Increasing goal congruence in project evaluation by introducing a strict market depreciation schedule

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Int. J. Production Economics 121 (2009) 519–532

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Increasing goal congruence in project evaluation by introducinga strict market depreciation schedule

Ted Lindblom, Stefan Sjogren�

Department of Business Administration, Industrial and Financial Management, Gothenburg School of Business,

Economics and Law, Box 610, SE 405 30, Sweden

Received 30 March 2006; accepted 12 December 2006

Available online 1 March 2007

Abstract

The economic accuracy of accrual-based managerial performance measures is most essential for value added investment

decisions in decentralised firms. Contemporary EVA-literature often lends support to annuity-based depreciation

schedules for accomplishing congruence between capital budgeting criteria, like NPV, and accounting measures, like ROI

and RI. This is incongruent with the principal agent literature aiming at designing managerial incentive contracts. We

introduce a strict market-based depreciation schedule which is shown to be superior to ordinary straight-line, annuity-

based or IRR-based depreciation schedules. It gives the right managerial investment incentives also in the case of growth,

inflation or technological development.

r 2007 Elsevier B.V. All rights reserved.

Keywords: Depreciation; Managerial incentive; Performance measurement; Capital budgeting; EVA

1. Introduction

Both within single firms and in the society a lot ofefforts have been put down over the years in orderto develop routines and adequate decision criteriafor accepting profitable investment alternativesand rejecting unprofitable ones. The rationalebehind these efforts is in accordance with theprincipal agent theory (Jensen and Meckling,1976), describing the costs that arise due toasymmetric information and goal incongruencebetween the principal (in first hand the owners)and the agent (management). Decision authority is

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ss: [email protected] (S. Sjogren).

also delegated throughout the organisation leadingto arising agent costs also on lower levels within theorganisation. In hierarchical organisations, thereexist a number of principal agent relationshipswhere ‘‘a middle level manager might be the agentof managers above him and the principal toemployees below him’’ (Lambert, 2001, p. 6). Thedevelopment and implementation of accurate in-formation systems and incentive control mechan-isms are essential for minimising agent costs due toconflicts of interest. However, for obtaining goalcongruence and efficient resource utilisation in thelong run it is also vital to stimulate decision-makers(managers) to use adequate investment appraisal orcapital budgeting techniques, like a discounted cashflow (DCF) technique in the form of the net presentvalue (NPV) formula.

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1The relationship between NPV and relative accounting

measures, like ROI, is not as evident, though. Quite the contrary

‘‘ythere is a built-in incentive not to accept projects which

reduce the average ROI. This selection criterion also generally

lacks congruence with the usual discounted cash flow model’’

(Bromwich and Walker, 1998, p. 397).

T. Lindblom, S. Sjogren / Int. J. Production Economics 121 (2009) 519–532520

In surveys of the use of investment appraisaltechniques it is repeatedly discovered that managersare often using and, in some cases, even seeming tofavour simpler and less advanced techniques anddecision criteria, like the pay-back criterion (San-dahl and Sjogren, 2003). Moreover, only in a fewfirms the manager is relying on one single capitalbudgeting technique implying that users of the(slightly) more advanced NPV-formula are consid-ering other criteria as well (Arnold and Hatzopou-los, 2000; Graham and Harvey, 2001). Many ofthem even adopt ordinary accounting measures, likereturn on investment (ROI) and residual income(RI) (cf. Drury et al., 1993), as complementarydecision criteria. This is likely to be explained by thefact that managerial compensation as well as theevaluation of firm/division performance is usuallybased on accounting income instead of economicprofit (Antle and Smith, 1986; Stern et al., 1996;Biddle et al., 1997; Rogerson, 1997; Sullivan andLaScola Needy, 2000; Dutta, 2003). Hence, beforeaccepting a new project, managers are interested infinding out what impact it would have on the bookof accounts.

A common argument among advocators ofbringing in new managerial incentive programmesis that investment appraisals based on accruals(accounting figures) are likely to lead to eitherunder- or overinvestment. Accounting measures arewidely known to be subject to significant errors,which ‘‘arise in large part because accountingmethods of depreciation do not adequately measuretrue depreciation’’ (McFarland, 1990, p. 521). Ingeneral firms are using a linear or straight-linedepreciation schedule (Berliner and Brimson, 1988;Ask and Ax, 1997), assuming implicitly that thedecline in value of a project is the same in eachperiod (year) of its economic life. In many cases theloss in (market) value is thereby overestimatedduring the first part of the project’s life, whichmeans too high initial capital charges in the form ofinterest and depreciation charges. This implies thatthe financial performance of the manager in chargeof the project would look worse than it actually is.Hence, managers may be reluctant to approvecertain projects even if the projects are profitablein terms of NPV. In the case of intangible assets, i.e.investments in R&D, education of employees,marketing, etc., the effect of underinvestment isemphasised even more. Such projects are inprinciple fully depreciated at the first period (i.e.year) of their economic life.

This may give the impression that there is aninherent and unsolvable conflict between economicprofitability and accounting profitability. That isnot necessarily the case, though. Economic profit-ability is project oriented and concerns cash flowsgenerated during the whole economic life of aproject, whereas accounting profitability is periodoriented and may be seen as a partial estimation of aproject’s profit (operating income) for a certainperiod of time, often a year. Even so they need notto be in contradiction with each other. Preinreich(1938) was early to point out that there exists afundamental relationship between the economicmeasure, NPV, and accounting measures, like RI.As will be shown in this paper, NPV equals the sumof the discounted periodical RI estimations over theeconomic life of a project regardless of thedepreciation rate chosen (O’Hanlon and Peasnell,1998). As the forecasted accounting measures are inline with the expected NPV, managerial compensa-tion based on RI would thus compensate managerscorrectly in the long run.1 From a managerialincentive perspective, however, the use of this kindof accrual-based managerial performance measure-ment criterion might still not lead to goal con-gruence. As Lambert (2001, p. 79) asserts, it isessential that the evaluation criterion is alsodisplaying the true value in each period of theproject’s economic life. ‘‘In order to get residualincome to correctly motivate the agent’s investmentchoice, the principal must calculate the ‘correct’depreciation schedule. To do this, the principal mustbe able to ‘match’ the depreciation to the timepattern of the cash flows generated by the invest-ment.’’ Hence, in order to achieve a higher level ofgoal congruence the depreciation schedule in useshould reflect the economic decline in the (asset)value of the project.

Today there exist a number of value-basedmanagement methods (residual income methods)for measuring managerial performance. Thesemethods are also being increasingly used asdeterminants for managerial compensation. Animportant motive for implementing managerialperformance measures is to oblige managers to actin a way that will maximise the welfare of share-

ARTICLE IN PRESST. Lindblom, S. Sjogren / Int. J. Production Economics 121 (2009) 519–532 521

holders. ‘‘Ideally, the performance measures se-lected for management compensation contracts arethose measures that best motivate management tomaximise the value of the firm’’ (Wallace, 1997,p. 276). This paper aims at clarifying the funda-mental relationship between economic and account-ing measures. For this purpose, we introduce theconcept of a strict market depreciation schedule.A second aim is to discuss implications for thedesigning of an efficient managerial performancemeasurement control system based on marketvaluation principles.

The paper adopts a principal agent perspective byadhering to the work by Rogerson (1997), Reich-elstein (2000) and Wagenhofer (2003) on optimalperformance measures. In that respect this paper isdistinguished from the vast literature on value-based management, like e.g. the EVA-literature.The focus on a strict market depreciation is,however, not on gaming and moral hazard issues.In terms of the categorisation by Magee (2001), it ismore referable to performance measure designissues than the incentive function design. Weassume a special form of a ‘‘plain vanilla’’ principalagent model implying that there is no informationasymmetry ex-post between the principal and theagent. In contrast to the single-period modellingthat is predominant in the principal agent literature(cf. Lambert, 2001), the robustness of our proposedsolution is analysed and demonstrated under amulti-period framework.

2. Managerial performance evaluation in

decentralised firms

When depreciation charges deviate from the realdecline in asset (market) value significant agentcosts may arise in decentralised firms that utiliseaccounting measures, like ROI or RI, for evaluatingthe financial performance of managers. Suchaccrual-based measures are likely to show adifferent result than NPV—at least in the short-run (Edwards and Bell, 1961; Flower, 1971;Bromwich, 1973). This gives rise to a managerial

incentive dilemma in decentralised firms that areusing accruals as leading evaluation criteria of thefinancial performance of middle/lower managers.As managers are induced to give priority to projectsthat fulfil the leading performance evaluationcriteria, projects that are profitable only in termsof NPV are likely to be systematically rejected.

In investment centres, managers are by definitionentitled to decide by themselves whether to acceptor reject an investment opportunity. If they areevaluated by accruals they may not only rejectprojects that are profitable in terms of NPV, theymay even pursue unprofitable projects if that wouldimprove the books of account. In this context,Jensen and Meckling (1998, p. 12) are particularlyconcerned about rate of return measures (like ROI)as ‘‘these measures are highly susceptible to gamingand tend to provide counterproductive incentiveswhen managers have decision rights over the level ofinvestment or assets.’’ As ROI is maximised if onlythe project with the highest return is pursued,investment centre managers will have a strongincentive not to take on other assets than thatsingle one. The origin to the managerial incentivedilemma is another in profit centres where theheadquarter or top management uses NPV as theleading decision criterion. Managers of profitcentres have to await the approval at the head-quarter. If their financial performance is evaluatedby accruals, profitable projects may still be forgone,though. The profit centre managers would then havethe incentive to send in applications only on thoseprojects that are profitable in terms of both NPVand the accounting measures in use. As a conse-quence, good projects in terms of NPV but not byaccruals might be rejected at an early stage by aprofit centre manager without even being sent to thecentral unit for consideration.

The managerial incentive dilemma may be illu-strated by the following example. Let us assume thatan investment centre manager is considering aproject that would require an initial outlay ðI0Þ ofh100; 000 and, generate an expected annual cashflow ðat ¼ aÞ of h17; 000 during its economic life ðNÞof 10 years. Let us further assume that theopportunity cost of capital or relevant required rateof return ðkÞ is 10%. Using the NPV-formula in Eq.(1) it can be shown that an accomplishment of thisproject would be profitable for the decentralisedfirm ðNPV ¼ h4458Þ:

NPV ¼ � I0 þXN

t¼1

atð1þ kÞ�t

¼ � I0 þ a1� ð1þ kÞ�N

k

� �. ð1Þ

As is demonstrated by Table 1, if a straight-linedepreciation schedule is applied, the manager of theinvestment centre would be better off in terms of

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Table 1

ROI and RI based on straight-line depreciation

Year Depreciation

charge

Asset

(book)

value

ROI

(%)

RI PV of RI

0 100,000

1 10,000 90,000

7.0

(3000) (2727.3)

2 10,000 80,000

7.8

(2000) (1652.9)

3 10,000 70,000

8.8

(1000) (751.3)

4 10,000 60,000

10.0

0 0

5 10,000 50,000

11.7

1000 620.9

6 10,000 40,000

14.0

2000 1129.0

7 10,000 30,000

17.5

3000 1539.5

8 10,000 20,000

23.3

4000 1866.0

9 10,000 10,000

35.0

5000 2120.5

10 10,000 0

70.0

6000 2313.3

P100,000 4458


ROI and RI (in the short-run) by rejecting theproject. This implies that she/he would be reluctantto approve this profitable project under this type ofaccrual-based managerial performance measure-ment system.

The residual income ðRItÞ and the return oninvestment ðROItÞ for year t are defined as2

RIt ¼ at �Dt � kAt�1, (2)

2The annual cash flow ðatÞ is here used as a proxy for the

difference between revenue and cost (excluding the depreciation

charge) for each year t. This seems to be a reasonable proxy in the

case of a single project. Solutions to how to deal with the

inconsistency between the accounting rate of return and the

economic rate of return that originates from using accruals

instead of cash flow on aggregated levels have been widely

discussed in the literature (e.g. McIntyre, 1977; Gordon and

Stark, 1989) Value-based management models, using accounting

information as the primary source for evaluating the economic

return, show how to adequately adjust each specific accounting

item in order to project the real cash flow produced from the

operations. Stern et al. (1996), for instance, identify 120 short-

comings in the conventional GAAP accounting that needs to be

corrected in order to calculate an EVA-measure.

ROIt ¼ðat �DtÞ

At�1, (3)

where At�1 is the asset (book) value at the beginningof year t, Dt the depreciation charge year t.

According to Table 1 it would take four yearsbefore the project ‘‘breaks even’’ in terms of both RIand ROI. In the first three years, the project wouldhave a negative effect on the financial performanceof the manager (and thereby also negatively affecteventual bonus payments based on accruals).Hence, the manager is likely to find it moreattractive to reject the project even though theproject appears to become ever more profitable inthe years to follow. She/he might have left thecompany by that time. The latter remark is notchanged by the fact that the project is correctlyevaluated over its total economic life when using RI(see column 4 in Table 1). As long as a straight-linedepreciation schedule is applied, RI-based measure-ment of financial performance would not solve themanagerial incentive dilemma and stimulate themanager to pursue every project that is profitable interms of NPV—let alone decline all other projects.Achieving this kind of goal congruence would notonly require that an investment centre managerpossesses the ability to accurately and truly ‘‘trans-late’’ cash flows of profitable projects into future RIfor each period of their economic life, but moreimportantly the manager must never be replacedduring the economic life of accepted projects. In on-going concerns the latter requirement could not besolved with employment contracts of ever so longduration. This means that the depreciation scheduleadopted by a decentralised firm is most essential forobtaining goal congruence.

3. Depreciation charges and goal congruence

We have discerned two main categories ofresearch on how to obtain goal congruence. Inone category, the authors adjust these charges whenimplicitly or explicitly trying to design internalmanagement accounting or performance measure-ment systems that will stimulate managers tobecome more efficient and act in the interest ofowners (shareholders). The concept of economicvalue added (EVA) has sprung from this kind ofresearch. According to the originators, EVA may beseen as a ‘‘refinement of economists’ concept of‘residual income’—the value that is left over after acompany’s stockholders (and all other providers of


capital) have been adequately compensated’’ (Sternet al., 1996, p. 224). This implies that depreciationcharges should be adjusted and set more in line withthe true change in the value of projects (Harcourt,1965; Gordon, 1974; Fisher and McGowan, 1983;Hartman, 2000; Shrieves and Wachowicz, 2001).The other category aims at designing managerialincentive contracts within a principal–agent frame-work (Rogerson, 1997; Reichelstein, 2000; Duttaand Reichelstein, 2002, 2003; Dutta, 2003; Wagen-hofer, 2003). A common denominator is then todescribe and analyse how different performancemeasurement methods are likely to affect andinfluence agent costs. In this category, the focus isthus on managerial incentives rather than ondepreciation schedules.

In the search for a depreciation schedule inaccordance with the true decline in the value ofprojects, annuity-based depreciation charges areoften suggested by researches in the former category(e.g. Gordon and Stark, 1989). Such depreciationcharges may be derived by Eq. (4):

Dt ¼ I0k

1� ð1þ kÞ�N

� �� kAt�1. (4)

As is shown in Table 2, applying an annuity-based depreciation schedule on the project in ourexample would considerably alter the managerialincentive picture.

As an annuity-based depreciation schedule isprogressive by nature and therefore incur lowerdepreciation charges at the beginning of theproject’s economic life, both ROI and RI (or

Table 2

ROI and RI based on annuity depreciation charges

Year Depreciation

charge

Asset

(book)

value

ROI

(%)

RI

(EVA)

PV of RI

0 100,000

1 6275 93,725 10.7 725.46 659.5

2 6902 86,823 10.8 725.46 599.6

3 7592 79,231 10.8 725.46 545.1

4 8351 70,880 10.9 725.46 495.5

5 9187 61,693 11.0 725.46 450.5

6 10,105 51,588 11.2 725.46 409.5

7 11,116 40,472 11.4 725.46 372.3

8 12,227 28,245 11.8 725.46 338.4

9 13,450 14,795 12.6 725.46 307.7

10 14,795 0 14.9 725.46 270.7P100,000 4458

EVA) are positive already in the first year.3 It maybe noted that the absolute accounting measure, RIor EVA, displays the same profitability each year(see column 5 in Table 2). The use of an annuity-based depreciation schedule leads to equally largeannual capital charges in terms of depreciation andinterest costs.

Although the annuity-based depreciation sche-dule is likely to give managers the incentive toaccept projects that are profitable in terms of NPV(i.e. provided EVA or RI is used),4 there is still a gapbetween the measurement of managerial perfor-mance and the actual performance of the project.A manager that leaves the company before theproject is terminated would not get any credit forthe positive results expected to occur the remainingyears. Likewise, a new manager would be (partly)credited for a decision she/he did not make. Thisdivergence between measured and actual managerialperformance may have a negative impact on theoverall objective of the firm to obtain goalcongruence. Hence, the managerial incentive dilem-ma still remains.5

In the other category, closely related discussionsand solutions to the managerial incentive dilemmahave been proposed by researchers like Gaeremynck(1995), Reichelstein (2000), Dutta (2003), andWagenhofer (2003). Reichelstein (2000) makes acomparison between managerial performance mea-surement methods based on realised cash flows andaccrual-based cash flow methods. He shows that theformer methods are superior in providing manage-rial incentives for obtaining goal congruence. Histheoretical model assumes a principal (or accoun-tant) with idealised information, though. In the caseof asymmetric information, Dutta (2003) finds thata principal can delegate investment decisions to

3In this simplified example we may assume EVA to be

equivalent to RI.4The manager might still think that ROI is too low if it is below

the average ROI (see note 1).5An alternative depreciation schedule that is also discussed in

the corporate finance literature is based on the project’s IRR

(McIntyre, 1977). When using IRR as a base for determining

depreciation charges ROI would equal IRR and, thus, assume the

same value each year. Provided that k is still equal to the required

rate of return in Eq. (2), RI would assume a positive value

already in the first year—a value that would thereafter diminish

year by year as the depreciation charges increase. (In the case

IRR is used instead of k, RI would of course be equal to zero

each year.) Hence, by the same reason as the annuity method

neither an IRR-based depreciation schedule would resolve the

managerial incentive dilemma.

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6This is in accordance to the Hick’s income concept described

and algebraically expressed in e.g. Gordon (1974).


better informed managers by using a RI-baseddepreciation schedule, whereas Gaeremynck (1995)argues that the chosen depreciation schedule can beused as a signalling devise along with the morecommon cash flow and inventory accountingmethod.

Wagenhofer (2003) extends the research byRogerson (1997), Reichelstein (2000), and Duttaand Reichelstein (2002) by assuming a risk avertmanager and, instead of focusing on incentives thatwould minimise under- or overinvestment, he isconsidering ‘‘a two-period model in which amanager simultaneously makes investments (longterm) and operative (short term) decisions’’ (Wa-genhofer, 2003, p. 289). This is made in order tocontrol incentives in a multi-action setting and toderive to the conclusion that depreciation, com-pared to cash flow, ‘‘. . . shifts part of the investmentcost away from the period in which the decision istaken and the effort is incurred, and, thus it betteraligns with the total economic consequences of theinvestment’’ (Wagenhofer, 2003, p. 303). This twoperiod model also allows for negative depreciationin the first period to guarantee that the agent willhave the right incentives. In line with the contrac-tual-based analysis by Wagenhofer (2003), we arguethat the manager that makes a decision to pursue aproject should be fully credited for the outcome ofthat project already in the year it is approved. Theconcept of a strict market depreciation schedulerests on this principle. In this paper we willdemonstrate a multi-period solution. In accordancewith true or theoretically correct depreciationcharges: depreciation charges based on a strictmarket depreciation schedule reflect the net loss(or sometimes even gain) in an implied market valueof a project under the assumption that the currentor any new ‘‘owner’’ will receive the remaining cashflow streams of it in the future.

Below we are analysing explicitly how an optimaldepreciation schedule should be constructed inorder to give full credit to the decision-maker overthe economic life of a multi-period project. Thisanalysis is thereafter further extended by theincorporation of growth, inflation, and technologi-cal development.

4. Strict market depreciation

By definition, a theoretically-based depreciationcharge of a project for a certain period is related tothe change in the implied market value of the

project under that period. A theoretically correctmarket oriented depreciation schedule for a projectmay thus be defined as the difference between thepresent value of all future cash flows at time t�

1ðPVt�1Þ and the present value of all future cashflow calculated at time tðPVtÞ.

6 This is illustrated byEq. (5):

Dt ¼ PVt�1 � PVt. (5)

Assuming fixed cash flows, ðaÞ, we can derive thedepreciation charge ðDtÞ for each year by using theformula for discounting annuities:

Dt ¼ a1� ð1þ kÞ�Nþðt�1Þ

k�

1� ð1þ kÞ�Nþt

k

!.

(6)

Rearranging Eq. (6):

Dt ¼a

kðð1þ kÞ�Nþt

� ð1þ kÞ�Nþðt�1ÞÞ,

Dt ¼a

kðð1þ kÞt�1ðð1þ kÞ�N

þ kð1þ kÞ�N

� ð1þ kÞ�NÞÞ.

Into:

Dt ¼ að1þ kÞt�1ð1þ kÞ�N . (7)

Evidently, the implied market value at the beginningof year 1 (i.e. at time 0) would be greater than theinitial investment cash outlay when the project isprofitable in terms of NPV, as is the case in ourexample. This is taken into account by adjusting fora strict market depreciation schedule ðADtÞ. TheNPV of the project is deducted from the differencebetween PV 0 and PV 1. The depreciation charge thefirst year as well as for the remaining years of theeconomic life of the project may be determined byEq. (8):

ADt ¼að1þ kÞt�1ð1þ kÞ�N ; t41;

að1þ kÞ�N�NPV; t ¼ 1:

((8)

It may be notified that Eq. (8) would result indepreciation charges in accordance with an annuity-based depreciation schedule if the project shows anNPV ¼ 0. In that case an annuity-based deprecia-tion schedule would fully reflect the change in theimplied market value of the project for each year (cf.Reichelstein, 2000). Using the other assumptions in

ARTICLE IN PRESS

Table 3

Depreciation charges and accounting profitability under a strict market depreciation schedule

Year NPV 4458 Depreciation charge ðADtÞ ROI (%) RI PV of RI

0 PV0 104,458

1 PV1 97,903 2095 14.9 4903.40 4458

2 PV2 90,694 7210 10.0 0 0

3 PV3 82,763 7931 10.0 0 0

4 PV4 74,040 8724 10.0 0 0

5 PV5 64,443 9596 10.0 0 0

6 PV6 53,888 10,556 10.0 0 0

7 PV7 42,276 11,611 10.0 0 0

8 PV8 29,504 12,772 10.0 0 0

9 PV9 15,455 14,050 10.0 0 0

10 0 15,455 10.0 0 0P100,000 4458

T. Lindblom, S. Sjogren / Int. J. Production Economics 121 (2009) 519–532 525

our example, this is easily verified by inserting k ¼

IRR in Eqs. (4) and (7), respectively.As is evident from Table 3, the application of a

strict market depreciation schedule will lead to goalcongruence. The agent (i.e. the manager responsiblefor the decision to pursue the project) will be fullycredited already in the first year. In this way, theseadjustments will provide the correct managerialincentive for decision-making by the agent in theinterest of the principal.7

Under this two-stage model (Eq. (8)), both ROIand RI will show a positive (affirmative) value forthe project the first year and thereafter add nofurther value to the project as long as it isdeveloping according to plan. A strict marketdepreciation schedule correctly reflects the changein the implied market value of the project in eachyear.

5. Strict market depreciation schedule under

assumptions of growth, inflation and technological

development

Growth, inflation and technological developmentmay be regarded as normal conditions of a project.They have in common that they relax the assump-tion of a constant cash flow. In the growth case weassume, like in the so-called Gordon’s growthmodel, a constant growth rate during the economiclife of the project. (The model may however be

7In the case the objective function of the agent was based on a

different required rate of return ðkaÞ from the one of the firm ðkÞ,

the agent would still act in the interest of the principal as long as

kaXk. This is also likely to be the case considering the shorter

time horizon of the agent.

developed further in order to take into account achange in the rate of growth as well.) We follow thesame principle as in the base case, i.e. for each yearthe depreciation charge should be equal to thedifference between implied market values at thebeginning and the end of each specific year.Accordingly, the depreciation charges ðADtÞ con-cerning the years of the project’s economic life maybe determined by using Eq. (9):

AD¼t

a

ðk � gÞk

1þ g

1þ k

� �N

ð1þ kÞt�1

� gð1þ gÞt�1�; t41;

a

ðk � gÞk

1þ g

1þ k

� �N

� g

!�NPV; t ¼ 1;

8>>>>>>>>>><>>>>>>>>>>:

(9)

where g is the growth rate, ðgakÞ.In order to demonstrate the impact on a project’s

profitability in accounting terms in the case ofgrowth, let us start with the base case and assumethat the fixed annual cash flow of h17; 000 wasa fairly good estimation of the average annualcash flow over the economic life of the project.Let us further assume that an accurate estimatefor the first year would have been h15; 000 and thatthis cash flow thereafter may be expected to growby 3% per year, i.e. the growth rate is equal to3%. As may be verified by Eq. (1), the projectwould still be profitable for the decentralised firmðNPV ¼ h3256Þ.

Table 4 shows that the project would not break-even in terms of ROI and RI until the fifth yearwhen a straight-line depreciation schedule is

ARTICLE IN PRESS

Table 4

A comparison between strict market depreciation and ordinary straight-line depreciation under the assumption of constant growth of cash

flow

Year PV Strict market depreciation Straight-line depreciation

NPV ¼ 3256 Depreciation charge ROI (%) RI ROI (%) RI PV of RI

0 103,256

1 98,582 1418 13.6 3582 5.0 (5000) (4545)

2 92,990 5592 10.0 0 6.1 (3550) (2934)

3 86,375 6615 10.0 0 7.4 (2087) (1568)

4 78,622 7753 10.0 0 9.1 (609) (416)

5 69,602 9020 10.0 0 11.5 883 548

6 59,173 10,429 10.0 0 14.8 2389 1349

7 47,179 11,994 10.0 0 19.8 3911 2007

8 33,449 13,730 10.0 0 28.2 5448 2542

9 1779 15,657 10.0 0 45.0 7002 2969

10 0 17,792 10.0 0 92.7 8572 3305P100,000 3256


applied. Still, the NPV of the project would beaccurately estimated by discounting the RI of eachyear (see the right column in Table 4). Both the caseof inflation and technological development, respec-tively, may be analysed and demonstrated accord-ingly.

The case of inflation is similar to the case ofconstant growth of cash flows. In contrast to theprevious analysis of the growth case, it will beassumed that cash flows are affected by the inflationrate already in the first year. Another importantassumption is that all future cash flows are expectedto exactly follow this inflation rate. As the initialoutlay is in nominal terms, an appreciation of thenominal asset value may in fact appear in the firstyear. The NPV will however remain unaffected.

Even though one way to handle inflation is tomake all calculations in real terms, Eq. (10) showshow a theoretically accurate depreciation scheduleunder the assumption of inflation may be derived innominal terms:

AD¼t

að1þ iÞ

ðkn � iÞkn

1þ i

1þ kn

� �N

ð1þ knÞt�1

� ið1þ iÞt�1�; t41;

að1þ iÞ

ðkn � iÞkn

1þ i

1þ kn

� �N

� i

!�NPV; t ¼ 1;

8>>>>>>>>>><>>>>>>>>>>:

(10)

where i is the inflation rate, and kn the nominalrequired rate of return.

In the case of technological development weassume that technology is progressing at a steadyrate, i.e. a constant annual improvement rate.Moreover, we will assume a certain degree ofmarket competition so that the technological devel-opment will have a negative impact on the futurecash flow of a project. When there is technologicaldevelopment the project may be exposed to thecompetition of superior (more efficient) projects ofthe same kind in the future. This is taken intoaccount by decreasing the future annual cash flowswith the development rate ðdÞ. Since newer andimproved projects will not exist in the first year, thisdecline of cash flows will start in the second year.Hence, technological development may be treated asa case of negative growth and future cash flows aredeflated. When applying a strict market deprecia-tion schedule, an annual rate of technologicaldevelopment may thus be derived by inserting g ¼

�d in Eq. (9). This gives Eq. (11):

AD¼t

a

ðk þ dÞk

1� d

1þ k

� �N

ð1þ kÞt�1

þ dð1� dÞt�1�; t41;

a

ðk þ dÞ

kð1� dÞN

ð1þ kÞNþ d

� ��NPV; t ¼ 1;

8>>>>>>>>><>>>>>>>>>:

(11)

where d is the technological development.Clearly, a strict market depreciation schedule will

lead to goal congruence by providing depreciationcharges in accordance with the true decline of the


implied market value of the project. As in the basecase, the manager responsible for pursuing theproject will be credited already when this decision isbeing made. There will be no further economic value

added the remaining years of the economic life of theproject as long as it is proceeding according to plan.

6. The importance of post-auditing systems in order

to solve the agency-dilemma

The adoption of post-audit procedures is gener-ally found to be associated with improved firmperformance (Gulliver, 1987; Myers et al., 1991).Despite that, the vast corporate finance literature oninvestment appraisal issues has put little attention tothe post-auditing processes and how companiesdetermine the real outcome of a project (Freemanand Beale, 1992; Akalu, 2003). The follow-up ofinvestment decisions in order to improve futuredecision-making is often an unutilised process inbusiness firms. The firms are generally adoptingrelative accounting measures, like ROI (Antle andSmith, 1986; Biddle et al., 1997; Rogerson, 1997;Sullivan and LaScola Needy, 2000; Dutta, 2003).This is often referred to as the so-called disentangle-ment problem (Pike, 1982; Neale, 1989). It arisesbecause the economic consequences of a project inprogress are aggregated in the accounting informa-tion system and evaluated together with the out-come of other project activities. The firms monitorthe progress of a project on a frequent and regularbasis using methods like variation in costs, sche-dules and/or time (Akalu, 2003). Regrettably, DCF-methods are seldom applied, though.

An important motive for the follow-up of aninvestment is to compare its actual performancewith the forecasts being made prior to the invest-ment decision (Neale, 1989). Another essentialmotive is to correct and take actions early if theproject is not developing according to plan (Pike,1982). In this respect, a major advantage ofadjusting the depreciation is that it allows postauditing of projects by still using accruals, like ROIand RI. With a strict market depreciation schedulethese accruals are based on economic (market)values instead of ordinary book values. This makesthem more in accordance with the economic termsand capital budgeting estimations that the invest-ment appraisal decision was based on.

Another kind of follow-up motives concerns theevaluation of the ability of middle managers indecision-making and the autonomy of lower orga-

nisational units (Honko et al., 1982). In the caseof asymmetric information there is a risk foropportunistic behaviour and that managers utiliseinformation advantages by deliberately makingmiscalculations. All performance measurement sys-tems are to a greater or less extent exposed to thiskind of misleading and deceptive conduct regardlessof whether they are accrual or cash flow based.Ingenuously used for evaluation and compensationof managers, the adjustments proposed will notresolve this incentive compatible problem. There isclearly a strong incentive for decision-makers tomanipulate future cash flow estimations whenever abonus programme is based on market value crea-tion. ‘‘For example, the agent could keep thereported overall profitability constant but under-state expected cash flows in early years and over-state them in later years. By understating them inearly years, he could receive a ‘favourable’ deprecia-tion schedule as well as look good by beating theforecast in the early years’’ (Lambert, 2001, p. 79).Obviously, the manager is expecting to have eitherbeen promoted or left the firm by the time theproject is underscoring and looking bad. The case ofconstant growth might invite the manager tocalculatingly achieve this effect by overstating thegrowth rate ðgÞ and understating the cash flowsurplus ðatÞ the first year. Therefore, it is vital tocontinuously consider and carefully examine anyreported deviation of significance from the originalinvestment appraisal analysis to determine whetherit is still valid or needs to be revised in order toensure the accuracy of managerial performanceevaluation and compensation. As Stern et al. (1996)emphasise, it is essential that the use of bonusprogrammes is handled with a delay for reducinguncertainty. According to them a solution might beto ‘‘freeze’’ a certain percentage of the performancebonus earned by managers on special bonusaccounts from which payments are being made inproportion to the successful realization of projectplans. This would gradually undermine opportunis-tic managerial behaviour and, thus, pave the wayfor efficient decision-making when using a strictmarket depreciation schedule.

7. A practical application

In this section, we will apply a strict marketdepreciation schedule on a more realistic and widelycited case presented by Weissenrieder (1997). He isan ardent advocate of cash flow-based evaluation of

ARTICLE IN PRESST. Lindblom, S. Sjogren / Int. J. Production Economics 121 (2009) 519–532528

managerial performance in decentralised firms. Heasserts that managers’ creation of value may beeffectively captured and measured by the cash valueadded (CVA) method, which was introduced anddeveloped by Ottosson and Weissenrieder (1996).CVA should provide a fairer evaluation of thefinancial performance of managers in charge ofolder established divisions or business units andthose managers operating new and more recentestablished units. In his paper, he illustrates asituation from the retail industry, where businessstores are operated as investment or profit centres.When using traditional performance measuresbased on accruals, it is very difficult—if possible—for managers of newly opened stores to performwell, particularly in comparison with the financialperformance shown by managers operating olderestablished stores.

Weissenrieder (1997) uses a numerical examplereferred to as HM/Wal-Mart. The ‘‘HM/Wal-Mart’’ case tries to replicate a fast growing retailfirm with heavily negative cash flows during anumber of years due to massive investments in newretail stores. It is assumed that a new storeinvestment (SI) is made every year during the first10 years and that each store is profitable in terms ofNPV. Every store is assumed to generate the samecash flow of 17% of the invested capital and have aneconomic life of 20 years. The required rate ofreturn is set to 15% in nominal terms given aninflation rate of 3%. As shown in Table 5, the costof open-up new retail stores is however assumed toincrease step-wise with an initial outlay of 1400 thefirst three years (1980–1982), 1500 the following twoyears (1983–1984), 2000 in year 1985 and thereafteran increase of 500 each year up to 1989.

Table 5

Cash flows at HM/Wal-Mart

1980 1981 1982 1983 1984 1985 1986 1987

SI1 �1400 238 245 252 260 268 276 284

SI2 �1400 238 245 252 260 268 276

SI3 �1400 238 245 252 260 268

SI4 �1500 255 263 271 279

SI5 �1500 255 263 271

SI6 �2000 340 350

SI7 �3000 510

SI8 �3500

SI9

SI10P�1400 �1162 �917 �764 �487 �702 �1323 �1263

Source: Weissenrieder (1997).

In Table 6, the annual financial performance ofHM/Wal-Mart is evaluated in terms of CVA andEVA based on a straight-line depreciation schedule.Both evaluations start out from the operating cashflow generated annually. These cash flows (¼ thesum of all positive cash flows each year) are directlyderived from Table 5. In order to calculate EVA thefinancial requirements or total cost of capital, i.e.the depreciation charge plus the product of therequired rate of return and the asset (book) value atbeginning of each year, should be deducted from theoperating cash flow. The ratio of operating cashflow and financial requirements then gives the EVAindex, which is a relative performance measureintroduced by Weissenrieder (1997). As soon as thisindex is greater than one, economic value is created.The greater the index value, the greater the valuecreation in relative terms. CVA is derived bysubtracting, what Ottosson and Weissenrieder(1996) refer to as, the operating cash flow demand

from the operating cash flow. Operating cash flowdemand is simply the annualised total cost of capitalin nominal terms. The ratio of operating cash flowand operating cash flow demand then gives thecorrespondent CVA index.

Not surprisingly, the financial performance interms of EVA will be negative at the beginning.Table 6 shows that it will take seven years, i.e. until1987, before the manager of HM/Wal-Mart will getany credit for the value that has actually beencreated already since 1981. Thereafter EVA willincrease substantially both in nominal and relative(EVA index) terms, even though no value is createdafter 1990. Clearly, as has been demonstrated andemphasised in this paper, this outcome should beexpected when using a straight-line depreciation

1988 1989 1990 1991 1992 1993 1994 1995 1996y

293 301 311 320 329 339 350 360 371y

284 293 301 311 320 329 339 350 360y

276 284 293 301 311 320 329 339 350y

287 296 304 314 323 333 343 353 364y

279 287 296 304 314 323 333 343 353y

361 372 383 394 406 418 431 444 457y

525 541 557 574 591 609 627 646 665y

595 613 631 650 670 690 710 732 754y

�4000 680 700 721 743 765 788 812 836y

�4500 765 788 812 836 861 887 913y

�1101 �834 4541 4678 4818 4963 5111 5265 5423y

ARTICLE IN PRESS

Table 6

HM/Wal-Mart’s financial performance in terms of EVA and CVA

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996y

EVA

Operating cash flow 238 483 736 1013 1298 1677 2237 2899 3666 4541 4678 4818 4963 5111 5265 5423y

Financial requirements 280 550 809 1077 1334 1680 2211 2820 3502 4254 4073 3891 3710 3528 3347 3165y

Economic value added �42 �66 �73 �64 �36 �3 26 80 164 287 605 927 1253 1583 1918 2257y

EVA index 0.85 0.88 0.91 0.94 0.97 1.00 1.01 1.03 1.05 1.07 1.15 1.24 1.34 1.45 1.57 1.71y

CVA


Operating cash flow demand 189 383 584 804 1030 1331 1775 2301 2909 3603 3711 3823 3937 4056 4177 4303y

Cash value added 49 100 152 209 268 346 462 599 757 938 966 995 1025 1056 1087 1120y

CVA index 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26y

Source: Weissenrieder (1997).

Table 7

Applying adjusted strict market depreciation charges on HM/Wal-Mart’s expansion

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996y

EVA (RI) with adjusted strict market depreciation


Financial requirements �181 64 316 564 849 1078 1339 1852 2469 3194 4678 4818 4963 5111 5265 5423y

Economic value added 419 419 419 449 449 599 898 1048 1198 1347 0 0 0 0 0 0y

EVA index �1.31 7.55 2.32 1.80 1.53 1.56 1.67 1.57 1.49 1.42 1.00 1.00 1.00 1.00 1.00 1.00y

T. Lindblom, S. Sjogren / Int. J. Production Economics 121 (2009) 519–532 529

schedule. Accordingly, CVA will give a positive cashvalue added already from the beginning of the timehorizon. As this measure is based on an annuity-based depreciation schedule, the CVA index conse-quently indicates that the same amount of value isbeing created each year in relative terms. Themanager is thus being credited for making decisionsthat increase the value of the business already fromthe first year. The problem is that she/he is beingawarded also towards the end of the period eventhough no additional investment decisions are thenmade that create economic value. This problem iseliminated when applying a strict market depreca-tion schedule. This is shown in Table 7, where EVA(RI) is based on such a depreciation schedule.

The adjusted EVA (RI) will now be positive everyyear up to 1990. Accordingly, the EVA index will begreater than one over the same period. As shown inTable 7, this index will actually show a negativevalue the first year. This is however due to a veryhigh profitability in terms of NPV. Each investmentin a new store creates a positive PV of future cashflow that is higher than the initial outlay. Hence, thefinancial requirement turns negative the first yeardue to a negative depreciation charge (i.e. anappreciation of the asset) this year. When no new

retail stores are opened, EVA will drop to zero andaccordingly the EVA index will equal one. Fromthen on no additional value is created from newinvestments. In Fig. 1 we have put together all threeevaluation measures of financial performance inorder to visualise differences in how they will belikely to affect the incentive and reward system atHM/Wal-Mart.

Fig. 1 shows how EVA based on a straight-linedepreciation schedule will increase dramatically innominal terms up to year 2001. Thereafter it willdecrease in accordance to the assumed life-time of20 years as old retail stores are now being closed oneby one each year. Another and perhaps morerealistic assumption might be that extra outlaysare needed in order to make those stores remainingcompetitive. In any case no positive NPV isexpected to be generated after the economic life-time of a store. When using an adjusted strictmarket depreciation schedule, EVA (RI) will bepositive already the first year. Thereafter it willincrease up to the year when the final SI is decidedupon. There exists no positive EVA/RI after 1991and onwards as no additional strategic investmentsin new stores are being made. The manager makingthe decisions is fully rewarded. What we clearly see

ARTICLE IN PRESS

-500

0

500

1000

1500

2000

2500

3000

3500

4000

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

EVA

CVA

RI (EVA with strict market depreciation)

Fig. 1. A comparison of financial performance evaluation approaches on the fictive HM/Wal-Mart case.


is the shift from accounting measures based on astraight-line depreciation schedule, where a deci-sion-maker will be reluctant to take on newinvestments, to a schedule acknowledging managersonly those years a value creating decision has beenmade. Certainly the use of CVA, i.e. an annuity-based depreciation schedule, will solve the manage-rial investment incentive dilemma as the financialperformance of the decision-making manager willbe positive also the initial years. However, mostimportantly, CVA-based performance measures willalso reward managers during the remaining life ofthe investment, i.e. all those years when theinvestment does not contribute to any increase inmarket value. This anomaly is avoided whenadopting a strict market depreciation schedule.

8. Concluding remarks

The idea of basing depreciation charges oneconomic valuation principles instead of accrualsis not new in itself. The novelty of our proposedadjustment is that it is linking managerial invest-ment incentives to firm performance. The imple-mentation of a strict market depreciation schedulewill lay a foundation for market value addedinvestment decisions by improving the accuracy ofaccrual-based performance measures. The decision-maker that approves an investment with anexpected positive NPV will be acknowledged andcredited already the year the project is pursued. Bythis reduction of inconsistency between economic

and accounting measures long term decisions areencouraged.

Throughout our analysis, an important prerequi-site has been that projected cash flows occur asexpected and, thus, the project proceeds ‘‘accordingto plan’’. In reality this is of course a very strongrequirement. In real life estimates on future cashflows are likely to be based on unsatisfactorystatistics and consequently these estimates may berather insecure or even erroneous. With unreliableforecasts of future cash flows, a managerial in-centive system based on expected present values willof course neither be a surety for the future success ofprojects approved nor a certain evaluation of thecorrectness of the decisions being made. Contrary toa conventional management accounting system,however, the use of the proposed depreciationschedule will indirectly contribute to a more reliabledecision support system as it implies a moreappropriate and qualitative follow-up of investmentappraisal decisions. This will gradually lead toimproved statistics and accurate information in apoor and insufficient post-auditing system.

In this paper, the development and demonstra-tion of a strict market depreciation schedule hasbeen carried out without any explicit considerationof moral hazard problems. This does not mean thatthe implementation would increase agent costs dueto opportunistic behaviour. On the contrary, as itenforces the firm to adopt a cash flow-based follow-up system of investment decisions, we are inclinedto argue that over time it is likely to contribute to


reduced information asymmetry between the prin-cipal and the agent as well as to more accurateestimations of future cash flows. A recent case studyof EVA-based management by Riceman et al.(2002) lends support to this standpoint. An im-portant finding in their study is that the success ofintroducing a value-based (EVA) bonus programmeis highly dependent on managers understanding ofthe EVA concept. In order to improve the decision-making of middle managers it is vital to categorisethe success or failure of investment decisions intomanageable and transparent measures. In thisrespect, bonus programmes based on a strict marketdepreciation schedule ought to be qualified as thefinancial performance of managers would be judgedon common and well-known evaluation criteria, i.e.RI or ROI.

Acknowledgement

We are grateful to the Jan Wallander and TomHedelius Foundation for financial support. We arealso grateful to referees for helpful comments.

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Documents

Increasing goal congruence in project evaluation by introducing a strict market depreciation schedule