Financial Goal setting

Chapter3 MCS By Aurora & Kale

Scope-EVA , Free Cash Flow, P/E EPS and their inter-relationships, ROI And sensitivity Analysis

Questions asked till date

Dec08 ABC ltd May 09 Q5 Short note- Free cash flow Dec07 Q11 Dec 06-Q10 Dec 02,06 Explain the concept of ROI What are the advantages? Dec03, 04,05 discuss the concept of Free cash flow and describe the process of its computation. Dec 04 Q13 Dec01- Q12Sterling associates Dec05-Q11Kalyani enterprises Dec03,q11 Sonali company Dec-02 Investment base used in Performance evaluation of Investment Centres consists of various elements. . Explain the general practice in organisations vis a vis the treatment of each element, and the likely response induced by the treatment of each of these elements in managers

Dec2011-Q6Explain diff. organizational goals. Briefly discuss shareholder value maximization .

Investment center Vs. Profit centers

Investment centers Decentralized units Managers decides product mix, pricing, customer relationship, production methods and level and type of assets used in the unit. Complete control over the profit of the unit Profits are compared with the assets used in earning the same. Profit centers Decentralized units. Evaluated on the basis of profit earned.

Performance measurement of Investment centers

Return on Investment

ROI= Pretax profits/Net assets Or ROI=(Pretax profit/Sales) * (Sales/Net assets)

Profit arising only from the normal activities of the business is considered. Tax is excluded as marginal of the SBU is not responsible for or in control of the tax paid. Net assets= Fixed assets + Net Current assets Assets not currently put to divisional use should be excluded. Also exclude intangible assets like goodwill, deferred revenue expenditures, preliminary expenses etc.

Improving ROI

Increasing the profit margin on sales Increasing the capital turnover Increasing both capital turnover and profit margin Reducing costs as that affects to the total earnings of the firm Increasing the profits by expanding present operations or developing new product line, increasing market share, etc Diversifying, introducing productivity improvement measures, expansion, replacement of old equipments.

Capital employed for the firm as a whole can be arrived at as follows

Share capital of the company Reserves and surplus Loans( secured and unsecured)
Less: a) investment outside the business XXX b) Preliminary expenses XXX c) Debit balance of P&L account XXX

XXX XXX XXX XXX

XXX XXX

Advantages of ROI

ROI relates return to the level of investment and not sales as the rate of return is more realistic. ROI can be decomposed into other variables as shown. These variables have tremendous analytical value. ROI is an effective tool for inter firm comparison. It is a comprehensive measure, anything that affects the financial statement is reflected in this ratio Simple to calculate , easy to understand Common denominator that may be applied to any organizational unit responsible for profitability

Disadvantages of ROI

Financial experts often differ on the components of profit and net assets as used in ROI. This generates different results making it difficult to decide which one is correct and reliable. Inter firm comparison possible only if firms being compared adopt similar accounting policies relating to depreciation, stock treatment , R&D expenses etc . Thus making it unreliable. ROI often induces margins to select projects that give higher rate of return. Investments that increase value to the business are often rejected.
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Is ROI an end of Financial objectives?

To add value, ROI must be compared with A target rate or a benchmark. (ROI less than 5% is considered low and more than25% is considered high) The ROI of the previous years to assess the trends. With other firms belonging to the same industry. It is not the end of the financial objectives.
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Contd

ROI is based on financial statements that are affected by financial and accounting policies ROI does not give the complete picture of the happenings of the business. Focuses on improving profitability and not the wealth maximization for the shareholders, achieving social acceptability and recognition and creating social wealth.
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Residual Income (RI)

RI is the operating profit or income of the division less the imputed interest on the assets used by the division. It is excess of net earning over cost of capital Advantages

1.Strives to maximize the absolute figure and thus maximize shareholders wealth. 2. COC helps the managers to calculate opportunity cost of funds.
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Disadvantages of residual income

1.Accuracy of COC is difficult as there are no. of controllable and uncontrollable factors that affect COC. 2.Divisional COC differs from Organizational COC making goal congruency difficult. 3. It is difficult to identify the controllable and uncontrollable factors at divisional level.
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Divisional Residual Income Statement

Sales revenue Less: Variable expenses Contribution Less: Controllable fixed costs Controllable profit Less: interest on controllable investment Controllable residual income Less: Uncontrollable costs (H.O. expenses) Less: interest on uncontrollable investment Net Residual Income

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Are RI and ROI appropriate tools of measuring performance?

Weaknesses Short term results Measures preoccupied with the objective of profit maximization rather than qualitative factors Tools focus on short term results end up making inappropriate choice of investment Encourages unjustified comparison across division
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ROI And sensitivity Analysis

PAT Invest ment 500 1000 1500 2000 200 300 400 500

40 20 13.33 10

60 30 20 15

80 40 26.66 20

100 50 33.33 25
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Economic value added

EVA seeks to measure the periodic performance in terms of change in value. This measure captures the true economic profit of the organization. It offers a consistent approach to setting goals and measuring performance, communicating with investors , evaluating strategies and allocating capital

Definition:- Net operating PAT minus appropriate charges for the opportunity cost of the all capital invested in the enterprise. EVA=NOPAT-(TCE*WACC)

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Components of EVA

NOPAT- dividend/interest/ income on securities outside business and non operating expenses will not be considered while calculating NOPAT. TCE- sum of shareholders funds plus loan funds but excludes investments outside the business WACC= After tax cost of debt + cost of equity+ cost of preference capital To calculate the cost of equity, CAPM model is used.Ke=Rf+ (Rm - Rf)
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How to improve EVA?

Increasing NOPAT while maintaining the amount of capital invested. Discarding unproductive assets without affecting earnings. Investing in projects that earn a return that is greater than COC. Reducing COC by substituting costly source of capital by cheaper source of capital.
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How EVA is superior to others?

Negative EVA indicates that company is destroying the value even though it has a positive and growing EPS. Holds company accountable for COC used for expansion or growth Encourages growth in new products, new equipments and new manufacturing facilities. Requires company to be more careful about resource mobilization, allocation and investment decisions
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Advantages of EVA

Peter Drucker Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. EVA gives companies a better focus on how they are performing Covers full range of managerial decisions like strategic planning, allocating capital, pricing acquisitions and divestitures, setting operating goals Line managers understand financial measures It is the only system that provides a common language for employees across all the functions and allows all management decisions to be communicated in terms of value added
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Disadvantages of EVA

Fails to measure the impact of inflation on the performance of the company EVA values have accounting distortions because EVA is after all an accounting based concept. EVA is affected by accounting policies. Thus in the long run higher EVA will be reported if for eg. R&D costs are charged to the income statement and are not capitalized.
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Free cash flow

FCF is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations . Value of companys operations depends on all the future expected free cash flows. It is defined as after tax operating profit minus amount of new investment in working capital and fixed assets necessary to sustain the business.
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Calculation of free cash flow

FCF= NOPLAT-(CAPEX-Dep.)- WC Where NOPLAT= Net operating profit less adjusted taxes WC= Change in working capital
FCF= NOPLAT-Net Investment FCF= (NOPLAT+ Depreciation)-( Net Investment+ Depreciation) FCF= Gross Cash Flow Gross Investment

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Uses of FCF
Pay off some part of the debt Pay dividends to the shareholders. Repurchase stocks from the shareholders Acquisition of another company Reinvest in companys capital project.
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Computation of FCF
Suppose the company had a NOLPAT of Rs. 170.3 million in the year 2001and depreciation is only the non cash charge which is Rs. 100 million, then its gross operating cash flow in 2001 would be NOPLAT plus any non cash adjustment in the statement of cash flow. Company had 1455 million operating assets, at the end of 2000, but 1800 at the end of 2001 Therefore Net investment in operating assets= 1800-1455 = 345 FCF= NOPLAT- Net Investment =170.3-345 =-174.7

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The company reported a depreciation of Rs100 million in the year 2001. Gross investment = net investment + depreciation =345+100 =445 Gross cash flow= NOPLAT + Depreciation = 170.3+100 =270.3 Therefore FCF= Gross cash flow- gross investment 270.3-445 =-174.7

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P/E, EPS and their inter-relationship

P/E= MPS/EPS P/E ratio basically measures the no. of times the market is ready to pay for each rupee earned by the company. If EPS Increases , the MPS should also increase. If EPS falls , the MPS should also fall. As P/E is affected by MPS which is non controllable variable for the company, the P/E number is not the right measure to comment about the operating performance of the company. EPS is a good ratio to compare the performance of the companies as any increase in EPS indicates better operational performance and vice versa .(assuming the number of shares remains same over the period of time)

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