5. a.

what are the key elements of EVA bonus plan I-101 (2marks)
The centre piece of the EVA financial management system is a unique bonus plan that overcomes the limitations and aligns the interest of managers and shareholders. The key elements of the EVA bonus plan are: 1. bonus is linked to increases in EVA 2. there is no floor or ceiling on the bonus 3. the target bonus is generous 4. performance targets are set by formula, not negotiation 5. a bonus bank is established

b.what is CFROI and how is it measured

I-115,116

(4 marks)

Cash flow return on investment (CFROI): TBR incorporates the returns (CFROIs) both for the assets in place and the assets to be created Thus CFROI has an important bearing on TBR What is CFROI and how is it measured? BCG defines CFROI as the sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firms assets Cash flow return on investment (CFROI): TBR incorporates the returns (CFROIs) both for the assets in place and the assets to be created Thus CFROI has an important bearing on TBR What is CFROI and how is it measured? BCG defines CFROI as the sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firms assets

c. A new plant entails an initial investment of Rs. 300,000, Rs.250,000 toward fixed assets and the balance toward net working capital. The plant has an economic life of 14 years. At the end of 14 years, fixed assets will fetch nothing, but net working capital will be recovered in full. The plant is expected to produce a NOPAT of Rs.21, 080 each year The cost of capital is 10%. It will cost Rs.250,000 to replace the fixed asset Calculate annual depreciation on straight line method, economic depreciation, ROCE, ROGI, and CFROI for 1st year, 6th year and 12th year I118,119 (6 marks) Calculation of economic depreciation:

 Rs.250,000= economic depreciation x FVIFA(14,10%)=250000(1.11)/(1.114-1)=8936 Economic depreciation= 250,000/27.975=Rs. 8937 Calculation of annual depreciation= 250,000/14= Rs. 17,857 Return on capital employed (ROCE) = NOPAT/book capital Return on gross investment (ROGI)= cash flow/cash invested

6.a. State key differences among VBM methods I- 10

(2 marks)

Key difference: key difference between these methods relates to VBM metrics. For ex., the Alcar et al method uses shareholder value added, the Stern Stewart method emphasizes EVA and MVA and the BCG method focuses of CFROI and CVA cash value added Each camp argues they are the best and cite supporting evidence, making it difficult to objectively asses the validity of these claims It seems EVA/MVA method has received more attention and gained popularity

b.

Explain key methods and premises of VBM I-7 to 9

(4 marks)

Methods and key premises of VBM: Three principle methods are: 1. the free cash flow method proposed by McKinsey /Alcar group 2.the economic value added/ market value added (EVA/MVA) method pioneered by Stern Stewart and company 3. the cash flow return on investment/ cash value added (CFROI/CVA) method developed by BCG and Holt Value Associates Though these methods look outwardly different, the basic premises underlying them are same. They are as follows: 1. the value of any company (or its individual strategies and investments) is equal to the present value of the future cash flows the company is expected to produce 2. conventional accounting earnings are not a sufficient indicator of value creation, because they are not the same as cash flow, they do not reflect risk, they do not include an opportunity cost of capital, they do not consider time value for money, and they are not calculated the same way by all firms because of variations in accounting policy . 3. For managing shareholder value, firms should use metrics that are linked to value creation and employ them consistently in all facets of financial management

4. A well designed performance measurement and incentive compensation system is essential to motivate employees to focus their attention on creating shareholder value

c. For the problem given in question no.5.c compare EVA and CVA

I-123 (6 marks)

Panel A: EVA
1 2 3 4 NOPAT Book capital 300000(17857x5)=2107i5

Rs. million

Year 1 21080 300000 10% 30000 (8920)

Year 6 21080 210715 10% 21072 8

Year 12 21080 103573 10% 10357 10732

Cost of capital Capital charge (10% of sl no 2) EVA (1-4)

Panel B: CVA
1 2 3 4 5 NOPAT Depreciation Cash flow Economic depreciation Cash invested 21080 17857 38937 8937 300000 21080 17857 38937 8937 300000 21080 17857 38937 8937 300000

6 7

Cost of capital Capital charge CVA= (3-4-7)

10% 30000 0

10% 30000 0

10% 30000 0