18.How to Analyze and Improve Corporate Profitability and Shareholder Value

CHAPTER 18 HOW TO ANALYZE AND IMPROVE CORPORATE PROFITABILITY AND SHAREHOLDER VALUE How you measure managerial performance and the return to stockholders? The ability to measure performance is essential in developing incentives and controlling operations toward the achievement of organizational goals Perhaps the most widely used single measure of profitability of an organization is the rate of return on investment (ROI) Related is the return to stockholders, known as the return on equity (ROE) What is return on investment (ROI)? ROI relates net income to invested capital (total assets) It provides a standard for evaluating how efficiently management employs the average dollar invested in a firm’s assets, whether that dollar came from owners or creditors Furthermore, a better ROI can also translate directly into a higher return on the stockholders’ equity ROI is calculated as: ROI = Net profit after taxes Total assets EXAMPLE 18.1 Consider the following financial data: Total assets Net profit after taxes $100,000 18,000 Then, ROI = $18,000 Net profit after taxes = = 18% Total assets $100,000 350 Corporate Profitability and Shareholder Value EXAMPLE 18.1 351 (continued) The problem with this formula is that it only tells you about how a company did and how well it fared in the industry Other than that, it has very little value from the standpoint of profit planning What is ROI made up of—DuPont formula? In the past, managers have tended to focus on the margin earned and have ignored the turnover of assets It is important to realize that excessive funds tied up in assets can be just as much of a drag on profitability as excessive expenses The DuPont Corporation was the first major company to recognize the importance of looking at both net profit margin and total asset turnover in assessing the performance of an organization The ROI breakdown, known as the DuPont formula, is expressed as a product of these two factors, as shown next ROI = = Net profit after taxes Total assets Sales Net profit after taxes × Sales Total assets = Net profit margin × Total assets turnover The DuPont formula combines the income statement and balance sheet into this otherwise static measure of performance Net profit margin is a measure of profitability or operating efficiency It is the percentage of profit earned on sales This percentage shows how many cents attach to each dollar of sales Total asset turnover, however, measures how well a company manages its assets It is the number of times by which the investment in assets turn over each year to generate sales The breakdown of ROI is based on the thesis that the profitability of a firm is directly related to management’s ability to manage assets efficiently and to control expenses effectively EXAMPLE 18.2 Assume the same data as in Example 18.1 Also assume sales of $200,000 Then ROI = $18,000 Net profit after taxes = = 18% Total assets $200,000 352 Corporate Profitability and Shareholder Value EXAMPLE 18.2 (continued) Alternatively, Net profit margin = = Net profit after taxes Sales $18,000 = 9% $100,000 Sales $200,000 Total asset = = = Times turnover Total assets $100,000 Therefore, ROI = Net Profit margin × Total asset turnover = 9% × times = 18% The breakdown provides a lot of insights to CFOs on how to improve the profitability of the company and investment strategy (Note that net profit margin and total asset turnover are called hereafter margin and turnover, respectively, for short.) Specifically, it has at least four advantages over the original formula (i.e., net profit after taxes/total assets) for profit planning They are: Focusing on the breakdown of ROI provides the basis for integrating many of the management concerns that influence a firm’s overall performance This will help managers gain an advantage in the competitive environment The importance of turnover as a key to overall return on investment is emphasized in the breakdown In fact, turnover is just as important as profit margin in enhancing overall return The importance of sales is explicitly recognized, which is not there in the original formula The breakdown stresses the possibility of trading one off for the other in an attempt to improve a company’s overall performance The margin and turnover complement each other In other words, a low turnover can be made up for by a high margin, and vice versa EXAMPLE 18.3 The breakdown of ROI into its two components shows that a number of combinations of margin and Corporate Profitability and Shareholder Value EXAMPLE 18.3 353 (continued) turnover can yield the same rate of return, as shown next.: Margin Turnover = ROI 9% (1) (2) (3) (4) × × × × × times = 18% = 18 = 18 = 18 The turnover-margin relationship and its resulting ROI is depicted in Exhibit 18.1 Is there an optimal ROI? Exhibit 18.1 can also be looked at as showing four companies that performed equally well (in terms of ROI), but with varying income statements and balance sheets There is no ROI that is satisfactory for all companies Manufacturing firms in various industries will have low rates of return Structure and size of the firm influence the rate considerably A company with a diversified product line might have only a fair return rate when all products are pooled in the analysis In such cases, it seems advisable to establish separate objectives for each line as well as for the total company Sound and successful operation must point toward the optimum combination of profits, sales, and capital employed The combination will necessarily vary depending on the nature of the business and the characteristics of the product An industry with products tailor-made to customers’ specifications will have different margins and 10 (4) Turnover (3) (2) (1) 2 10 Margin (%) Exhibit 18.1 THE MARGIN-TURNOVER RELATIONSHIP 354 Corporate Profitability and Shareholder Value turnover ratios, compared with industries that mass produce highly competitive consumer goods For example, the combination (4) may describe a supermarket operation that inherently works with low margin and high turnover, while the combination (1) may be a jewelry store that typically has a low turnover and high margin How you use ROI for profit planning? The breakdown of ROI into margin and turnover gives management insight into planning for profit improvement by revealing where weaknesses exist: margin or turnover, or both Various actions can be taken to enhance ROI Generally, management can employ three alternatives: Improve margin Improve turnover Improve both Alternative demonstrates a popular way of improving performance Margins may be increased by reducing expenses, raising selling prices, or increasing sales faster than expenses Some of the ways to reduce expenses are: ❍ ❍ ❍ Use less costly inputs of materials Automate processes as much as possible to increase labor productivity Bring the discretionary fixed costs under scrutiny, with various programs either curtailed or eliminated Discretionary fixed costs arise from annual budgeting decisions by management Examples include advertising, research and development, and management development programs The cost-benefit analysis is called for in order to justify the budgeted amount of each discretionary program A company with pricing power can raise selling prices and retain profitability without losing business Pricing power is the ability to raise prices even in poor economic times when unit sales volume may be flat and capacity may not be fully utilized It is also the ability to pass on cost increases to consumers without attracting domestic and import competition, political opposition, regulation, new entrants, or threats of product substitution The company with pricing power must have a unique economic position Companies that offer unique, high-quality goods and services (where the service is more important than the cost) have this economic position Alternative may be achieved by increasing sales while holding the investment in assets relatively constant, or by Corporate Profitability and Shareholder Value 355 reducing assets Some of the strategies to reduce assets are: ❍ ❍ ❍ ❍ Dispose of obsolete and redundant inventory The computer has been extremely helpful in this regard, making perpetual inventory methods more feasible for inventory control Devise various methods of speeding up the collection of receivables and also evaluate credit terms and policies See if there are unused fixed assets Use the converted assets obtained from use of the previous methods to repay outstanding debts or repurchase outstanding issues of stock You may release them elsewhere to get more profit, which will improve margin as well as turnover Alternative may be achieved by increasing sales or by any combinations of alternatives and Exhibit 18.2 shows complete details of the relationship of ROI to the underlying ratios—margin and turnover—and their components This will help identify more detailed strategies to improve margin, turnover, or both EXAMPLE 18.4 Assume that management sets a 20 percent ROI as a profit target It is currently making an 18 percent return on its investment ROI = Net profit after taxes Net profit after taxes = Total assets Sales × Sales Total assets Present situation: 18% = 200,000 18,000 × 200, 000 100,000 The following alternatives are illustrative of the strategies that might be used (Each strategy is independent of the other.) Alternative 1: Increase the margin while holding turnover constant Pursuing this strategy would involve leaving selling prices as they are and making every effort to increase efficiency so as to reduce expenses By doing so, expenses might be reduced by $2,000 without affecting sales and investment to yield a 20 percent target ROI, as follows 356 Corporate Profitability and Shareholder Value EXAMPLE 18.4 20% = (continued) 20,000 200,000 × 200,000 100,000 Alternative 2: Increase turnover by reducing investment in assets while holding net profit and sales constant Working capital might be reduced or some land might be sold, reducing investment in assets by $10,000 without affecting sales and net income to yield the 20 percent target ROI, as follows 20% = 18,000 200,000 × 200,000 90,000 Alternative 3: Increase both margin and turnover by disposing of obsolete and redundant inventories or through an active advertising campaign For example, trimming down $5,000 worth of investment in inventories would also reduce the inventory holding charge by $1,000 This strategy would increase ROI to 20 percent 20% = 19,000 200,000 × 200,000 95,000 Excessive investment in assets is just as much of a drag on profitability as excessive expenses In this case, cutting unnecessary inventories also helps cut down the expenses of carrying those inventories, so that both margin and turnover are improved at the same time In practice, alternative is much more common than alternative or What is the relationship between ROI and return on equity (ROE)? Generally, a better management performance (i.e., a high or above-average ROI) produces a higher return to investors (equity holders) However, even a poorly managed company that suffers from a below-average performance can generate an above-average return on the stockholders’ equity, simply called the return on equity (ROE) This is because borrowed funds can magnify the returns a company’s profits represent to its stockholders Another version of the DuPont formula, called the modified DuPont formula, reflects this effect The formula ties together the ROI and the degree of financial leverage (use of borrowed funds) The financial leverage is measured by the equity multiplier, which is the ratio of a company’s total asset base to its equity investment, or, stated another way, the ratio of how many dollars of assets held per dollar of stockholders’ equity It is calculated by dividing 357 Exhibit 18.2 Noncurrent Assets + Current Assets Total Cost minus Sales Total Assets + Sales Sales + Net Profit after Taxes RELATIONSHIPS OF FACTORS INFLUENCING ROI Machinery and Equipment Buildings Land Prepaid Expenses Inventories Notes Receivable Accounts Receivable Cash Administrative Expenses Marketing Expenses Cost of Goods Sold Total Asset Turnover × Net Profit Margin Return on Investment (ROI) 358 Corporate Profitability and Shareholder Value total assets by stockholders’ equity This measurement gives an indication of how much of a company’s assets are financed by stockholders’ equity and how much with borrowed funds The return on equity (ROE) is calculated as: ROE = = Net profit after taxes Stockholders’ equity Total assets Net profit after taxes × Total assets Stockholder’s equity = ROI × Equity multiplier ROE measures the returns earned on the owners’ (both preferred and common stockholders’) investment The use of the equity multiplier to convert the ROI to the ROE reflects the impact of the leverage (use of debt) on stockholders’ return: The equity multiplier = = Total assets Stockholders’ equity (1 − Debt ratio) Exhibit 18.3 shows the relationship among ROI, ROE, and financial leverage EXAMPLE 18.5 In Example 18.1, assume stockholders’ equity of $45,000 Then Total assets Equity = multiplier Stockholders’ equity = = ROE = $100,000 = 2.22 $45,000 1 = = = 2.22 (1-Debt ratio) (1 − 0.55) 0.45 Net profit after taxes $18,000 = = 40% Stockholders’ equity $45,000 ROE = ROE × Equity multiplier = 18% × 2.22 = 40% If the company used only equity, the 18 percent ROI would equal ROE However, 55 percent of the firm’s capital is supplied by creditors ($45,000/$100,000 = 45% is the equity-to-asset ratio; $55,000/$100,000 = 55% is the debt ratio) Since the 18 percent ROI all goes to stockholders, who put up only 45 percent of the capital, the ROE is higher than 18 percent This example indicates that the company was using leverage (debt) favorably 359 Exhibit 18.3 1– Measures the proportion of total assets provided by the firm’s creditors Debt Total liabilities = Ratio Total assets Measures overall effectiveness in generating profits with available assets Net profit after taxes Return on = Investment (ROI) Total assets DuPont Formula ROI, ROE, AND FINANCIAL LEVERAGE (MODIFIED DUPONT FORMULA) Measures the returns earned on the owners’ (both preferred and common stockholders’) investment Net profit after taxes Return on Equity = (ROE) Stockholders’ equity Modified DuPont Formula = Measures efficiency in using assets to generate sales Sales Total asset = turnover Total assets × Measures profitability with respect to sales generated Net profits Net profit after taxes margin = Sales 360 Corporate Profitability and Shareholder Value EXAMPLE 18.6 To further demonstrate the interrelationship between a firm’s financial structure and the return it generates on the stockholders’ investments, let us compare two firms that generate $300,000 in operating income Both firms employ $800,000 in total assets, but they have different capital structures One firm employs no debt, whereas the other uses $400,000 in borrowed funds The comparative capital structures are shown as: A Total assets Total liabilities Stockholders’ equity (a) Total liabilities and stockholders’ equity B $800,000 — 800,000 $800,000 $800,000 400,000 400,000 $800,000 Firm B pays 10 percent interest for borrowed funds The comparative income statements and ROEs for firms A and B would look like this: Operating income Interest expense Profit before taxes Taxes (30% assumed) Net profit after taxes (b) ROE [(b)/(a)] $300,000 — $300,000 (90,000) $210,000 26.25% $300,000 (40,000) $260,000 (78,000) $182,000 45.5% The absence of debt allows firm A to register higher profits after taxes Yet the owners in firm B enjoy a significantly higher return on their investments This provides an important view of the positive contribution debt can make to a business, but within a certain limit Too much debt can increase the firm’s financial risk and thus the cost of financing If the assets in which the funds are invested are able to earn a return greater than the fixed rate of return required by the creditors, the leverage is positive and the common stockholders benefit The advantage of this formula is that it enables the company to break its ROE into a profit margin portion (net profit margin), an efficiency-of-asset-utilization portion (total asset turnover), and a use-of-leverage portion (equity multiplier) It shows that the company can raise shareholder return by employing leverage—taking on larger amounts of debt to help finance growth Since financial leverage affects net profit margin through the added interest costs, management must look at the various pieces of this ROE equation, within Balanced Scorecard EXAMPLE 18.6 361 (continued) the context of the whole, to earn the highest return for stockholders CFOs have the task of determining just what combination of asset return and leverage will work best in its competitive environment Most companies try to keep at least a level equal to what is considered to be ‘‘normal’’ within the industry BALANCED SCORECARD How does a balanced scorecard to evaluate performance work? A problem with just assessing performance with financial measures like profit, ROI, and economic value added (EVA) is that the financial measures are backward looking In other words, today’s financial measures tell you about the accomplishments and failures of the past An approach to performance measurement that also focuses on what managers are doing today to create future shareholder value is the balanced scorecard Essentially, a balanced scorecard is a set of performance measures constructed for four dimensions of performance As indicated in Exhibit 18.4, the dimensions are financial, customer, internal processes, and learning and growth Having financial measures is critical even if they are backward looking After all, they have a great effect on the evaluation of the company by shareholders and creditors Customer measures examine the company’s success in meeting customer expectations Internal process measures examine the company’s success in improving critical business processes And learning and growth measures examine the company’s success in improving its ability to adapt, innovate, and grow The customer, internal processes, and learning and growth measures are generally thought to be predictive of future success (i.e., they are not backward looking) How is balance achieved in a balanced scorecard? A variety of potential measures for each dimension of a balanced scorecard are indicated in Exhibit 18.4 After reviewing these measures, note how ‘‘balance’’ is achieved: 362 Corporate Profitability and Shareholder Value Measures Financial Is the company achieving its financial goals? Operating income Return on assets Sales growth Cash flow from operations Reduction of administrative expense Customer Is the company meeting customer expectations? Customer satisfaction Customer retention New customer acquisition Market share On-time delivery Time to fill orders Internal Processes Is the company improving critical internal processes? Defect rate Lead time Number of suppliers Material turnover Percent of practical capacity Learning and Growth Is the company improving its ability to innovate? Amount spent on employee training Employee satisfaction Employee retention Number of new products New product sales as a percent of total sales Number of patents Exhibit 18.4 ❍ ❍ ❍ BALANCED SCORECARD Performance is assessed across a balanced set of dimensions (financial, customer, internal processes, and innovation) Quantitative measures (e.g., number of defects) are balanced with qualitative measures (e.g., ratings of customer satisfaction) There is a balance of backward-looking measures (e.g., financial measures like growth in sales) and forward-looking measures (e.g., number of new patents as an innovation measure) Note: The balanced scorecard measures vary with a company’s strategy and industry Exhibit 18.5 lists examples of performance indicators for each balanced scorecard dimension across a wide rage of industries There are numerous Web resources that you can log on to to learn more about the balanced scorecard and performance evaluations For example, managers frequently look to industry ‘‘best practices’’ or examples of 363 Sales growth from new products Inventory turnover Computer manufacturers Supermarkets Exhibit 18.5 Client retention rate Profit margin Accounting, consulting, and law firms EXAMPLES OF BALANCED SCORECARD MEASURES BY INDUSTRY Customer satisfaction Number of corporate customers Number of new accounts opened Ratio of assets of debt Consumer retail banks Frequent flier program participation rates Customer Dimenstion Return on assets Financial Dimenstion Airlines Industry Product spoilage rates Number of product defects Percentage of projects completed on time Number of new branches Percentage of ontime takeoffs and arrivals Internal Process Dimension Employee turnover rates Percentage of factory employees who completed quality control training Certification and education levels of professionals Hours of employee training completed Labor contract length Learning and Growth Dimenstion 364 Corporate Profitability and Shareholder Value successful implementations at other firms when developing measurement programs The next list provides valuable resources for evaluating performance and business decision making across a wide range of industries ❍ ❍ ❍ ❍ The Balanced Scorecard Institute (www.balancedscore card.org) The Balanced Scorecard Institute is an independent educational institute that provides training and guidance to assist government agencies and companies in applying best practices in balanced scorecard (BSC) and performance measurement for strategic management and transformation Their Web site provides background information about implementing the balanced scorecard and the proper selection of nonfinancial measures It also provides several examples of past successes American Productivity and Quality Center (www.apqc org) The American Productivity & Quality Center (APQC), an internationally recognized nonprofit organization, provides expertise in benchmarking and best practices research APQC helps organizations adapt to rapidly changing environments, build new and better ways to work, and succeed in a competitive marketplace It has a membership of over 450 prestigious global firms including M, AT&T, Cisco Systems, and Ernst & Young The objective of this collaborative center is to ‘‘Understand how innovative organizations create succession management programs to identify and cultivate potential leaders who will provide a sustainable business advantage.’’ The Best Practices and Free Resources links lead to many useful resources Management Help (www.managementhelp.org) This Web site offers a robust library of decision-making tools and resources The site offers many resources on such topics as strategic planning, performance measurement, employee development, and make-or-outsource decisions It also includes online discussion groups, decision-making guidance, and free reference material Performance Measurement Association (www.perform anceportal.org) This Web site, home to the United Kingdom’s Performance Measurement Association, covers references to valuable articles, a free newsletter, and insight into current trends in performance measurement It is representative of the types of professional associations that managers join to share ideas and continue the development of their personal and managerial skills Economic Value Added (EVA®) 365 ECONOMIC VALUE ADDED (EVA®) Why is economic value added (EVA) gaining popularity? EVA is a concept similar to residual income but is often applied at the overall firm level as well as at the departmental level It is a registered trademark of Stern Stewart & Co (www.sternstewart.com), which developed the concept EVA is a measure of economic profit, but not the accounting profit we are accustomed to seeing in a corporate profit and loss statement It is a measure of an operation’s true profitability The cost of debt capital (interest expense) is deducted when calculating net income, but no cost is deducted to account for the cost of common equity Hence, in an economic sense, net income overstates ‘‘true’’ income EVA overcomes this flaw in conventional accounting EVA is found by taking the net operating profit after taxes (NOPAT) for a particular period (such as a year) and subtracting the annual cost of all the capital a firm uses EVA recognizes all capital costs, including the opportunity cost of the shareholder funds It is a business’s true economic profit Such economic profits are the basis of shareholder value creation NOTE The calculation of EVA can be complex because it makes various cost of capital and accounting principles adjustments The formula is: EVA = NOPAT − after-tax cost of total capital = Earnings before interest and taxes (EBIT) × (1 − tax rate) − [Total capital × (After = tax cost of capital)] Total capital used here is total assets minus current liabilities Hence, it is long-term liabilities plus equity (preferred stock and common equity) Thus, EVA is an estimate of a business’s true economic profit for the year, and it differs sharply from accounting profit EVA represents the residual income that remains after the cost of all capital, including equity capital, has been deducted, whereas accounting profit is determined without imposing a charge for equity capital Equity capital 366 Corporate Profitability and Shareholder Value has a cost because funds provided by shareholders could have been invested elsewhere where they would have earned a return In other words, shareholders give up the opportunity to invest funds elsewhere when they provide capital to the firm The return they could earn elsewhere in investments of equal risk represents the cost of equity capital This cost is an opportunity cost rather than an accounting cost, but it is quite real nevertheless Example 18.7 illustrates how an operation’s economic profit differs from its accounting profit EXAMPLE 18.7 A company with $100,000 in equity capital (stated at fair value) and $100,000 in percent debt (also at fair value) had $60,000 in earnings before interest and taxes (EBIT) Assume also that $200,000 equals capital employed The corporate tax rate is 40 percent If that company’s weighted-average after-tax cost of capital is 14 percent, the EVA is $2,000, calculated as: EBIT Minus taxes (40% × $60,000) NOPAT Capital charge (14% × $200,000) EVA $60,000 (24,000) $36,000 (28,000) $8,000 The company’s traditional income statement reports income of $31,200, calculated as: EBIT Minus interest (8% × $100,000) Income before taxes Income taxes (40% $52,000) Net income after taxes $60,000 (8,000) 52,000 (20,800) $31,200 Initially, a 31.2 percent return on equity ($31,200 of net income/$100,000 of equity capital) seems favorable, but what is the cost of that equity capital? Given equal amounts of debt and equity, the cost of the equity capital must be 23.2 percent because the after-tax weighted average cost of capital was 14 percent and the after-tax cost of debt capital was 4.8% = 8% (1.0 – 40%) NOTE Since 14% = (4.8%)(1/2) + X (1/2), X = 23.2% More on NOPAT 367 EXAMPLE 18.7 (continued) Thus, $23,200 of the $31,200 of net income is nothing more than the opportunity cost of equity capital The $8,000 of EVA is the only portion of earnings that has created value for the shareholders Accordingly, if income after taxes had been only $20,000 (a 20 percent return on equity), shareholder value would have been reduced because the cost of equity capital would have exceeded the return EVA AND VALUE CREATION In the previous example, the $2,000 of EVA is the only portion of earnings that has created value for the shareholders EVA provides a good measure of whether the firm has added to shareholder value Therefore, if managers focus on EVA, this will help to ensure that they operate in a manner that is consistent with maximizing shareholder value Note also that EVA can be determined for divisions— it is more often called residual income—as well as for the company as a whole, so it provides a useful basis for determining managerial compensation at all levels Although most companies adopt EVA for purposes of internal reporting and for calculating bonuses, some are publishing the results in the corporate annual reports For example, Eli Lilly reports EVA in the Financial Highlights section of the annual report Companies like SPX made it clear in its 1998 annual report: ‘‘EVA is the foundation of everything we It is a common language, a mindset, and the way we business.’’ MORE ON NOPAT Before computing NOPAT, analysts routinely adjust the company’s reported earnings figures These adjustments fall into three broad categories: Isolate a company’s sustainable operating profits by removing nonoperating or nonrecurring items from reported income Eliminate after-tax interest expense from the profit calculation so that profitability comparisons over 368 Corporate Profitability and Shareholder Value time or across companies are not clouded by differences in financial structure Adjust for distortions related to as accounting quality concerns, which involve potential adjustments to both income and assets for items such as the off-balance sheet operating leases NOPAT is used to improve the comparability of EVA calculations Otherwise, firms with different debt structures could have the same operating performance but different net incomes NOPAT = Net income after taxes + (Charges and gains × (1 − Tax rate)) + (Interest × (1 − Tax rate)) Example 18.8 illustrates the NOPAT computation EXAMPLE 18.8 Given the following income statement for years 20X4 and 20X5: COMPARATIVE INCOME STATEMENT 20X5 Sales Cost of sales Gross margin Selling, general, and administrative expenses Restructuring charges and gains Interest expense Other revenue and expenses 20X4 $5,199.0 (2,807.5) $5,954.0 (3,294.4) 2,391.5 2,659.6 (1,981.0) (2,358.8) 113.4 (106.8) 1,053.5 (131.6) Net income (1.5) (2.2) 415.6 (166.2) 1,220.5 (488.2) $249.4 $732.3 20X5 Before-tax income Income taxes (40%) 20X4 NOPAT CALCULATIONS Net income as reported Restructuring charges and gains after-tax Interest expense after-tax $249.4 $732.3 −68.04 64.08 −632.1 79.0 Net operating profit after taxes (NOPAT) $245.4 $179.2 Capital Charge 369 EXAMPLE 18.8 (continued) For example, for year 20X2, NOPAT = Net income after taxes + (Charges and gains ×(1 − Tax rate)) + (Interest × (1 − Tax rate)) = $247.9 − ($113.4(1 − 0.4)) + ($106.8(1 − 0.4)) = $247.9 − $68.04 + $64.08 = $254.4 CAPITAL CHARGE The capital charge is the most distinctive and important aspect of EVA Under conventional accounting, most companies appear profitable, but many in fact are not The capital charge equals the after-tax weighted-average cost of capital (calculated based on fair values of debt and equity) times the investment base or total capital employed (total assets minus current liabilities or the sum of long-term debt, preferred stock, and common equity) Key Features of EVA The main characteristics of EVA are summarized in this way: ❍ ❍ For internal purposes, EVA is a better measure of profitability than ROI because a manager with a high ROI would be reluctant to invest in a new project with a lower ROI than is currently being earned, even though that return might be higher than the cost of capital Thus, including a capital charge on departmental income statements helps managers to make decisions that will benefit the company There is evidence of a direct correlation between EVA and increases in stock prices For example, AT&T found an almost perfect correlation between its EVA and its stock price In fact, many analysts have found that stock prices track EVA far more closely than other factors such as earnings per share (EPS), operating margin, or return on equity (ROE) The argument is that simply having a continuing stream of income is not enough; that income must exceed the cost of capital for a stock to rise significantly in the stock market 370 ❍ ❍ Corporate Profitability and Shareholder Value EVA uses dollars instead of percentages to measure changes For example, it is much more appealing to report that the company generated $1 million in shareholder value than to say that the ROI increased from 10 to 15 percent EVA is the only financial management system that provides a common language for employees across all operating and staff functions and allows all management decisions to be modeled, monitored, communicated, and compensated in a single and consistent way—always in terms of the value added to shareholder investment What Value-Driven Managers Can Do to Improve EVA As a simplified form, EVA = NOPAT − (After-tax weighted average cost of capital) × (Net assets) Another way to look at it is: EVA = NOPAT Net assets × Net assets − (After-tax weighted average cost of capital × Net assets) = NOPAT After-tax weighted − Net assets average cost of capital × Net assets = (Return on net assets −After-tax weighted average cost of capital) × Net assets = (Rona − WACC) × Net assets Assuming other variables stay constant, EVA increases when RONA increases; or WACC decreases; or net assets increase (assuming profitable growth) or net assets decrease (in the case of money-losing assets) Evidence from EVA adopters shows six ways to achieve improvements Increase asset turnover Dispose of unprofitable businesses Refurbish assets Structure deals that require less capital Increase leverage and use less equity finance Invest in profitable growth A Caveat 371 Note that three of these actions (increasing asset turnover, repairing assets, and structuring deals with less capital) increase EVA through improvement in RONA Disposing of unprofitable businesses increases EVA, providing improvements in the spread between RONA and WACC are greater than the reduction in net assets Increasing leverage increases EVA by reducing WACC, assuming that the company is underlevered when it begins taking on more debt Investing is profitable and increases Eva, as long as the RONA on the investment exceeds the WACC EVA Compensation EVA bonus plans not just motivate managers to think about current EVA If they did, managers would focus entirely on short-term performance at the expense of the future Value-creating investments might be avoided because their immediate effects on EVA are negative The solution is to give managers a direct economic state in future EVA, not just the current period The performance evaluation will be more meaningful if the current EVA is compared to EVAs from previous periods, target EVAs, and EVAs from other operating units or companies A CAVEAT EVA is no panacea, and it is no substitute for sound corporate strategies But when EVA is at the center of a company’s performance measurement system, and when management bonus systems and bonus systems are linked, alignment between the interests of managers and shareholders improves The effect is that when managers make important decisions, they are more likely to so in ways that deliver superior returns for shareholders  ... operating and staff functions and allows all management decisions to be modeled, monitored, communicated, and compensated in a single and consistent way—always in terms of the value added to shareholder. .. the cost of capital for a stock to rise significantly in the stock market 370 ❍ ❍ Corporate Profitability and Shareholder Value EVA uses dollars instead of percentages to measure changes For example,... Sales 360 Corporate Profitability and Shareholder Value EXAMPLE 18.6 To further demonstrate the interrelationship between a firm’s financial structure and the return it generates on the stockholders’