MODULE XIII:

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MODULE XIII PERFORMANCE MEASURES
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• PERFORMANCE MEASUREMENT
• EPS
• Cash Flow
• Net Income
• Sales Growth
• RONA
• ROE
• EVA
• Desired Criteria
• Should be highly correlated with shareholder
  wealth
• Should affect employees behavior (individual
  employee must feel he/she/ can affect measure,
  and it should be tied to compensation)
• Should be simple
• Should strike appropriate balance between
  short-term and long-term

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• What Sort of Incentives Do Traditional Accounting
  Measures Create?

Measure Incentive Revenue Max. Sales
Volume Cost of Materials Min. Raw Material Unit
Cost Value-Added or Min. Manufacturing Unit
Cost Conversion Cost SG A Minimize Operating
Earnings Maximize
MOST OPERATING MANAGERS FOCUS ON THE PL (UNLESS
THEY ARE REQUESTING CAPITAL) AND NOT THE B/S
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• But Previous Measures Which Encouraged Earnings
  Maximization Downplayed the Capital Implications

Measure Incentive Capital
Implication Revenue Sales Volume ?
Plant equipment ? Accounts
Receivable ? Inventory Cost of Materials
Raw materials ? Raw material
inventory unit cost ? Early pay
discounts Conversion or Mfg. unit cost
? WIP, finished goods Value-Added Cost
inventory SG A Minimize ?
Sacrifice focus on capital-saving
value
drivers Operating Earnings Maximize ?
Maximize Capital
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Definition of EVA


Capital or Net Assets
Adjusted RONA
EVA
KW
Return from business
Payments to -banks
-bondholders -shareholders
Money invested in the business -Cash
-Receivables -Inventory -Property
-Plant Equipment NFANWC

• Where RONA
• OR
• EVA NOPAT during period
• KW CAPITAL at beginning of period
• (After-tax) Profit Capital Charge
• Note Net Assets capital NFA NWC

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• EVA is a performance measure that helps avoid
  these behavioral traps and align incentives with
  shareholder wealth maximization.

That is, --- From a capital budgeting
standpoint, while IRR, payback, etc. can
all produce answers inconsistent with NPV,
this never happens with EVA. WHY?
Because PV of EVA NPV! --- From a performance
measurement standpoint, all of the measures
considered have a poorer correlation with
shareholder value (MVA) than EVA does.
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Calculating EVA
Item
Year 1
Year 2
Sales 145,000 150,000
Operating Costs,
excluding depreciation 95,000
105,000 Depreciation 20,000
10,000 Operating Profit 30,000
35,000 Interest 5,000
5,000 Earnings Before Taxes 25,000
30,000 Taxes _at_ 40
10,000 12,000 Net Income 15,000
18,000
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Balance Sheets at Year End
Item (in Thousands of Dollars) Current Assets
Gross Fixed Assets Reserve for Depreciation Net
Fixed Assets Total Net Assets
Interest-Bearing Debt NIBCLs (Payables)
Shareholders Equity Liabilities and Net Worth
Year 0
Year 1
Year 2
40 70 60 70 100 100
10 30 40 60 70
60
100 140 120

30 45 45
20 30 30
50 65 45
100 140 120
WACC Kw 10
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Capital
Beginning of year 2
NOPATS From income statement
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(No Transcript)
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Start of year 1 capital
End-of-year 2 capital
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• Relationship Between EVA and Free Cash Flow NPV

Free Cash Flow NPV (1)

PV of EVA NPV (2)

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WHY EVA?

• 4 reasons.
• (1) Better tool for strategic resource
  allocation.
• (2) EVA-adopters seem to deliver greater
  shareholder value.
• (3) Very useful for value-driver analysis of
  components of shareholder value.
• (4) Creates an ownership mindset in employees
  when tied to compensation.

Resource Allocation System
VALUE
People and Organization Culture
Performance Metrics
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(1) Better tool for strategic resource allocation

• Question Should we invest more in a business in
  which our rate of return on invested capital is
  falling?
• RONA (or ROE) Perspective
• EVA Perspective
• Which is the right answer? Why?

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Consider WalMart
WACC 12.5

• WalMart Cash Flows during this time were negative

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Return Net Assets vs. EVA Wal-Mart Corporation
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Free Cash Flow vs. EVA Wal-Mart Corporation
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90,000 80,000 70,000 60,000 50,000 40,000 3
0,000 20,000 10,000 -
MVA for Wal-Mart
1984 4
1985 7
1986 11
1987 12
1988 14
1989 21
1990 28
1991 60
1992 64
1993 46
Value Creation MVA (B)
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(2) Greater Shareholder Value Delivered by EVA
adopters
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(3) EVA Drivers

• Establish a link between operating decisions and
  EVA
• Provide a tool for benchmarking against previous
  results and against peers
• Enable managers to analyze the impact of business
  plans on EVA

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• VALUE DRIVER ANALYSIS WITH EVA
• EVA RONA WACC ? CAPITAL
• ? (a) Increase RONA (b) decrease WACC,
  holding CAPITAL fixed.
• Increase RONA - PL productivity
• b) Decrease WACC
• EVA RONA WACC ? CAPITAL
• ? (a) Increase CAPITAL invested at
• RONA gt WACC
• (b) Divest assets with RONA lt WACC

• Cost Productivity (Whirlpools 5/year TCP goal
  McDonalds global sourcing of sesame seed buns)
• Increase brand equity (Mercedes Benz)
• Coca Cola 500 million Eurobond issue

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• Growth of assets with RONA gt WACC
• Wal-Mart
• Cokes investments in product line
  extensions
• Citibanks international consumer banking
  strategy
• b) Divestitures of assets with RONA lt WACC
• A-Bs divestiture of St. Louis Cardinals
• Citigroup divesting insurance
• Coke divesting wines and pastas
• EVA NOPAT KW ? CAPITAL
• ? Holding NOPAT fixed, decrease CAPITAL (asset
  productivity)
• ? NWC Dell model of negative NWC
• Wal-Mart inventory model
• ? NFA Automakers down-streaming asset
  
• ownership to Tier-1 Suppliers
• Nike outsourcing manufacturing

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THE VALUE CHAIN EVA HELPS US TO IDENTIFYTHE
VALUE DRIVERS WE NEED TO MANAGE
Net Sales
N O P A T
Gross Profit
Operating Profit
MINUS
MINUS
MINUS
COGS
SGA
Taxes
EVA
MINUS
Net Fixed Assets
Fixed Assets
Net Assets
C a p I t a l C h a r g e
MINUS
Accumulated Depreciation
PLUS
Current Assets
Net Working Capital
MINUS
Selected Current Liabilities
TIMES
Cost of Equity
Weighted Cost of Equity
TIMES
Fraction of Equity in Cap. Structure
WACC
PLUS
After-Tax Cost of Debt
Weighted After-Tax Cost of Debt
TIMES
Fraction of Debt in Cap. Structure
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EVA Drivers
EVA
Operating Financing
Expenses Expenses
Sales
EVA Drivers