retained earnings or dividends
= Retained
Earnings
= Net
Income
- Dividends
Revenue
- Costs
Income Statement
Balance Sheet
Assets Liabilities
Current
Assets
Net Fixed
Assets
Other
Assets
NIBLs
Debt
Equity
Income Statement and Balance Sheet Traditional Link (2 of 2)
Economic Profit
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•If you could buy the same factory for £100K, but
could only finance 70% with debt and required
equity for the remaining 30%, how much after-tax
profit would you require to break-even?
–assume tax rate = 40%
–assume cost of equity = 15%
Break-Even Example - 70% Debt / 30% Equity Revisited
Economic Profit
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•If you could buy the same factory for £100K, but
could only finance 70% with debt and required
equity for the remaining 30%, how much after-tax
profit would you require to break-even?
–assume tax rate = 40%
–assume cost of equity = 15%
Debt:
Equity:
£70K @ 7%
(£30 @ 15%) (1 -40%)
£
K
£
(cover interest
payments)
(cover equity charge,
which is not tax-
deductible)
•Therefore £ is required to break-even with 30%
equity, compared to £7K with 100% debt financing
•Any after-tax profits beyond £ will be economic
profits
£
�
Break-Even Example - 70% Debt / 30% Equity - Solution
Economic Profit
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Economic Profit
Agenda
•Definition
•Advantages/Disadvantage
s
•Framework
•Use in Strategy Work
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Advantages
Source: Stern Stewart
EP is more successful than other measures in
explaining shareholder returns
TM
Economic Profit
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Advantages (1 of 3)
A manager with high ROE will not undertake
projects with ROE greater than required but
lower than current ROE, creating missed
opportunities
•Managers are typically
evaluated based on maximising
ROE
•A manager with ROE level of R
will not undertake any projects
with ROE < R 1
•Any projects with ROE > R 0 but
ROE < R, will still have positive
NPV but will not be undertaken
by manager
–creates missed opportunities
NPV
0
0 R 1R 0
(after equity
charge)
ROE EP > 0
Economic Profit
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Advantages (2 of 3)
A manager with low ROE will undertake any project
that increases ROE, even if it is below required
level. If project ROE is below required level, value
is destroyed
0
0 Ro
(After equity Charge)
•A manager with
ROE level of R2 will
undertake any
project that
increases ROE
•If any projects with
ROE < Ro are
undertaken, value
is destroyed
NPV
R 2
EP >0ROE
Economic Profit
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Advantages (3 of 3)
Note: * Some projects may have negative EP in early years but large positive EP in later years. To adjust for this, MVA, or
PV and EP can be used
By evaluating managers based on EP, their
incentives will be to focus on all projects that
create value
0
0 Ro
(After equity
Charge)
•By evaluating
managers based
on EP, manager
behaviour can be
altered such that
only projects with
NPV > 0 are
undertaken
NPV
EP <0 Do not
undertake project*
EP >0 Under
take project
ROE
Economic Profit
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Disadvantages
Critics of EP cite under-investment by
managers and size bias as reasons to use
different measures to evaluate managers
Under-investment by Managers
Size Bias
•EP discourages new investments that do not
generate positive returns in initial phases
because manager will be charged for any
capital used from the start of project
–solution is to under-charge capital at start
of project
•EP generally rewards larger divisions because
performance measured by $ generated, not %
•Divisional managers argue that % return is
better measure of their skills than $ return
–$ return is the important measure for
shareholders
–Diageo looks at Operating Economic Profit per
case of spirits to normalise
8ROCE basis
Economic Profit
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Even measures that tie in the asset side of a
company's financial performance need to be
understood carefully...
•Asset revaluations (especially in Australia)
•In general accounting ratios will tend to bias
performance upwards in relation to true economic
returns because they ignore inflation, asset life and
asset mix
•ROE tends to increase due to inflation, which may be
contrary to actual economic performance in real
terms
•Furthermore, the other issue to be aware of is that
older PPE assets tend to generate higher returns
(RONA, ROC, even ROE) because they are more fully
depreciated
•One consequence of this is that companies growing
assets quickly will appear to have a lower return than
those with slow growth
Economic Profit
Beware: Capital is in the Ratio Formula
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By avoiding common pitfalls with EP,
managers can prevent significant over or
under-investment
•Looking at absolute EP levels instead of changes in EP
–business with high EP may under invest and/or become
complacent
•Focusing on current EP levels in highly cyclical businesses
–may lead to significant over or under investment
•Ignoring natural trends in EP that occur in certain
businesses
–. high-tech startup would have low or negative initial
EP that increases over time
Economic Profit
Common Pitfalls
55CorporatePerformanceMeasurement
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Corporate Performance Measurement
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Agenda
Economic Profit
•Definition
•Advantages/Disadvantage
s
•Framework
•Use in Strategy Work
56CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Framework
Note: *Net Operating Profit After Tax
Both the Operating and Financing Approaches
can be applied to the EP framework. These
approaches will give identical EP figures, but
Bain typically uses the Operating Approach
Operating
Approach:
•EP = NOPAT
- (Net Assets
& WACC*)
•Estimate
Weighted
Average Cost
of Capital
(WACC)
•Calculate Net
Assets
•Adjust
Operating
Income (EBIT)
Calculate
NOPAT
Adjust Balance
Sheet
Estimate Cost
of Capital
Calculate EP
Financing
Approach:
•EP = NOPAT -
(Invested
Capital
WACC*)
•Estimate
Weighted
Average Cost
of Capital
•Calculate
Capital
Employed or
Invested
Capital
•Adjust Net
Income
Economic Profit
57CorporatePerformanceMeasurement
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Corporate Performance Measurement
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NOPAT
Note: *Adjustment discussed in Accounting Adjustments section
The Operating and Financing Approaches adjust
different income figures to calculate the same level of
NOPAT
Operatin
g
Approac
h
Financin
g
Approac
h
NOPAT
Calculatio
n
•NOPAT = Operating income
(EBIT)
+ Non-operating
income/(loss)
+ Accounting adjustments*
- Cash operating taxes
•NOPAT = Net income
+ After-tax interest
expense
+ Financing adjustments
+ Accounting
adjustments
Economic Profit
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Corporate Performance Measurement
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Note: NOPAT = Net operating profit after tax; Invested capital = All debt equity invested in format at book value;
WACC = Weighted average cost of capital ROIC = Return on invested capital = (NOPAT / invested capital) also known
as: Return on Net Assets (RONA) or Return on Capital employed (ROCE)
EP can be calculated beginning with either profits,
NOPAT, or returns, ROIC, depending on the availability
of data. The NOPAT method is more commonly used
EP Calculation
Using ROICUsing NOPAT
EP = NOPAT - Capital Charge EP = (ROIC - WACC) * Invested Capital
Spread
between
what is
achieved
and what is
required
Invested
Capital *
WACC
Discount Rates - Framework
Economic Profit
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LON * May be referred to as Return on Capital (ROC) or Return on Investment (ROI)
There are two different frames of reference for calculating the
“economic value” of any business - analogous to the
perspectives used in ROI and ROE analysis
Total Capital Perspective Equity Capital Perspective
Banks and Shareholders Shareholders
EP = NOPAT - (Assets x WACC)
... the "profitability" of
the business from the
frame of reference of
the debt and equity
holders
"... profitability" of the
business from the frame
of reference of the
equity holders
Opportunity cost of the
(blended) debt and equity
capital
Opportunity cost of the
equity capital
"Profitability" is
measured as income
earned less the
opportunity cost of total
capital invested
"Profitability" is
measured as income
earned less the
opportunity cost of
equity capital invested
Stakeholder:
EP definition:
Perspective:
. . . given that,
what is the
frame of
reference?Accordingly
:
Performance
Measurement
Linkages:
- Ratio:
- EP:
Total Capital Spread = ROA -
WACC EP = Total Capital * (ROC-
WACC)
Equity Capital Spread = ROC -
Ke
EP = Equity Capital * (ROC-Ke)
Return on Assets (ROA)* Return on Equity (ROE)Key Ratio:
Discount Rates - Two Different Definitions of EP
Economic Profit
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Discount Rates
Calculate
WACC
Calculate Firm
Tax Rate
Calculate
Industry
Average for
Unlevered b
Determine
Appropriate
Market Risk
Premium
Determine
Market Value
of Debt and
Equity
Determine
Appropriate
Cost of Debt,
K D
Re-Lever Target
Leverage for your
Firm to Calculate
Ke
•Use 10 year T-Bond
or 30 Year T-Bond
less liquidity
premium (of %
for US) for
appropriate country
•Only use
government bonds
if little or no risk of
default for country
in question
•Use long-term
average of
difference
between
expected market
rate of return
and risk-free
rate E(Rm) - Rf
•For US,
Copeland, Koller
and Murrin
recommend 5%
to 6% based on
geometric
average from
1926-1993
•Find comparable
firms for
industry in
question and
unlever b based
on formula*
•Use average of
bu of
comparable
firms
•Use target
leverage in
formula* to
calculate b L
•Once b L
calculated, use
CAPM formula Ke
= Rf + b L [E(Rm)
- Rf] to calculate
Ke
•K D is not
necessarily equal
to coupon rate of
bond (. IBM
2005 % does
not necessarily
have K D = %
•Must calculate or
obtain yield on
outstanding debt
•If not available,
use K D of firms
with similar rating
from agencies
such as Moody’s
or S&P
•Book value of debt
can generally be
used a proxy for
market value of
debt
•Market value of
equity = current
share price
multiplied by # of
shares
outstanding **
•If firm not publicly
traded use P/E
ratios of
comparable firms
•Divide income tax
payable (not
income tax
expense) by net
earnings
• Use WACC
formula:
Where :
E = market value of
equity
D = market value of
client
K E = cost of equity
K D = cost of debt
T = corporate tax
rate
Determine
Appropriate Risk
-Free Rate
Use
Published
Estimates of
b
•Take average of highest
quality sources
•For US firms BARRA
publishes estimates of
b
( )( )E
D+E
D
D+E
Ke + K D (I-T)
Publicly traded:
Non-publicly traded:
Note: ** Since invested capital is calculated based on book value of debt + equity,
WACC can be calculated for EVA purposes with book value weighting
*Bu = Unlevered Beta = BL
1 + (1 tax rate) (market value ÷ of debt market value of equity)
Economic Profit
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EVA � and MVA measures differ from other more
standard Economic Profit and Market/Book
measures primarily due to adjustments to book
capital and earnings advocated by Stern/Stewart
...
Source: The Quest for Value
Stern Stewart’s Stated Objective Key Adjustments
•Make NOPAT a more
realistic measure of the
actual cash yield from
recurring business
activities
•Turn capital into a more
accurate measure of the
base upon which investors
expect returns
•Convert from accrual accounting to
cash accounting
–Reserves, deferred taxes
•Convert from successful efforts to full-
cost accounting
–Cumulative unusual items
•Do not discriminate between tangible
and intangible assets
–Capitalize R&D
–Value brand equity
•Capitalize goodwill (never write off)
•Convert off balance sheet financing to
debt
Economic Profit
Accounting Adjustments
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•High inventory industries
•Consumer goods and services (bad
debt)
•Industries with large deferred tax
reserves (eg . natural resources
companies)
•Industries with short product life
cycles (inventory obsolescence)•R&D intense industries
•Industries with large upfront
marketing investments ( eg .
development of geographic markets)
•Restructuring industries
•Cyclical industries
•Discovery industries (natural resources,
research - intense industries, entertainment,
etc.)
Key Adjustments Highest Impact Industries
•Acquisitive industries
Reserves
Goodwill
Capitalisation of Outlays
Full-cost Accounting
Unusual Items
Capitalisation of Leases •Capital intense industries
For instance, certain adjustments to capital and earnings may
be necessary to normalise industry-specific accounting
treatments and may make comparisons across industries
more meaningful.
Accounting Adjustments - Stern Stewart
Economic Profit
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Equity equivalent reserves gross up the standard
accounting book value for common equity; the
period-to-period change flows through the
income statement
Note: NOPAT is net of depreciation; depreciation is considered a true conomic expense because assets need to be replenished
Source: ‘The Quest for Value’
Additions to Book Capital:
Equity equivalents
Additions to NOPAT:
Change in Equity Equivalents
Deferred Tax Reserve
LIFO Reserve
Other Reserves
Cumulative Goodwill Amortisation
Unrecorded Goodwill
(Net) Capitalised Intangibles
Full-Cost Reserve
Cumulative Unusual Loss (Gain) after
Tax
Increase (decrease) in Reserves
Eliminate Goodwill
Amortisation
Increase in (net) capitalised
intangibles
Increase in full-cost reserve
Unusual loss (gain) after tax
Non-capitalised leases are capitalised and form debt
equivalents; the interest expense is added back to
NOPAT
Accounting Adjustments - Stern Stewart’s Mechanics
Economic Profit
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Source: INSEAD
•Is it likely to have a material impact on EP?
•Can managers influence the outcome?
•Can operating managers understand it?
•Is the required information relatively easy to track or
derive?
•If the adjustment is made, will manager behaviour
improve ?
The following five criteria should be used to
determine whether an adjustment should be
made
Basic Principle: Eliminate distortions to the extent that it is practical to do so
Economic Profit
Accounting Adjustments - Selection Criteria
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Corporate Performance Measurement
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The following short-cut approach provides a
quick means of calculating EP, but does not
include the appropriate adjustments
Operating Income (EBIT)
+Interest Income
+Equity Income (or - equity loss)
+Other Investment Income
- Cash operating taxes
- Tax shield on interest*
=Net Operating Profit After Tax (NOPAT)
Total Assets
- Short-Term Non-Interest Bearing Liabilities (ST
NIBL)**
=Invested Capital (IC)
Average IC = (IC Beginning + IC End) ÷ 2
Note: Sometimes IC Beginning, not IC Average used
NOPAT
- Capital Charges (Average IC * Cost of Capital)
=EP
* Operating income x marginal statutory tax rate (gives no credit for tax shield on interest)
** STNIBL = Current liabilities less all interest bearing liabilities, such as short-term notes payable
Source: INSEAD
Economic Profit
Short-Cut Approach (Excludes Adjustments)
66CorporatePerformanceMeasurement
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Corporate Performance Measurement
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Agenda
Economic Profit
•Definition
•Advantages/Disadvantage
s
•Framework
•Use in Strategy Work
67CorporatePerformanceMeasurement
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Corporate Performance Measurement
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Use in Strategy Work
EP works effectively for manufacturing
companies, but is generally not appropriate for
service firms
Manufacturing Sector Service Sector
Use of EP/MVA
•Capital - intensive
industries benefit
most from EP
–forces managers to
consider capital
invested in business
•. Coca-Cola
spinning off bottlers
–UDV spinning off
wine production
assets to focus on
blending
•EP generally not
appropriate due to
difficulty in
measuring human
capital (typically
most valuable
asset)
•Structure of
balance sheet
precludes use of EP
in Financial Services
sector
Economic Profit
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Corporate Performance Measurement
LON
An organisation needs to establish the optimum
level of information complexity in order to create
the most value
Optimum level of
adjustment and
analysis will be
determined by:•Absolute sensitivity of
value measures to
adjustments
•Level of the organisation
that is using the
(economic value added)
information
•Strategic use of
information
•Ability of management to
make decisions on the
information
Value to the
Organisation
*
Level of Complexity
(Adjustment and
Analysis)
Optimal
Adjustments
and Analysis
Organisation
below full
potential as a
result of too
simplistic a
measurement
/decision
making
process
Diminishing
value to
organisation as
cost of
adjustment/analys
is Outweighs
incremental gain
on decisions
made
Maximum value to
organisation from 'economic
value-added'
Note: Value defined as incremental value created from management decision less cost of the information base/ decion making process
Economic Profit
Optimum Information Level
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Corporate Performance Measurement
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Use in Strategy Work
EP can be improved in a number of ways
Improving EP
Achieving
economically
profitable growth
Exiting
uneconomic
activities
Raising the
efficiency of
current
operations
•Generating
incremental
gains in EP from
existing capital
investments
•Generating
incremental
positive EPs from
new capital
investments
•Immediate exit from
activities generates
proceeds > subsequent
cash flow foregone
Economic Profit
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Corporate Performance Measurement
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The following guidelines should be
considered when setting up EP
Link to Compensation
Keep it Simple
•Senior Managers should be both evaluated
and compensated based on their EP results
•Aligns incentives of Shareholders and
Management
•Use change in EP as basis for evaluation to
incent managers to create additional value
•The more complex the EP system is, the less
likely it is to be used
•Accounting adjustments must be sufficient to
eliminate major distortions from economic
value, but not too complicated for
management to understand or utilise on long
-term basis
Economic Profit
Guidelines
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Corporate Performance Measurement
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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Corporate Performance Measurement
LON
•Cash Flow Return on Investment (CFROI), also known
as the Holt method, is a return on investment measure
that adjusts for deficiency in typical IRR calculations
–CFROI uses cash flows and investments stated in
constant monetary units
•Once calculated, CFROI compared to benchmark, the
firm’s cost of capital to evaluate management
performance
•Two firms use the Holt Method
–Holt Value Associates, LP for portfolio management
–BCG/Holt for Corporate Management
CFROI is an adjusted IRR that is compared to the
firm’s WACC
CFROI
Definition
73CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
•Determine
average life
of firms
assets
•Approximat
e by
median of
Gross Plant
Depreciatio
n Expense
over last 3
years
Calculate
Life of
Assets
Calculate
Gross Cash
Investment
Calculate
Sum of Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash Flow
Compare
CFROI to
Benchmark
Cash Flow Return on Investment - CFROI Framework (1 of 6)
CFROI
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Corporate Performance Measurement
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•Start with Net
Income (after
taxes)
•Add back
non cash
operating
expenses
•Add back
financing
expenses
•Use
monetary
inflation
adjustment
to restate in
current
dollars
Calculate
Life of
Assets
Calculate
Gross Cash
Investment
Calculate
Sum of Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash Flow
Compare
CFROI to
Benchmark
Cash Flow Return on Investment - CFROI Framework (2 of 6)
CFROI
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•Gross up
book assets
with
accumulated
depreciation
of value of
operating
bases
•Discount
operating
leases over
life of assets
period using
real rate of
interest of
firms’ debt
Calculate
Life of
Assets
Calculate
Gross Cash
Investment
Calculate
Sum of Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash Flow
Compare
CFROI to
Benchmark
Cash Flow Return on Investment - CFROI Framework (3 of 6)
CFROI
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•Terminal value
consists of
non
depreciating
assets,
including:
–land
–net working
capital
–investments
in
marketable
securities
•Use inflation
adjustment to
restate in
current dollars
Calculate
Life of
Assets
Calculate
Gross Cash
Investment
Calculate
Sum of Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash Flow
Compare
CFROI to
Benchmark
Cash Flow Return on Investment - CFROI Framework (4 of 6)
CFROI
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Corporate Performance Measurement
LON
•Calculate CFROI
using IRR
methodology:
–Present Value =
Gross Cash
Investment
–Payments =
Gross Cash
Flow
–Future Value =
Sum of
Nondepreciatin
g assets
–Number of
Periods = Life
of Assets
Calculate
Life of
Assets
Calculate
Gross Cash
Investment
Calculate
Sum of Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash Flow
Compare
CFROI to
Benchmark
Cash Flow Return on Investment - CFROI Framework (5 of 6)
CFROI
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•Use firms cost
of capital
(WACC) for
benchmark
•Must restate
WACC in real
terms to be
able to
compare to
CFROI
Calculate
Life of
Assets
Calculate
Gross Cash
Investment
Calculate
Sum of Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash Flow
Compare
CFROI to
Benchmark
Cash Flow Return on Investment - CFROI Framework (6 of 6)
CFROI
79CorporatePerformanceMeasurement
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LON
EP
Calculat
e Life of
Assets
Calculate
Gross
Cash
Investmen
t
Calculate
Sum of
Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash
Flow
Compare
CFROI to
Benchmark
•Add back
goodwill
amortisation
•Adjust tax
expense to
actual cash
taxes
•Add back
interest
portion of
operating
rental
expenses
•Add back
accumulate
d goodwill
•Only use
assets net
of
depreciatio
n
•WACC in
nominal
terms
Target
Audience
Methodolog
y
•Managemen
t
•External
Investors
•NPV
Cash Flow Return on Investment - EP/CFROI Differences (1 of 2)
CFROI
80CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
CFROI
Calculat
e Life of
Assets
Calculate
Gross
Cash
Investmen
t
Calculate
Sum of
Non
Depreciatin
g Assets
Calculate
CFROI
Calculate
Gross
Cash
Flow
Compare
CFROI to
Benchmark
•Add back
goodwill
amortisation
+
depreciation
•No tax
expense
adjustment
•Add back
operating
rental
expenses
•Accumulate
d goodwill
is normally
not added
back
•Assets
grossed up
for
accumulate
d
depreciatio
n
•WACC
restated
in real
terms
Target
Audience
Methodolog
y
•External
Investors
•IRR
Cash Flow Return on Investment - EP/CFROI Differences (2 of 2)
CFROI
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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Source: Harnischfeger’s 1996 Annual Report, INSEAD
•47,598,340 common shares outstanding
•Market Value of common shares: $40
•Since Market Value of debt and minority interest not
reported assume market value = book value
•Assume operating cash equal to 1% of total sales
Information
Required:
Exercise: Calculate Harnischfeger’s MVA at October 31, 1996
MVA Exercise
Market Value Added Exercise (1 of 3)
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Corporate Performance Measurement
LON Source: Harnischfeger’s 1996 Annual Report, INSEAD
Dollars amounts in thousands 1996 1995
Assets
Current Assets
Cash and cash equivalents 36,936 239,043
Accounts receivable – net 667,786 499,953
Inventories 547,115 416,395
Business held for sale 26,15
2
-
Other current assets 132,26 57,999
1,410,250 1,213,390
Property, plant and equipment
Land and improvements 48,371 31,571
Buildings 301,010 233,788
Machinery and equipment 776,332 676,546
1,125,713 941,905
Accumulated depreciation (491,668) (454,249)
634,045 487,656
Investments and other assets
Goodwill 512,693 147,943
Intangible assets 39,173 66,796
Other assets 93,868 124,982
645,734 339,721
$2,690,029 $2,040,767
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Market Value Added Exercise (2 of 3)
MVA Exercise
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Corporate Performance Measurement
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Source: Harnischfeger’s 1996 Annual Report, INSEAD
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Liabilities and Shareholders’ Equity
Current Liabilities:
Short-term notes payable 49,633 22,802
Trade accounts payable 346,056 263,750
Employee compensation and
benefits
160,488 100,041
Advance payments and progress
billings
155,19
9
154,40
1Accrued warranties 50,718 43,801
1,077,127 723,303
Long-term obligations 657,765 459,110
Liability for post retirement benefits 78,814 101,605
Accrued pension and related costs 39,902 52,237
Other liabilities 14,364 20,820
Deferred income taxes 54,920 34,805
Minority Interest
188,000 209,467
Shareholders Equity:
93,652 89,611
Common stock 51,407 51,118
Capital in excess of par value 615,089 603,712
Retained earnings 148,175 53,560
Cumulative translation adjustments (37,584) (42,188)
Less: Stock Employee Compensation
Trust Treasury Stock (42,242) (46,513)
673,485 559,276
$ 2,690,029 2,040,767
(61,350) (60,483)
Other Liabilities:
Other current liabilities 315,033 138,508
Market Value Added Exercise (3 of 3)
MVA Exercise
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Harmishfeger’s market value at 31 October, 1996 was $2,
M
Market
Value
($ M)
Market Value Added - Solution (Market Value)
MVA Exercise
86CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Harnishfeger’s excess cash at October 31, 1996 was
$8,296 M
Amount
($ K)
Market Value Added - Solution (Excess Cash)
MVA Exercise
87CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Harnischfeger’s working capital requirements at October 31, 1996
were $ M
A
m
o
u
n
t
(
$
K
)
Working
Capital
Requirements
Market Value Added - Solution (Working Capital Requirements)
MVA Exercise
88CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Harnischfeger’s net fixed assets at October 31, 1996 were $
B
A
m
o
u
n
t
(
$
T
h
o
u
s
a
n
d
s
)
Net PP&E
Market Value Added - Solution (Net Fixed Assets)
MVA Exercise
89CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Harmishfeger’s invested capital at 31 October, 1996 was
$1, M
I
n
v
e
s
t
e
d
C
a
p
i
t
a
l
(
$
M
)
Market Value Added - Solution (Invested Capital)
MVA Exercise
90CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Harnischfeger’s market value added at October 31, 1996 was
$ M
Market Value Added - Solution (Market Value Added)
MVA Exercise
91CorporatePerformanceMeasurement
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Corporate Performance Measurement
LON
Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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Exercise: Calculate Harnischfeger’s EP for the year ended October 31,
1996
Information
Required:
Interest income $ million
WACC equals 12%
Economic Profit Exercise
EP Exercise
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Asset
s
199
6
199
5
Property, Plant and
Equipment:
Land and improvements
Buildings
Machinery and
equipment
Accumulated
depreciation
48,371
301,010
776,332
1,125,713
(491,668)
634,045
31,571
233,788
676,546
941,905
(454,249)
487,656
Investment and Other
Assets:
512,693
39,173
93,868
645,734
$2,690,029
147,943
66,796
124,982
339,721
$2,040,76
7Source: Harnischfeger’s 1996 Annual Report; INSEAD
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Economic Profit Exercise
Current Assets:
Other current assets
Business held for sale
Inventories
Accounts receivable - net
Cash and cash equivalents
1,213,390
57,999
-
416,395
499,953
$239,043
1,410,250
132,261
26,152
547,115
667,786
$36,936
Other assets
Intangible assets
Goodwill
EP Exercise
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Source: Harnischfeger’s 1996 Annual Report; INSEAD
Liabilities and Shareholders’ Equity 1996 199
5
$22,802
263,750
100,041
154,401
43,801
138,508
723,303
459,110
Long-term
Obligations
78,81
4
101,605
52,237
20,820
34,805
209,467
89,611Minority Interest
51,118
603,712
53,560
(42,118
(60,483
(46,513
559,276
$ 2,040,767
)
)
)
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Economic Profit Exercise
Other current liabilities
Accrued warranties
Advance payments and progress billings
Employee compensation and benefits
Trade accounts payable
Short-term notes payable
Current Liabilities:
657,765
1,077,127
315,033
50,718
155,199
160,488
346,056
$49,633
Deferred income taxes
Other liabilities
Accrued pension and related costs
Liability for post-retirement benefits
Other Liabilities:
93,652
188,000
54,920
14,364
39,902
Treasury Stock
Less: Stock Employee Compensation Trust
Cumulative translation adjustments
Retained earnings
Capital in excess of par value
Common stock
Shareholders’ Equity:
$ 2,690,029
673,485
(42,242)
(61,360)
(37,584)
148,175
615,089
51,407
EP Exercise
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Dollar amounts in thousands
Sales
Cost of Sales
Product Development, Selling and Administration Expenses
Restructuring Charge
$2,887,570
2,166,775
433,776
43,000
Operating Income
Interest Expense - Net
244,019
(62,258)
Income before Taxes and Minority Interest
Provision for Income Taxes
Minority Interest
181,761
(63,600)
(3,944)
Source: Harnischfeger’s 1996 Annual Report; INSEAD
Net Income $114,21
7
Harnischfeger Industries Inc.
Consolidated Balance Sheet - Year Ended 31 October 1996
Economic Profit Exercise
EP Exercise
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Harnischfeger’s 1996 NOPAT was $ M
Operating Income
+ Interest Income
+Equity Income
+ Other Investment Income
- Income Taxes
- Tax shield on interest*
= Net Operating Profit After Tax
(NOPAT)
*Tax shield on interest =
$
0
0
()
()
$
$ M
Provision for income
taxes
Income before taxes
and minority interest
Net Interest Expense +
Interest Income
+
= x =
Economic Profit - Exercise Solution
EP Exercise
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Harnischfeger’s 1996 average Invested Capital was $1, M
Total Assets
- ST NIBL*
= Invested Capital
2,
(1,)
1,
2,
()
1,
* ST NIBL = Current Liabilities - Short-Term Notes Payable =1,
()
1,
()
1996 1995
1996 1995
$ M
Average Invested Capital1,
Economic Profit - Exercise Solution
EP Exercise
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Harnischfeger’s 1996 EP was ($ M)
NOPAT
- Capital Charges*
EP
Note: * Capital Charges = Average IC * WACC = 1, x 12% =
()
()
$ M
Harnischfeger was approximately value-neutral in
1996, which contrasts sharply with the $1 billion MVA
(see MVA section). The discrepancy indicates that
despite adding no value in 1996, the market expects
management to deliver value in the future. The large
MVA implies that future EPs will be much higher than
1996.
Economic Profit Exercise Solution
EP Exercise
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Agenda
•Executive Summary
•Objectives
•Background
•Performance Measurement Framework
•Market Value Added (MVA)
•Economic Profit (EP)
•Cash Flow Return on Investment (CFROI)
•Exercises
–MVA
–Economic Profit
•Case Study - Diageo
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•Lower grape costs
–purchasing on spot
market
–long-term
contractual supply
contracts
•Blending techniques
used to ensure
consistent quality
The success of New World wine producers can be
attributed to three initiatives, of which the reduction in
capital intensity was most closely linked to the EP
analysis
Decreased
Importance
of Appellation
Reduction in
Capital Intensity
Premium Positioning
and
Varietal Dominance
New World Wine
Economics
•Wider range of outsourcing
opportunities
–third-party grape
sourcing and production
reduces need to own and
operate vineyards and
production facilities
•New technology enabling
reduction in stock holding
time
•More premium the
wine, higher the returns
•Scale achieved through
varietal dominance
leads to higher returns
•Low •High •Low
Link to EP
Analysis
Case Study - Diageo
Drivers of Value
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By focusing solely on bottling, only Glen Ellen
generated positive economic profits for the wine
produced
Source: HWG Strategic Position Assessment
Cost per
Case ($)
$$ EP/Case: ($) ($) ($) ($) ($)
As a non-
vertically
integrated
Vintner
with
bottling
facility
only, Glen
Ellen
maintains
a low
asset base
and capital
charge
As a
vertically
integrated
Vintner
with
vineyard
and
crushing
facilities,
BV has a
large asset
base and
capital
charge
Case Study - Diageo
Brand Performance
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The Glen Ellen system is more efficient than the BV
system
Source: HWG Strategic Position Assessment
Maturing
Stock as
% of NSV
Total
Inventor
y Turns
Glen Ellen System Beaulieu
Vineyard
73%
51%
Maturin
g Stock
as % of
NSV
Total
Inventory
Turns
Maturin
g Stock
as % of
NSV
Total
Inventory
Turns
Case Study - Diageo
Asset Utilisation
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Analysis of the components of ROCE highlights
the different economics of the two systems
•Margins
–price
–mix
–grape costs
–production
costs
–selling/
distribution
costs
•Volume
•Tax
rate
•Accountin
g policies
•Degree
of
vertical
integratio
n
•Wine mix
–colour
–quality
–dry vs.
sweet
•Ageing
technolog
y
•Trade
relatio
n-
ships
•Accountin
g policies
Drivers:
ROCE
Capital EmployedNOPAT
Operatin
g Profit
Cash
Operatin
g Taxes
Other
Adjustmen
ts
- +/-
Other
Adjustment
s
Other
Net
Working
Capital
Inventory
Net
Fixed
Assets
+/-++
¸
Case Study - Diageo
Components of ROCE
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The traditional wine making process is very capital
intensive. Through selective outsourcing, New World
wine producers have been able to significantly reduce
their asset base
Traditional old world
wine producer
activities
Vertically integrated New
World wine producer
activities (Robert
Mondavi )Non vertically
integrated wine
producer activities
(Glen Ellen)
Activities systematically performed
Activities performed only for super/ultra premium
wines
Source: Literature search, Expert interviews
Notes: ¹ Ageing can be done in oak barrels or in stainless steel vats
Grapes
Culture &
Production
Harvest
Grapes
Crushing
Alcoholic
Fermen -
tation
Matur -
ation
Malolactic
Fermen -
tation
Ageing¹ Blending Bottling
Bottle
Stock
Keeping
Distri-
bution
Vineyard Vinification Ageing
Process
(Outsourced
activities)
Case Study - Diageo
Breakthrough Strategies: Change the Rules
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•Ignoring the capital requirements necessary under
different business models can mask the true
profitability of each product
–the only wine that was economically profitable was
the Glen Ellen product that Diageo bottled but did
not grow from the vineyard
•A fresh approach to the business may be necessary in
order to devise more economically profitable business
models
–less prestige in only performing bottling, but many
vineyards driven by non-economic factors
Case Study - Diageo
Lessons Learned
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