VALUE BASED MANAGEMENT Teemu Malmi Accounting for Management Control -

Measuring profitability Most firms aim for increasing profits How should we measure profitability and does it matter?

Basic idea of VBM: Owner is a residual claimant Company comprises of the contracts with stakeholders. Each contract is a balance between risk and return Owners receives the residual and faces the risk which remains after all other stakeholders  owners have a privilege to the excess return after other stakeholders, but also… –You give us your £10,000 nest egg that you need for your retirement and we, the directors of the firm, do not promise that you will receive a dividend or even see your capital again. We will try our hardest to produce a return on your money but we cannot give any guarantee. Sorry. (Arnold, 2002)

Where does the shareholder value of company comprise of?

Shareholder value is the most commonly accepted corporate goal in text books The objective of the firm is to maximise shareholder value. … Given this objective, any financing or investment decision expected to improve the value of the shareholders’ stake in the firm is acceptable. (Pike & Neale, 2006, for undergaduate and MBA students, UK) Management must focus on creating value for shareholders. (Van Horne & Wachowicz, 2005, USA)

EVA for management control Which profitability measure to choose? Why EVA instead of ROI for performance measurement? How to create measures based on EVA philosophy? What are the challenges of using EVA? -

Challenges with ROI Same measures are used for evaluating profit centres and management ROI may lead to sub-optimal decision making What about inflation and depreciation? -

- X (€)Y (€)Z (€) Machine cost initial outlay (time zero)861 Estimated net cash flow (year 1) Estimated net cash flow (year 2) Estimated net cash flow (year 3) Estimated NPV at 10% cost of capital77(52)52 Ranking132 X (€)Y (€)Z (€) Year 1(37)103(237) Year 283(37)(237) Year Total profits X (%)Y(%)Z (%) Year 1(4.3)11.9(27.5) Year 214.5(6.4)(41.3) Year Average Return on investment Profits Mutually Exclusive Capital Projects NPV

In Economic Value Added (EVA) cost of capital is deducted from profit EVA is net operating profit after taxes minus a charge for the opportunity cost of the capital invested. EVA = NOPAT – ((TOTAL ASSETS – CURRENT LIABILITIES) x WACC) EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders or lenders at comparible risk.

EVA Net operating income Capital employed Cost of capital Net working capital Fixed capital WACC Turnover Expenses EVA in graph

EVA Combines shareholder interest to the control systems. Adds required rate of return into the calculations. Absolut measure, which is compared with the budget/target. Budget/target is defined based on the required rate of return. -

Corporate Value Cost of Capital Profitability Growth Market Growth Market Share EBIT Efficient Use Of Capital Cost of equity Leverage Business Risk Growth Strategy Trust among investors Use of capacity Level of Technology Timing of Investments Revenues Expenses Product mix Number of Big Accounts Market Price Location of Mills Product mix Growth by Mergers & Aquisitioins Growth by Investments Customer Value Added Agility to markets Geographical positioning Micro DriversMacro Drivers

VBM IN PRACTICE There is a huge variety of VBM applications in practice We found: –Rhetoric use (signaling) –Increased attention to capital employed, i.e. by applying an additional capital charge –Full adoption, including compensation, throughout organization Also those who have abandoned it

Dimension of VBM useVBM solutions Management control Objectives and strategies Maximisation shareholder wealth. EVA TM metrics (or its value drivers) as a single goal throughout the organisation. A value creating strategy is the only possible solution, though silent about the type of strategy per se. Business units are responsible for strategic planning. Performance measurement Performance measured using economic profit metrics and their value drivers from top to bottom. Other measures abandoned. Target setting Improvement in the current level EVA TM. Zero-EVA TM minimum acceptable level. Target setting linked to value drivers. Compensation Bonuses paid are based upon changes in EVA TM. Bonuses have no caps. Banking to avoid myopia. Stock options only to top management with increasing target level in line with the cost of capital. Influence on decision making Strategic decisions Based on EVA TM calculations, no room for decision-making beyond; acquisitions, strategic capital investments and divestments are made accordingly. Strategizing within the business units. Operational decisions Both balance sheet and income statements are considered, leading to improved capital investments and more efficient working capital management. Source: Malmi & Ikäheimo, Management Accounting Research, 2003

Dimension of VBM useVBM practice Management control Objectives and strategy Maximisation of shareholder wealth. Both growth and efficiency strategies. Mainly used at the group level. Performance measurement EVA TM metrics or its value drivers used at different organisational levels. Such measures are not the only ones throughout the organisation. Old measures are retained. Target setting Mainly negotiated, frequently other measures are used. Zero-EVA TM does not have any major relevance. Compensation Bonuses paid based upon several financial metrics. EVA TM has a minor role. No banking is present. Stock options mainly for the top management at a fixed price. Influence on decision making Strategic decisions Still room for strategic judgement beyond VBM. Impact on acquisitions, strategic capital investments and divestments. Operational decisions Increased emphasise on balance sheet. Leads to lower hunger for capital investments and more concern about the cost of working capital. Source: Malmi & Ikäheimo, Management Accounting Research, 2003

Discussion How EVA based performance measures are derived? What are the major challenges in adopting and using EVA? –Technical –Organizational and behavioral -