The above story makes the point that, if one concentrates only on a few areas of per- formance, other important areas may be ignored. Too narrow a focus can adversely affect behaviour and distort performance. This may, in turn, mean that the busi- ness fails to meet its strategic objectives. Perhaps we should bear in mind another apocryphal story concerning a factory in Russia which, under the former communist regime, produced nails. The factory had its output measured according only to the weight of nails manufactured. For one financial period, it achieved its output target by producing one very large nail! Scorecard problems Not all attempts to embed the balanced scorecard approach within a business are suc- cessful. Why do things go wrong? It has been suggested that often too many measures are employed, thereby making the scorecard too complex and unwieldy. It has also been suggested that managers are confronted with trade-off decisions between the four different dimensions, and struggle because they lack a clear compass. Imagine a man- ager who has a limited budget and therefore has to decide whether to invest in staff training or product innovation. If both add value to the business, which choice will be optimal for the business? Whilst such problems exist, David Norton believes that there are two main reasons why the balanced scorecard fails to take root within a business, as Real World 9.9 explains. MEASURING SHAREHOLDER VALUE 339 Traditional measures of financial performance have been subject to much criticism in recent years and new measures have been advocated to guide and to assess strategic management decisions. In this section we shall consider two new measures, both of which are based on the idea of increasing shareholder value. Before examining each Measuring shareholder value REAL WORLD 9.9 When misuse leads to failure There are two main reasons why companies go wrong with the widely used balanced scorecard, according to David Norton, the consultant who created the concept with Robert Kaplan, a Harvard Business School Professor. ‘The number one cause of failure is that you don’t have leadership at the executive levels of the organisation,’ says Mr Norton. ‘They don’t embrace it and use it for managing their strategy.’ The second is that some companies treat it purely as a measurement tool, a problem he admits stems partly from its name. The concept has evolved since its inception, he says. The latest Kaplan–Norton thinking is that companies need a unit at corporate level – they call it an ‘office of strategy management’ – dedicated to ensuring that strategy is communicated to every employee and translated into plans, targets and incentives in each business unit and department. Incentives are crucial, Mr Norton believes. Managers who have achieved breakthroughs in per- formance with the scorecard say they would tie it to executive compensation sooner if they were doing it again. ‘There’s so much change in organisations that managers don’t always believe you mean what you say. The balanced scorecard may just be “flavour of the month”. Tying it to com- pensation shows that you mean it.’ Source: When misuse leads to failure, ft.com, © The Financial Times Limited, 24 May 2006. FT M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 339 method, we shall first consider why increasing shareholder value is regarded as the ulti- mate financial objective of a business. The quest for shareholder value For some years, shareholder value has been a ‘hot’ issue among managers. Many lead- ing businesses now claim that the quest for shareholder value is the driving force behind their strategic and operational decisions. As a starting point, we shall consider what is meant by the term ‘shareholder value’, and in the sections that follow we shall look at two of the main approaches to measuring shareholder value. In simple terms, ‘shareholder value’ is about putting the needs of shareholders at the heart of management decisions. It is argued that shareholders invest in a business with a view to maximising their financial returns in relation to the risks that they are pre- pared to take. As managers are appointed by the shareholders to act on their behalf, management decisions and actions should therefore reflect a concern for maximising shareholder returns. Though the business may have other ‘stakeholder’ groups, such as employees, customers and suppliers, it is the shareholders that should be seen as the most important group. This, of course, is not a new idea. As we discussed in Chapter 1, maximising share- holder wealth is assumed to be the key objective of a business. However, not everyone accepts this idea. Some believe that a balance must be struck between the competing claims of the various stakeholders. A debate concerning the merits of each viewpoint is beyond the scope of this book; however, it is worth pointing out that, in recent years, the business environment has radically changed. In the past, shareholders have been accused of being too passive and of accepting too readily the profits and dividends that managers have delivered. However, this has changed. Shareholders are now much more assertive, and, as owners of the business, are in a position to insist that their needs are given priority. Since the 1980s we have witnessed the deregulation and globalisation of business, as well as enormous changes in technology. The effect has been to create a much more competitive world. This has meant not only competition for products and services but also competition for funds. Businesses must now compete more strongly for shareholder funds and so must offer competitive rates of return. Thus, self-interest may be the most powerful reason for managers to commit them- selves to maximising shareholder returns. If they do not do this, there is a real risk that shareholders will either replace them with managers who will, or allow the business to be taken over by another business that has managers who are dedicated to maximising shareholder returns. How can shareholder value be created? Creating shareholder value involves a four-stage process. The first stage is to set objec- tives for the business that recognise the central importance of maximising shareholder returns. This will set a clear direction for the business. The second stage is to establish an appropriate means of measuring the returns, or value, that have been generated for shareholders. For reasons that we shall discuss later, the traditional methods of measuring returns to shareholders are inadequate for this purpose. The third stage is to manage the business in such a manner as to ensure that shareholder returns are maximised. This means setting demanding targets and then achieving them through CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING 340 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 340 the best possible use of resources, the use of incentive systems and the embedding of a shareholder value culture throughout the business. The final stage is to measure the shareholder returns over a period of time to see whether the objectives have actually been achieved. Figure 9.8 shows the shareholder value creation process. The need for new measures Given a commitment to maximise shareholder returns, we must select an appropriate measure that will help us assess the returns to shareholders over time. It is argued that the traditional methods for measuring shareholder returns are seriously flawed and so should not be used for this purpose. MEASURING SHAREHOLDER VALUE 341 The four-stage process for creating shareholder value Figure 9.8 What are the traditional methods of measuring shareholder returns? The traditional approach is to use accounting profit or some ratio that is based on accounting profit, such as return on shareholders’ funds or earnings per share. Activity 9.6 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 341 There are broadly four problems with using accounting profit, or a ratio based on profit, to assess shareholder returns. These are: l Profit is measured over a relatively short period of time (usually one year). However, when we talk about maximising shareholder returns, we are concerned with max- imising returns over the long term. It has been suggested that using profit as the key measure will run the risk that managers will take decisions that improve perform- ance in the short term, but which may have an adverse effect on long-term per- formance. For example, profits may be increased in the short term by cutting back on staff training and research expenditure. However, this type of expenditure may be vital to long-term survival. l Risk is ignored. A fundamental business reality is that there is a clear relationship between the level of returns achieved and the level of risk that must be taken to achieve those returns. The higher the level of returns required, the higher the level of risk that must be taken. A management strategy that produces an increase in profits can reduce shareholder value if the increase in profits achieved is not commensurate with the increase in the level of risk. Thus, profit alone is not enough. l Accounting profit does not take account of all of the costs of the capital invested by the busi- ness. The conventional approach to measuring profit will deduct the cost of bor- rowing (that is, interest charges) in arriving at profit for the period, but there is no similar deduction for the cost of shareholder funds. Critics of the conventional approach point out that a business will not make a profit, in an economic sense, unless it covers the cost of all capital invested, including shareholder funds. Unless the business achieves this, it will operate at a loss and so shareholder value will be reduced. l Accounting profit reported by a business can vary according to the particular accounting policies that have been adopted. The way that accounting profit is measured can vary from one business to another. Some businesses adopt a very conservative approach, which would be reflected in particular accounting policies such as immediately treating some intangible assets (for example, research and development and good- will) as expenses (‘writing them off’) rather than retaining them on the statement of financial position as assets. Similarly, the use of the reducing-balance method of depreciation (which means high depreciation charges in the early years) reduces profit in those early years. Businesses that adopt less conservative accounting policies would report higher profits in the early years of owning depreciating assets. Writing off intangible assets over a long time period (or, perhaps, not writing off intangible assets at all), the use of the straight-line method of depreciation and so on will have this effect. In addition, there may be some businesses that adopt particular accounting policies or carry out particular transactions in a way that paints a picture of financial health that is in line with what those who prepared the financial statements would like shareholders and other users to see, rather than what is a true and fair view of financial performance and position. This practice is referred to as ‘creative accounting’ and has been a major problem for accounting rule makers and for society generally. Real World 9.10 provides some examples of creative accounting methods that have recently been found in practice. CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING 342 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 342 Net present value (NPV) analysis To summarise the points made above, we can say that, to enable us to assess changes in shareholder value fairly, we need a measure that will consider the long term, take account of risk, acknowledge the cost of shareholders’ funds, and will not be affected by accounting policy choices. Fortunately, we have a measure that can, in theory, do this. Net present value analysis was discussed in Chapter 8. We saw that if we want to know the net present value (NPV) of an asset (whether this is a physical asset such as a machine or a financial asset such as a share in a business) we must discount the future cash flows generated by the asset over its life. Thus: NPV == +++···+ where C 1 , C 2 , C 3 and C n are cash flows after one year, two years, three years and n years, respectively, and r is the required rate of return. Shareholders have a required rate of return, and managers must strive to generate long-term cash flows for shares (in the form of dividends or proceeds from the sale of the shares) that meet this rate of return. The expectation that the managers will, in the future, fail to generate the minimum required cash flows will have the effect of reduc- ing the value of the business as a whole and, therefore, of the individual shares in it. If a business is to create value for its shareholders, it must be expected to generate cash flows that exceed the required returns of shareholders. We should bear in mind here that the value of a business and its shares is entirely dependent on two factors: C n (1 ++ r) n C 3 (1 ++ r) 3 C 2 (1 ++ r) 2 C 1 (1 ++ r) 1 MEASURING SHAREHOLDER VALUE 343 REAL WORLD 9.10 Dirty laundry: how businesses fudge the numbers The ways in which managers can manipulate the financial statements are many and varied. The methods below have come to light in the recent wave of accounting scandals that have been reported in the US and UK. l Hollow swaps: telecoms businesses sell useless fibre optic capacity to each other in order to generate revenues on their income statements. l Channel stuffing: a business floods the market with more products than its distributors can sell, artificially boosting its sales revenue. An international condom maker shifted £60m in excess inventory on to trade customers. Also known as ‘trade loading’. l Round tripping: also known as ‘in-and-out trading’. Used to notorious effect by Enron. Two or more traders buy and sell energy among themselves for the same price and at the same time. Inflates trading volumes and makes participants appear to be doing more business than they really are. l Pre-despatching: goods such as carpets are marked as ‘sold’ as soon as an order is placed. This inflates sales revenues and profits. l Off-balance-sheet activities: businesses use special-purpose entities and other devices such as leasing to push assets and liabilities off their statements of financial position. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 343 1 expectations of future cash flows; and 2 the shareholders’ required rate of return. Past successes are not relevant. The NPV approach fulfils the criteria that we mentioned earlier as a means of fairly assessing changes in shareholder value because: l It considers the long term. The returns from an investment, such as shares, are con- sidered over the whole of its life. l It takes account of the cost of capital and risk. Future cash flows are discounted using the required rates of returns from investors (that is, both long-term lenders and shareholders). Moreover, this required rate of return will reflect the level of risk asso- ciated with the investment. The higher the level of risk, the higher the required level of return. l It is not sensitive to the choice of accounting policies. Cash rather than profit is used in the calculations and is a more objective measure of return. Extending NPV analysis: shareholder value analysis (SVA) We know from our consideration of NPV in Chapter 8 that, when evaluating an invest- ment project, shareholder wealth will be maximised if we maximise the net present value of the cash flows generated from the project. Leading on from this, the business as a whole can be viewed as simply a portfolio of investment projects and so to max- imise the wealth of shareholders the same principles should apply. Shareholder value analysis (SVA) is founded on this basic idea. The SVA approach involves evaluating strategic decisions according to their ability to maximise value, or wealth, for shareholders. To enable a business to assess the effect of a particular set of strategies on shareholder value, it needs a means of measuring shareholder value both before and after adopting the strategy and comparing the two values. We shall now go on to see how this can be done. Measuring free cash flows The cash flows used to measure total business value are the free cash flows. These are the cash flows generated by the business that are available to ordinary shareholders and long-term lenders. In other words, they are equivalent to the net cash flows from operations after deducting tax paid and cash for additional investment. These free cash flows can be deduced from information contained within the income statement and statement of financial position of a business. It is probably worth going through a simple example to illustrate how the free cash flows are calculated in practice. CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING 344 ‘ ‘ Sagittarius plc generated sales revenue of £220m during the year and has an oper- ating profit margin of 25 per cent of sales revenue. The depreciation charge for the year was £8.0m and the effective tax rate for the year was 20 per cent of operat- ing profit. During the year £11.3m was invested in additional working capital and £15.2m was invested in additional non-current assets. A further £8.0m was invested in the replacement of existing non-current assets. Example 9.2 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 344 This shortened approach leads us to identify the key variables in determining free cash flows as being l sales revenue l operating profit margin l tax rate l additional investment in working capital l additional investment in non-current assets. These are value drivers of the business that reflect key business decisions. These deci- sions convert into free cash flows and finally into shareholder value. Any actions that management can take to l boost sales revenue; and/or l increase the operating profit margin; and/or l reduce the effective tax rate; and/or l reduce the investment in working capital; and/or l reduce the investment in non-current assets will have the effect of increasing shareholders’ wealth. Figure 9.9 shows the process of measuring free cash flows. MEASURING SHAREHOLDER VALUE 345 The free cash flows are calculated as follows: £m £m Sales revenue 220.0 Operating profit (25% × £220m) 55.0 Depreciation charge 8.0 Operating cash flows 63.0 Tax (20% × £55m) (11.0) Operating cash flows after tax 52.0 Additional working capital (11.3) Additional non-current assets (15.2) Replacement non-current assets (8.0) (34.5) Free cash flows 17.5 We can see that to derive the operating cash flows, the depreciation charge is added back to the operating profit figure. We can also see that the cost of replace- ment of existing non-current assets is deducted from the operating cash flows to deduce the free cash flow figure. When we are trying to predict future free cash flows, one way of arriving at an approximate figure for the cost of replacing exist- ing assets is to assume that the depreciation charge for the year is equivalent to the replacement charge for non-current assets. This would mean that the two adjustments mentioned cancel each other out. In other words, the calculation above could be shortened to: £m £m Sales revenue 220.0 Operating profit (25% × £220m) 55.0 Tax (20% × £55m) (11.0) 44.0 Additional working capital (11.3) Additional non-current assets (15.2 ) (26.5) Free cash flows 17.5 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 345 At this point, it is probably worth going through an example to illustrate the way in which we might calculate shareholder value for a business. Business value and shareholder value We have just seen how SVA measures the value of the business as a whole through dis- counting the free cash flows. The value of the business as a whole is not necessarily, however, that part which is available to the shareholders. CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING 346 Measuring free cash flows Figure 9.9 The information required in the process of measuring the free cash flows for a business can be gleaned from the income statement and statement of financial position of a business. If the net present value of future cash flows generated by the business represents the value of the business as a whole, how can we derive that part of the value of the busi- ness that is available to shareholders? A business will normally be financed by a combination of borrowing and ordinary share- holders’ funds. Thus lenders will also have a claim on the total value of the business. That part of the total business value that is available to ordinary shareholders can therefore be derived by deducting from the total value of the business (total NPV) the market value of any borrowings outstanding. Hence: Shareholder value = total business value − market value of outstanding borrowings Activity 9.7 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 346 MEASURING SHAREHOLDER VALUE 347 The directors of United Pharmaceuticals plc are considering making a takeover bid for Bortex plc, which produces vitamins and health foods. It will do this by offer- ing to buy all of the shares in Bortex plc. It is expected that the Bortex plc share- holders will reject any bid that values the shares at less than £11 each. Bortex plc generated sales revenue for the most recent year of £3,000m. Extracts from the business’s statement of financial position at the end of the most recent year are as follows: £m Equity Share capital £1 ordinary shares 400 Reserves 380 780 Non-current liabilities Loan notes 120 Forecasts that have been prepared by the business planning department of Bortex plc are as follows: l Sales revenue will grow at 10 per cent a year for the next five years. l The operating profit margin is currently 15 per cent and is likely to be main- tained at this rate in the future. l The cash tax rate is 25 per cent. l Replacement non-current asset investment (RNCAI) will be in line with the annual depreciation charge each year. l Additional non-current asset investment (ANCAI) for each year over the next five years will be 10 per cent of sales revenue growth. l Additional working capital investment (AWCI) for each year over the next five years will be 5 per cent of sales revenue growth. After five years, the business’s sales revenues will stabilise at their Year 5 level. The business has a cost of capital of 10 per cent and the loan notes figure in the state- ment of financial position reflects its current market value. The free cash flow calculation will be as follows: Year 1 Year 2 Year 3 Year 4 Year 5 After Year 5 £m £m £m £m £m £m Sales revenue 3,300.0 3,630.0 3,993.0 4,392.3 4,831.5 4,831.5 Operating profit (15%) 495.0 544.5 599.0 658.8 724.7 724.7 Less Cash tax (25%) (123.8) (136.1) (149.8) (164.7) (181.2) (181.2) Operating profit 371.2 408.4 449.2 494.1 543.5 543.5 after cash tax Less ANCAI* (30.0) (33.0) (36.3) (39.9) (43.9) – AWCI † (15.0) (16.5) (18.2) (20.0) (22.0) – Free cash flows 326.2 358.9 394.7 434.2 477.6 543.5 Notes: * The additional non-current asset investment is 10 per cent of sales revenue growth. In the first year, sales revenue growth is £300m (that is, £3,300m − £3,000m). Thus, the investment will be 10% × £300m = £30m. Similar calculations are carried out for the following years. † The additional working capital investment is 5 per cent of sales revenue growth. In the first year the investment will be 5% × £300m = £15m. Similar calculations are carried out in following years. Example 9.3 ‘ M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 347 Managing with SVA We saw earlier that the adoption of SVA indicates a commitment to managing the business in such a way as to maximise shareholder returns. Those who support this approach argue that SVA can be a powerful tool for strategic planning. For example, SVA can be extremely useful when considering major shifts of direction such as l acquiring new businesses l selling existing businesses l developing new products or markets l reorganising or restructuring the business because it takes account of all the elements that determine shareholder value. Figure 9.10 shows how shareholder value is derived. CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING 348 Having derived the free cash flows (FCF), the total business value can be calcu- lated as follows: Year FCF Discount factor Present value £m @ 10% £m 1 326.2 0.909 296.5 2 358.9 0.826 296.5 3 394.7 0.751 296.4 4 434.2 0.683 296.6 5 477.6 0.621 296.6 Terminal value: 543.5/0.10 (see Note) 5,435.0 0.621 3,375.1 Total business value 4,857.7 Note: After Year 5 there is no further sales expansion, so no increase in assets will be involved. Also, since the shareholders require a 10 per cent return, they will place a value of £5,435m on the future returns after Year 5. This is a value on which £543.5m represents a 10 per cent return. Example 9.3 continued What is the shareholder value figure for the business in Example 9.3? Would the sale of the shares at £11 per share add value for the shareholders of Bortex plc? Shareholder value will be the total business value less the market value of the loan notes. Hence, shareholder value is £4,857.7m − £120m = £4,737.7m The proceeds from the sale of the shares to United Pharmaceuticals would yield 400m × £11 = £4,400.0m Thus, from the point of view of the shareholders of Bortex plc, the sale of the business, at the share price mentioned, would not increase shareholder value. Activity 9.8 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 348 [...]... to make investment decisions It is, in many respects, a business within a business In practice, it appears that top management is more prepared to allow discretion over production and sales decisions than over capital expenditure decisions Thus, profit centres are more common than investment centres Divisional structures A business may be divided into divisions in any way that top management considers... more or less as a separate business should develop their ability to think in strategic terms This can be of great benefit to the business when it is looking for successors to the current generation of top managers Specialist knowledge Where a business offers a wide range of products and services, it would be difficult for top management to have the expertise to make operating decisions concerning each... threats facing the business and make appropriate plans By taking a broader view of the business and plotting a course to be followed, top managers will be making the most valuable use of their time Timely decisions If information concerning a local division has to be gathered, shaped into a report and then passed up the hierarchy before a decision is made, it is unlikely that the business will be able... ensures that individuals do not make shortterm decisions such as deferring essential expenditure from one year to the next and receive a bonus for doing so; and secondly, the bonus bank can act as a retention tool For 2006, the target level of bonus for A J Murray was 62.5% of basic salary and for G Dransfield 37.5% of basic salary No bonus entitlement arose for J C Nicholls who left the Company on October... STRATEGIC MANAGEMENT ACCOUNTING SUMMARY The main points in this chapter may be summarised as follows: Strategic management accounting (SMA) l SMA is concerned with providing information to support strategic plans and decisions l It is more outward looking, more concerned with outperforming the competition and more concerned with monitoring progress towards strategic objectives than conventional management. .. expected to last for 16 years 2 The allowance for trade receivables (bad debts) was created this year and the amount of the provision is very high A more realistic figure for the allowance would be £4 million 3 Restructuring costs were incurred at the beginning of the year and are expected to provide benefits for an infinite period 4 The business has a 7 per cent required rate of return for investors... 5/29/09 10:41 AM Page 367 DIVISIONALISATION Divisionalisation Why do businesses divisionalise? ‘ Many large businesses supply a wide range of products and services and have operating units located throughout the world Where business operations are complex, there is usually a need for an extended management hierarchy so that some decisions relating to particular operating units can be devolved from... managers to those further down the hierarchy It is not really feasible for those at the top of the hierarchy to know everything that is going on within the various operating units, and it is therefore impractical for them to take all the decisions relating to these units By creating separate divisions, a large business can therefore become more responsive to the market and can operate more effectively... turn, shareholder value, management targets can be set for improving performance in relation to each value driver and responsibility assigned for achieving these targets Activity 9.9 Can you suggest what might be the practical problems of adopting an SVA approach? Two practical problems spring to mind: 1 Forecasting future cash flows lies at the heart of this approach In practice, forecasting can be difficult,... have a significant influence over divisional decisions Research evidence suggests that participation in decision making encourages a sense of responsibility towards seeing those decisions through There is a danger that divisional managers will simply lose motivation if decisions concerning the division are made by top management and then imposed on them Management development Allowing divisional managers . (10% × C) after tax rate 10% of EVA ® £m £m £m £m £m 1 30.0* 3.0 15.0 12.0 0.91 10. 9 2 20.0 2.0 15.0 13.0 0.83 10. 8 3 10. 0 1.0 15.0 14.0 0.75 10. 5 32.2 Opening capital 30.0 62.2 Loan notes ( 10. 0. the shareholders to act on their behalf, management decisions and actions should therefore reflect a concern for maximising shareholder returns. Though the business may have other ‘stakeholder’ groups,. financial performance and position. This practice is referred to as ‘creative accounting’ and has been a major problem for accounting rule makers and for society generally. Real World 9 .10 provides