Maf 635 Chapter 3

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Chapter 3 : Financial Performance Measures for

Profit Organizations

Prepared by:Hamisah Tahir(2009994473)Farihana Aniza Taha(2009113635)Nurulzia Ibrahim(2009190093)Rahah Adeni(2009782789)Nur Anisaa Safri (2009775685)2009775685


Overview

• Introduction to financial measures in investment centers

• Return on Investment (ROI)

• Residual Income (RI)

• Measuring performance and invested capital

• Measures of shareholder value

• Reward system

• Performance-related reward system


Introduction

• Financial measures in an investment centre

– Commonly used to assess the performance of profit centre and investment centre.

– Focus on profit-based performance measurement for the investment centers

– 3 types of financial performance measures :-

• Return on investment (ROI)

• Residual Income (RI)

• Economic Value Added (EVA)


Return on Investment

• Return on investment (ROI) is a financial measures calculated as profit divided by invested capital.

• The focus of ROI is not how much profit each investment centre earned, but rather on how well each investment centre used its invested capital to earn a profit.

• Invested capital – the assets that the investment centre has available to generate profit.

ROI =


ROI (cont’d)

• Example page 657- Rio Tinto Alcan (company which involved in aluminium business )

Operation Profit Invested capital

ROI

Refining $32 $400 32/400 = 0.08/8%

Smelting $48 $800 48/800 = 0.06/6%


Components of ROI

• ROI = Return on sales X Investment turnover

=

• Return on sales – the percentage of each sales dollar that remains as profit after all expenses are covered, calculated as profit divided by sales revenue.

• Investment turnover – the number of sales dollars generated by every dollar of invested capital (assets), calculated as sales revenue divided by invested capital.


Component of ROI (cont’d)

Operation Return on Sales

Investment turnover

ROI

Refining 32/600=5.3% 600/400=1.5 8%

Smelting 48/900=5.3% 900/800=1.125 6%

-For refining , Return on sales indicate that for each dollar of sales resulted in about 5 cents profit. Investment turnover 1.50 of sales revenue was generate by each dollar of capital invested.-For Smelting - has an investment turnover on 1.125 which indicates that it is less efficient in its use of assets.-Thus, the utilization of asset that drives the different of ROI, not the profit..


How to Improve ROI ?

• Improve Return on Sales– Increase the selling price, increase the sales

volume, decrease the expenses (reduce costs)• Improve Investment Turnover

– Increase sales revenue or reducing invested capital. For example, reduce inventories, sell plant or other non-current asset.

• However, managers should be careful when any taking actions to ensure there is no adverse effects on the product quality, performance or customer satisfaction in the future.


Advantages of ROI

• ROI is used by many decentralized business to evaluate the performance of investment centers.

• Some of the advantages are :-

– Encourages managers to focus on both profits and assets required to generate those profit. Eg. Discourage excessive investment assets and focus on increasing revenue and reducing cost

– ROI can be used to evaluate the relative performance of investment centers for both large and small business.


Disadvantages of ROI

• ROI can lead to dysfunctional decision where:

– It encourage manager to focus on short-term financial performance, at the expense of long term. Eg. Cost-cutting activity could increase ROI but weaken future profits and business future competitiveness likes quality and customer satisfaction.

– Encourage manager to defer asset replacement and disposal of asset would result increase in ROI.

– Discourage managers from investing in project that are acceptable from the total organization's point of view.


Minimizing Behavioral Problem of ROI• The problems associated with ROI can be minimized in the

following ways:-– Use ROI as one of the series of performance measures

that focus on both short-term and long-term performance. A more balanced set of measure (both financial and non-financial) can counter the dysfuntional incentive associated with ROI.

– Consider alternative way of measuring invested capital, so that the replacement of an assets is less likely to result in a reduction of ROI.

– Using alternative financial measures – likes Residual Income and Economic Value Added.


Residual Income

• The amount of profit that remains(as a residual) after subtracting an imputed interest charge.

Where as:

=profit – (invested capital x imputed interest rate)

• Unlike ROI, residual income is a dollar amount, not a ratio.


Imputed interest charge

• The required rate of return that a company expects of its investments, which is based on the organization cost of capital.

Where as:

Imputed interest rate = the firm’s required rate of return

Residual Income


Weighted Average Cost of Capital

• The weighted average cost of capital is the weighted average of the cost of funds from all sources of borrowings and equity.

- Different rates of WACC can be assigned to investment centers with different risk level.


Advantages of RI

• To promote goal congruence compared to ROI

• Encourages investment in projects which yield a higher residual income to the organization.

• More flexible because different imputed interest charge can be used for different levels of risk.

• Takes account of the organization required rate of return in measuring performance.


Disadvantages of RI

• Cannot be used to compare the performance of different-sized business units.

• Can also encourage a short-term orientation

• Residual income formula is biased in favour of larger businesses.


Measuring Profit and Invested Capital• Total assets

Investment centre manager is responsible for decisions about all of the assets of the investment centre, including non-productive assets.

• Total productive assets Investment centre manager retain non-

productive assets such as vacant land

• Total assets less current liabilities Encourage manager to minimize resources tied

up in assets and manage short-term liabilities.


Asset Measurement

• Advantages of carrying amount(disadvantages of the acquisition cost) using the carrying amount maintains consistency

with the balance sheet using the carrying amount to measure invested

capital is also consistent with the definition of profit


• Advantages of the acquisition cost (disadvantages of the carrying amount) Selection of a depreciation method(straight-line)

is arbitrary which resulting carrying does not provide a reliable measure

Depreciating non-current assets may provide a disincentive to invest in new equipment.

Asset Measurement


• Profit margin controllable by the investment centre manager Suitable profit measure if the focus is to measure

the performance of the manager of the investment centre.

To encourage goal-congruent behavior

• Profit margin attributable to the investment centre Used to calculate the investment centre ROI or

residual income.

Asset Measurement


MEASURES OF SHAREHOLDER VALUE Shareholder value (Economic Value) define as :

improving the worth of the business from the shareholder’s perspective which is interested in increased of profitability, share price, dividend and also the management is charged with the responsibility of delivering these outcomes.

The rationale behind measuring shareholder value is to determine whether a business is generating value for its shareholders or the owner.


VALUE-BASED MANAGEMENT (VBM) A framework for making key business decisions that add economic

value to the business. A particular strategy or decision creates shareholder value which

make the return on capital is greater than the cost of capital. This strategy are able to measure the value created from decision

such as whether to acquire a new business or move into new markets.

Product lines or business units that are not providing sufficient value may be deleted and the outcomes of a proposed project/asset acquisition can be analyzed.


4 aspect of VBM:

i. Valuation• The common method are used to measure value is using the

Discounted Cash Flow (DCF) model.• By using this method, the investors and the capital

market usually value a business based on the discounted future cash flows of the business.

• To increase the value of the firm, managers should know and understand the driver of value which is spread, growth, sustainability and the cost of capital.


ii. Strategy

• A strategic decision should have a substantial and continuing impact on the value of a business.

• The valuation technique can help managers to compare the value created by alternative differentiation or cost strategies.

iii. Finance

• The value creation can be influenced by the financial policies such as the adoption of particular financial and capital structure that may reduce the cost of capital.

iv. Corporate Governance

• Selecting and implementing systems that contribute to value creation.

• Performance measure can be used to measure the value-creating performance of the business.

4 aspect of VBM (cont’d)


•Used to measures the value created over a single accounting

period, measured by the spread between the return generated

by business activities.

Weighted Average Cost of Capital (WACC) :

EVA = Net Operating Profit After Tax – (capital employed x WACC)

WACC = After –tax cost mkt value cost of mkt valueof debt capital x of debt + equity capital x of equity mkt value of debt + mkt value of equity

Economic Value Added (EVA)


Illustration :

Zee Company net operating profit after-tax is RM 81,600. The company obtains its funds from long-term debt & equity. The capital employed is RM 300,000 and WACC is estimated to be 6%.

Workings:

EVA = net operating profit after tax – (capital employed x WACC)

= RM 81,600 – (RM 300,00 x 0.06)

= RM 81,600 – RM 18,000

= RM 63,600

Therefore, Zee Company generated RM 63,600 of value for shareholder for the current year.

Economic Value Added (EVA) (cont’d)


The definition of net operating profit after tax is not necessarily the same as the accounting measure of profit used in the residual income.

WACC is used in the calculation of EVA , where in RI required to use rate of return and only some case are using the WACC method.

In EVA formula, capital employed is often calculated as the company’s assets less non-interest-bearing current liabilities. While, in RI formula, invested capital can be defined in a variety of ways.

Comparing Residual Income (RI) & EVA


Improve profitability without employing any additional capital.

Borrow additional fund firm can generate profits on those funds which are in excess of the cost of borrowing.

Pay off debt by selling assets. As long as the savings in reduced interest are greater than profit through reducing the assets.

The strategies to maximize EVA :


Shareholder Value Added (SVA)

The corporate value of the company is calculated as the PV of the future Cash Flow plus the Residual Value (RV) of the business.

The RV of the business is the value of the company at the end of the forecast period. Here, WACC are used.

Shareholder Value = Corporate Value – The Mkt Value of Debt


Reward system

Reward systemProcess, practices & systems that are used to provide levels of pay and benefits to employee

base salary, performance related-pay & non financial reward.


Process that account for an individual’s intensity, direction & persistence of effort towards attaining goals.

Intrinsic motivation derives from interest & enjoyment of the work

Extrinsic motivation derives from sources outside of the individual.

Motivation


Theories of motivation

Herzberg’s two-factor theory – intrinsically rewardingHygiene factors

factors that provide the necessary setting for motivation but do not themselves motivate employees. Egg: working condition, wage levels

Motivators factors that related to job content or outcomes of

the job that will encourage motivation. Eg:recognition, achievement, nature of work


State that employee motivation is a function of the strength of expectancy, instrumentality and valence.

Expectancy – (effort → performance)Instrumentality – (performance → reward) Valence – (reward → personal goal)

Expectancy theory


Motivational theories and rewardExpectancy theory suggest that individuals

will be motivated to perform when they perceive a close linkage between their effort with high level of expectancy, with high instrumentality and with high valence.

Herzberg’s theory suggest that it is not hygiene factors but factors such as achievement, recognition & responsibility that are strong motivators.


Performance related reward systemsBased rewards on achieving or exceeding

some performance target.Employee paid a base pay and then

additional pay will be awarded based on individual or group performance.

Various type of these scheme are:


Individual incentives plan reward individuals for achieving individual

performance target.

Profit sharing plans employees paid cash bonuses based on a

specified percentage of the company’s profit

Employee share plans provides the employees with the right to

purchase shares in the company, at a specified price at some specified future time.

Performance related reward systems


Advantageous of reward schemeIdentification with the group

designed to encourage employees to identify with the company, business or unit team ton achieve goal & team work.

Equity among employees provide same reward to each employees

Competitiveness between employee individuals reward can encourage excessive

competitiveness.


Relating individual effort to reward difficult for employee particularly at operational level to

understand how their own effort can directly influence overall company performance.

Rewarding only good performers group scheme do not discriminate between employees

who are good and those who are bad performers. bad performers may still be rewarded in high performing

team or business unit.

Advantageous of reward scheme


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Maf 635 Chapter 3