Question 13 MCS 2011 A company has two divisions Division A and Division B.

The financial details of Divs A and B for 2 years are given below: Div A Div A Div B Div B P&L 2010 2011 2010 2011 Sales 500 400 600 800 Variable Cost 300 240 360 480 200 160 240 320 Fixed Cost 50 40 80 120 PBIT 150 120 160 200 Interest 30 11 30 40 PBT 120 109 130 160 Tax @40% 48 44 52 64 PAT 72 65 78 96 Balance Sheet 2010 2011 2010 2011 Fixed Assets 400 350 400 500 Net Current Assets 200 150 200 300 600 500 600 800 Management evaluates the performance of the Div Managers on the basis of Return on Total Assets (ROTA). Managerial compensation is linked to ROTA. Based on this criteria, the Div manager of Div A was given a higher incentive compensation as he has improved the ROTA of his Div. Manager of Div B felt it was unfair to judge him on this criteria. He had identified a new investment opportunity and improved the sales. He felt he should be judged on the basis of Economic Value Added, which directly contributes to the wealth of the shareholders. His Div has grown by 25% on sales and assets wheras Div A has contracted during this period both in sales and size of assets. Cost of equity is 10%. Economic Value Added can be calculated as EVA = [PAT - Cost of Equityin %* Equity Share Capital]. Calculate Return on Total Assets for both Div A and B for the year 2010 and 2011. Also calculate EVA for both Divs for the year 2010 and 2011. Discuss views raised by Manager of Div B; does judging Div Manager on ROI could lead to dysfunctional behaviour on their Part.

solution SOLUTION: The construction of this problem has some limitations: 1 ROTA should have been defined as (PAT/Total Assets) to avoid confusion (Please refer to a separate enclosed note in word file "Note on Financial Statements Analysis") 2 The equity and debt figures are not given; hence some assumption is to be made while calculating EVA. 3 Sales of Div B grew at 33.33% not 25%. Making the above assumptions, the solution is as follows: Div A 2010 500 Div A 2011 400 Div B 2010 600 Div B 2011 800

Sales

Variable Cost Fixed Cost PBIT Interest PBT Tax @40% PAT Balance Sheet Fixed Assets Net Current Assets

300 200 50 150 30 120 48 72 2010 400 200 600 2010 72 600 12%

240 160 40 120 11 109 44 65 2011 350 150 500 2011 65 500 13%

360 240 80 160 30 130 52 78 2010 400 200 600 2010 78 600 13%

480 320 120 200 40 160 64 96 2011 500 300 800 2011 96 800 12%

ROTA PAT Total Assets ROTA

EVA EVA=PAT-(Cost of equity% * equity share capital) PAT 72 cost of equity(rate) 10% equity share capital 400 cost of equity(amount) 40 EVA 32

65 350 35 30

78 400 40 38

96 500 50 46

CONCLUSION: 1 The variations in ROTA are negligible to make any decisive conclusions about the performance. 2 PAT of Div A has actually reduced, but since it has reduced its assets, both fixed and current, there is an improvement in its ROTA. This is not a healthy sign. 3 Div B has increased its PAT, seen new opportunities of growth and made investments. Although ROTA has marginally reduced, the investments will result in higher PAT in future years. 4 By comparing EVA of both Divs, it can be seen that Div B has added more economic value to the company. While Div A's EVA has reduced from 32 to 30, the EVA of Div B has increased significantly from 38 to 46. Div B brings more wealth to the shareholders and is working towards the firm's growth. 5 Thus Div B deserves a higher rating and compensation.

EVA worked as per conventional method : result same as per formula given: Div A Div A Div B PBIT 150 120 160 Tax rate 40% NOPAT 90 72 96 Cost of equity 40 35 40 Cost of debt (post tax) 18 7 18 Cost of capital 58 42 58

Div B 200 120 50 24 74

EVA

32

30

38

46

Statements Analysis")

about the performance. oth fixed and current,