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Learning Note 19.

1:
Reconciling short- and long-term residual
income/EVA(TM) measures
ADVANCED READING

In this learning note alternative depreciation models are examined that seek to
ensure that the short-term residual income measure does not conflict with the
long-term measure.

Valuing assets at NPV of future cash flows


It is not easy to design a short-term measure of performance that does not conflict with
decisions based on the NPV rule. One approach is to value the assets at the present
value of the future cash flows. This is illustrated in Exhibit LN19.1 in respect of the
information presented in Exhibit 19.3 in the main body of this chapter for project X.
You will see that the asset is valued at £938 000 at the start, and because it is pur-
chased for £861 000, an immediate profit of £77 000 is recognized. This is identical
with the NPV calculated in Exhibit 19.3 of the text. EVA(TM) of zero will then be
recorded for the next three years. This approach recognizes that the firm will be bet-
ter off at the time of the acquisition by £77 000. However, because of the difficulty
of valuing an asset at the present value of future cash flows, and writing the asset up
in value above cost at the start, it is unlikely that this approach will be acceptable to
accountants and managers.

Annuity depreciation
When the cash inflows are constant and the annuity method of depreciation is used,
the short-term EVA(TM) will also be constant. In addition, the total present value of
the EVA(TM) will be equal to the NPV calculation. In other words, decisions taken on
the basis of the short-term measure will be consistent with decisions taken on the
basis of the long-term measure or the NPV rule. Let us illustrate the procedure using
the annuity method of depreciation. Consider Example LN19.1.
There is a danger that this project will be rejected on the basis of the first year’s
EVA(TM) calculation if the straight-line method of depreciation is used. If we use the
annuity method of depreciation, the annual depreciation will be equivalent to the
capital element of an annuity required to redeem £100 000 borrowed at 10% over
five years.
The capital element of an annuity can be derived from dividing the investment
outlay (£100 000) by the annuity factor for 5 years at 10% (3.791 shown in
Appendix B in the text). A repayment of £26 380 per annum (£100 000/3.791) is
therefore required to repay £100 000 borrowed for five years. The repayment sched-
ule is set out in Exhibit LN19.2.
The £100 000 will be repaid with interest, and the capital repayment column rep-
resents the annual depreciation charge. The EVA(TM) calculation using this deprecia-
tion charge is shown in Exhibit LN19.3.

LEARNING NOTE 19.1: RECONCILING SHORT-TERM AND LONG-TERM RESIDUAL INCOME/EVA(TM) MEASURES
EXHIBIT LN19.1
Effect of valuing assets (£000s)
at NPV of future cash
Value of asset at start (£) (250 × 0.909) + (370 × 0.826) +
flows (000s)a
(540 × 0.751) = 938
Value at end of year 1 (£) (370 × 0.909) + (540 × 0.826) = 782
Value at end of year 2 (£) (540 × 0.909) = 491
Value at end of year 3 (£) = nil

Year 1 Year 2 Year 3


(£000) (£000) (£000)

Cash inflow 250 370 540


Depreciation 156b 291 491
Profit before interest 94 79 49
Interest (at 10%) 94c 79 49
EVA(TM) — — —
aAllcalculations are to the nearest (£000s)
bValue at start (£938) less value at end of year 1 (£782)
cCalculated on opening written-down value (10% of £938)

EXAMPLE LN19.1
A division has the opportunity to acquire a new machine for £100 000. The
machine is expected to produce cash savings of £29 000 every year for five
years. The cost of capital is 10%.
The net present value for the new machine is £9939 and is calculated as follows:

(£)

Investment cost 100 000


Present value of cash savings (29 000 × 3.791) 109 939
Net present value 9 939

The EVA(TM) for year 1 using the straight-line method of depreciation is:

(£) (£)

Annual cash inflow 29 000


Less Depreciation 20 000
Interest on capital (10% of £100 000) 10 000 30 000
EVA(TM) (1 000)

The annual cash inflow is constant, and the EVA(TM) is also constant at £2620 per
annum for five years. The present value of £2620, which is received annually for five
years, is equal to the net present value calculation of £9939. The short-term measure
should therefore lead to decisions being made that are consistent with decisions that
would be taken on the basis of NPV calculations, when the cash inflows are constant
and the annuity method of depreciation is used. A manager will undertake the
machinery purchase, even if he or she places great emphasis on the impact of the pur-
chase on the first year’s performance. The manager may, however, reject the purchase
if straight-line depreciation is used because a negative figure for EVA(TM) is reported.

LEARNING NOTE 19.1: RECONCILING SHORT-TERM AND LONG-TERM RESIDUAL INCOME/EVA(TM) MEASURES
EXHIBIT LN19.2
Annual 10% interest on Capital Capital Capital repayment
Year repayment capital outstanding repayment outstanding schedule
(1) (2)
(3) = (1) – (2) (4) = (4) – (3)
(£) (£) (£) (£)

0 100 000
1 26 380 10 000 16 380 83 620
2 26 380 8 362 18 018 65 602
3 26 380 6 560 19 820 45 782
4 26 380 4 578 21 802 23 980
5 26 380 2 398 23 982 (2)

EXHIBIT LN19.3
EVA(TM) calculation

Opening written Cash Interest on


Year down value inflow Depreciation capital (10%) EVA(TM)
(1) (2) (3) (4) (2) – [(3) + (4)] (5)
(£) (£) (£) (£) (£)

1 100 000 29 000 16 380 10 000 2620


2 83 620 29 000 18 018 8 362 2620
3 65 602 29 000 19 820 6 560 2620
4 45 782 29 000 21 802 4 578 2620
5 23 980 29 000 23 982 2 398 2620

Uneven cash flows


Unfortunately, the annuity method of depreciation only produces a short-term mea-
sure that will lead to decisions consistent with the NPV rule when the net cash
inflows are equal each year. Example LN19.1 has been amended so that the total net
cash inflows of £145 000 fluctuate between years. All other items remain unchanged.
The revised problem is presented in Example LN19.2. The EVA(TM) for this exam-
ple, using the annuity method of depreciation that was calculated in Exhibit LN19.2,
is presented in Exhibit LN19.4.
The present value of the EVA(TM) in Exhibit LN19.4 is £9938, which is identical
with the NPV calculation. There is, however, a danger that the manager may reject
the investment because of the negative EVA(TM) calculations in years 1 and 2. This
means that the short-term EVA(TM) measure may be in conflict with the NPV rule
when the annuity method of depreciation is used and unequal cash flows occur.
Tomkins (1975) shows that it is possible to construct a depreciation schedule that
avoids negative residual income or EVA(TM) calculations and that will motivate man-
agers to accept projects yielding positive NPVs. He suggests that, instead of using the
annuity method of depreciation, a depreciation figure should be calculated by
deducting the interest on the written-down value of the asset from the expected cash
inflows for the year, instead of deducting it from the annuity required to redeem the
loan. This procedure is illustrated in Exhibit LN19.5.

LEARNING NOTE 19.1: RECONCILING SHORT-TERM AND LONG-TERM RESIDUAL INCOME/EVA(TM) MEASURES
EXAMPLE LN19.2
A division has the opportunity to acquire a new machine for £100 000. The
machine has expected cash savings of £145 000 over five years. The timing of
the expected cash savings is as follows:

(£)

Year 1 20 000
Year 2 25 000
Year 3 50 000
Year 4 40 000
Year 5 10 000

The cost of capital is 10% and the NPV is £9938.

EXHIBIT LN19.4
EVA(TM) with unequal Opening written- Cash Interest on EVA(TM)
cash flows Year down value inflow Depreciation capital
(£) (£) (£) (£) (£)

1 100 000 20 000 16 380 10 000 (6 380)


2 83 620 25 000 18 018 8 362 (1 380)
3 65 602 50 000 19 820 6 560 23 620
4 45 782 40 000 21 802 4 578 13 620
5 23 980 10 000 23 982 2 398 (16 380)

EXHIBIT LN19.5
Depreciation based on Capital
interest deducted from Cash outstanding Interest Depreciation EVA(TM)
cash flows Year inflow (written-down (10%) (4) = (1) – (3) (5) = (1) – [(3)
(1) value) (2) (3) + (4)]
(£) (£) (£) (£) (£)

0 100 000
1 20 000 90 000 10 000 10 000 0
2 25 000 74 000 9 000 16 000 0
3 50 000 31 400 7 400 42 600 0
4 40 000 0 3 140 31 400 5 460
5 10 000 0 0 0 10 000

You will see that the interest is calculated on the opening written-down value. For
example, the £9000 interest charge for year 2 is based on 10% of the opening writ-
ten-down value for year 2 of £90 000. (This is represented by the written-down value
at the end of year 1.) Depreciation is then calculated by deducting interest from the
cash inflow. In year 4 the depreciation charge is limited to the written-down value of
£31 400. The effect of the depreciation charge being based on a deduction of interest
from the cash flow means that EVA(TM) is zero each year until the asset is completely
written off. Any cash inflows received after this point will result in a positive EVA(TM)

LEARNING NOTE 19.1: RECONCILING SHORT-TERM AND LONG-TERM RESIDUAL INCOME/EVA(TM) MEASURES
calculation. The present value of the EVA(TM) in years 4 and 5 is £9931, compared
with the capital investment net present value calculation of £9938.
If a divisional manager is evaluated with EVA(TM) calculated in the manner illus-
trated in Exhibit LN19.5, he or she will recognize that in the short term EVA(TM) will
remain unchanged, and that by years 4 and 5 the benefits will be reflected in the per-
formance measure. The manager will be motivated to accept the project. It remains
doubtful, though, whether widespread adoption of this method can be achieved,
since the depreciation is merely a balancing figure that does not conform to any of
the usual notions of depreciation. The calculations also indicate that the EVA(TM)
does not become positive until the initial investment cost topped up with interest
cost has been recovered. Tomkins suggests that a better description of the concept
would be capital surplus rather than residual income.

Comparison of actual with budget


When considering performance evaluation, the actual EVA(TM) must be compared
with a predetermined standard such as budgeted EVA(TM). If we use the procedure
suggested in Exhibit LN19.5, however, we shall obtain a zero EVA(TM) calculation in
the early years of a project’s life for both the actual and budgeted results.
Consequently, there are no benefits to be derived from making such a comparison
between budgeted and actual EVA(TM). Tomkins suggests that the relevant yardstick
of performance in this situation is a comparison between the budgeted capital out-
standing at the end of the year and the actual capital outstanding. Any difference,
though, between budgeted and actual capital outstanding can only result from actual
cash flows being different from budgeted cash flows, since both interest and depreci-
ation charges will be dependent on actual cash flows.1 Tomkins therefore concludes
that calculating residual income (and therefore EVA(TM)) and comparing budgeted
and actual capital outstanding is only an elaborate way of achieving what can be
attained far more simply merely by comparing actual cash flows with those budgeted
in the capital investment proposals.
It appears that the choice is between using an accounting method based on the
accruals concept, which will lead to the correct decision more often than other
methods, or comparing budgeted and actual cash flows. If the former method is
preferred, EVA(TM) is the most appropriate method of measuring the performance
of divisional managers.

Notes
1 Assuming that the actual cash flows in Exhibit LN19.5 were £15 000 for year 1, instead of
£20 000, the capital outstanding will be as follows:
Cash Capital Interest Residual
Year inflow outstanding (WDV) (10%) Depreciation income

(1) (2) (3) (4) = (1) – (3) (5) = (1) – [(3) + (4)]
(£) (£) (£) (£) (£)
0 100 000
1 15 000 95 000 10 000 5 000 0
You will see that the capital outstanding is £95 000 compared with £90 000 in Exhibit
LN19.5. Any difference between this calculation of capital outstanding and Exhibit LN19.5
will be due entirely to the actual cash inflow (£15 000) being different from the budgeted
cash inflow (£20 000).

LEARNING NOTE 19.1: RECONCILING SHORT-TERM AND LONG-TERM RESIDUAL INCOME/EVA(TM) MEASURES