Management Control Systems Value Based Management Corporate Objective- Creating Value for the Shareholders Why Value

Creation has become the objective? - Institutional investors have begun exerting influence on corporate managers to create value for shareholders - Many leading corporations have accorded value creation a central place in their corporate planning to serve as a role model for others - Business is emphasizing shareholders value creation in performance rating exercise. - Greater attention is now being paid to link top management compensation to shareholder return. To help firms to create value for share holders Value Based Management (VBM) approaches have been created.

VBM represents synthesis of various business disciplines From Finance-Goal of Shareholder value maximization and DCF Model From Business Strategy-Notion of value creation stems from exploiting opportunities based on firms competitive advantage From Accounting-Structure of Financial Statements with modifications Organizational Behaviour-Borrowed the notion that you get what you measure and reward

Methods of VBM The free cash flow method proposed by Mc Kensy and LEK/Alcar Group The economic value added /market value added (EVA/MVA) pioneered by Stern Stewart and Company

The Cash Flow Return on Investment /Cash Value Added(CFROI/CVA) method developed by BCG and Holt Value . Common Premises of the above methods - The value of any company is equal to the present value of the future cash flows the company is expected to provide - Conventional accounting methods are not a sufficient indicator of value creation because They are not the same as cash flow They do not reflect risk They do not include an opportunity cost of capital They do not consider time value of money They are not calculated the same way by all firms because of variations in accounting policy - For Managing share holder value firms should use metrics that are linked to value creation and employ them consistently in all facets of financial management. - A well designed performance measurement and incentive compensation system is essential to motivate employees to focus their attention on creating shareholder value. EVA Approach Proposed by Stern Stewart and Co-Currently a very popular idea EVA is the surplus left after making an appropriate charge for the Capital Employed in the business. EVA=NOPAT-(WACC x Capital) EVA=Capital ( ROC-WACC) EVA =[PAT+INT(1-T)-WACC x Capital EVA=PAT-COE x EQUITY NOPAT= Net Operating Profit After Tax WACC=Weighted Average Cost of Capital

Capital =Economic Book Value of Capital Employed ROC= Return on Capital Employed (NOPAT/Capital) PAT=Profit After Tax INT= Interest Expenses of the Firm Balance Sheet of Create Value Corporation(Rs) -------------------------------------------------------------------------------------------Liabilities Assets Equity Debt 200 200 ------400 Fixed Assets 280 Current Assets 120 ------400

P& L a/c for the year ended 31-3-2010 is as follows Net Sales 600 COGS 516 PBIT 84 Int 24 PBT 60 Tax(30%) 18 PAT 42 The Companys Cost of Equity is 18% and Interest on debt is 12% and Marginal tax rate is 30%.

How can EVA be improved? 1. By improving operating efficiency.-The rate of return on existing capital increases because of improvement in operating efficiency.-Operating efficiency increase s without infusion of additional capital in business.

2. Additional capital is invested in projects that earn a rate of return greater than the cost of capital. 3. Capital is withdrawn from activities which earn inadequate profits. 4. The WACC is lowered by altering the financing strategy. Market Value Added The MVA is the difference between the market value of the firm and the capital employed by the firm. MVA is the PV of all future EVAs

MVA= EVA 1 + ----------

EVA 2 ---------

(1+WACC)1 (1+WACC)2

MVA is a Stock Measure while EVA is a flow measure

EVA and incentive compensation The EVA bonus plan is unique that it overcomes the limitations of existing incentive plans and aligns the interest of the manager with that of the shareholders. The key elements of EVA bonus plan are Bonus is linked to increase in EVA There is no floor ceiling on bonus The target bonus is generous Performance targets are set be formula not by negotiation A bonus bank is established

Free Cash Flow Model Proposed by McKinsey and LEK/Alcar Group Calculation of Value Creation by Adopting a Strategy Steps 1.Forecast the Operating cash flow stream for the business unit (strategy) over the planning period

Cash Flow=[(Sales)(Operating Profit Margin)(1-Effective Tax Rate)-[Fixed Capital Investment+ Working Capital Investment]

2.Discount the fore casted operating cash flow stream using the weighted average cost of capital (WACC) 3.Estimate the residual value of the business unit (strategy) at the end of the planning period and find its present value Perpetuity Cash Flow --------------------Cost of Capital

4Determine the total shareholder value Present Value of the operating cash flow stream + Present Value of the residual value Market Value of the debt

5Establish the pre-strategy Value Cash Flow before the new investment --------------------------------------------Cost of Capital 6 Value created by the new strategy= Total Shareholder value Pre strategy Value - Market Value of Debt

The Income Statement and balance sheet of Good Hope Company Ltd for the year 2010 is as follows

Income Statement (Rs) Sales Gross Profit Margin(25%) Ad.Charges (10%) PBT Tax Net Profit 1000 250 100 150 60 90 Balance Sheet Liabilities Equity Capital 500 Assets Fixed Assets 300

Current Assets 200 ---500 ------500

The company is debating whether it should maintain the status quo or adopt a new strategy. If it maintains status quo -Sales will remain constant at Rs 1000 -Gross Margin and Ad.Expenses will remain 25% and 10% respectively -Depreciation charges will be equal to new investments -The asset turnover ratio will remain constant -The discount rate will be 16% -The income tax rate will be 40% If the company adopts a new strategy its sales will grow at 10% per year for 5 years. The margins ,the turnover ratio, capital structure ,the I.T rate and the discount rate will remain unchanged. Depreciation charges will be equal to 10% of the net fixed assets at the beginning of the year .Calculate the value created by the new strategy.

Free Cash Flow

Cash flows can be estimated in different ways Simplest form of cash flow EBDA= Net Income+ Depreciation+ Amortization

EBITDA Earnings before interest, depreciation ,and amortization This is the cash flow available to all suppliers of capital ( creditors and owners) EBITDA=Net Income+ Interest+ Depreciation +Amortization

Cash Flow Based on Activities- Operations, Financing and Investment Of these cash flow from operations will reflect the financial health of the company Cash Flow from Operations= Net Income+ Depreciation+ Amortization+ Other Non-Cash Charges(incomes)-increase in net working capital. Free Cash Flow Free Cash Flow is a measure of cash flow beyond that is necessary to grow at the current rate. Companies must invest cash to grow and free cashflow considers this in arriving at the cash available. Free Cash Flow=CFO-Capital Expenditure

Free Cash Flow to Equity Free Cash Flow to Equity=CFO-Capital Expenditure+ Net Borrowings Net Borrowings=New Debt Financing-Debt Repayment Free Cash Flow to the Firm FCFF=EBIT (1-TAX RATE)+Non Cash Charges(or incomes)-Capital Expenditure-Increase in Working Capital Free Cash Flow is also referred to as unlevered cash flow because it is the cash flow interest on debt is considered. Valuation Using Free Cash Flow Value of the firm can be calculated by discounting the free cash flows The model depends on the cash flow growth assumption ---------------------------------------------------------------------------------------------------Growth Assumption Model Formula

---------------------------------------------------------------------------------------------------No Growth Perpetuity V= FCF/r Constant Growth Non-Constant Growth Gordon Model DCF V= V= FCF 1 /r-g n t-1 FCF t ------r

Cost Capital is the discounting rate -In valuation of equity , cost of capital is the cost of equity and free cash flow is the free cash flow to equity

- In the value of the firm , the cost of capital is the weighted average cost of capital and cash flow is the free cash flow to the firm Value of Equity assuming that free cash flow will grow at a constant rate

Value of Equity=FCFE 1 / re-g

Return on Investment (ROI)

ROI is the relation of profits of the firm to its Investments Concept of Investment may be - Assets - Capital Employed - Shareholders Equity Based on the above concepts there are 3 broad categories of ROI - Return on Assets - Return on Capital Employed - Return on Shareholders Equity

Return on Assets Relationship between net profits and assets Also known as profit-to-asset-ratio

Depending upon the definition of assets and profits many valuation of RA is possible.

Net Profit may be - Net Profit after Taxes - Net Profit after Taxes plus interest - Net Profit after taxes plus interest minus tax savings Assets may be defined as - Total Assets - Fixed Assets - Tangible Assets

Variations in ROA

ROA =

Net Profit After Taxes ---------------------------- x Average Total Assets 100

The above method calculation fails to reflect the true earnings as the assets are financed by owners as well as debt. A more reliable indicator of the return on assets , therefore is the net profit which includes interest. ROA = Net Profit after Taxes &Interest --------------------------------------Average of Total Assets x 100

ROA =

Net Profit After Taxes ---------------------------- x Average Tangible Assets 100

ROA =

Net Profit after Taxes ---------------------------- x Average Fixed Assets 100

The ROA calculation may not provide correct result for inter-firm comparison especially , when the firms have varying capital structure This is because interest payment qualifies for tax deduction. The effective cash outflow is less than the actual payment of interest

ROA =

EAT+( Interest-Tax Advantage on Interest) ----------------------------------------------------------------Average of Total Assets/Tangible Assets/Fixed Assets x 100

The ROA measures the profitability of total funds /investments of a firm But it fails to throw light on the profitability of different sources of funds.

Return on Capital Employed

It is similar to ROA except in one aspect.-Profits are in relation to capital employed. Capital employed refers to funds put in by Owners and Long Term Lenders.

Capital Employed = OR Capital Employed =

Long-Term Liabilities + Owners Equity

Fixed Assets+ Working Capital

Computation of ROCE

ROCE

EBIT 100

-------------------------------------------- x Average of Total Capital Employed

ROCE

EAT+ ( Interest-Tax Advantage on Interest) x 100

------------------------------------------------------------Average of Total Capital Employed

ROCE

EAT+( Interest-Tax Advantage on Interest) ----------------------------------------------------------------x 100

Average of Total Capital Employed-Average Intangible Assets