VBM Lecture SS15 Complete

Technische Universitt Mnchen
Value-Based Management
Lecture 1:
Value Maximization and Corporate Objectives
Prof. Dr. Gunther Friedl
Lehrstuhl fr Controlling
Email: gunther.friedl@tum.de
Overview
1. Value Maximization and Corporate Objectives
2. Measuring Income: Financial Statements
3. Measuring Value Creation: Value-Based Performance Measures
4. Management Compensation: Objectives and Alternatives

5. Calculating the Cost of Capital
6. Accounting Adjustments: Overview
7. Accounting Adjustments: Goal Congruent Performance Measures
8. Valuing and Managing Real Options
9. Identifying the Drivers of Value Creation
Value-Based Management: Lecture 1
Gunther Friedl SS 2015
Required readings
Young, S. David and OByrne, Stephen F.: EVA and Value-Based Management: A
Practical Guide to Implementation, New York et al. 2001, chapter 1.
Jensen, Michael C.: Value Maximization, Stakeholder Theory, and the Corporate
Objective Function, Journal of Applied Corporate Finance, Fall 2001. Also available
at: http://papers.ssrn.com/abstract_id=220671.
Outline
1.1 Development of the shareholder value view
Value
Maximization
and
Corporate
Objectives
1.2 Differences between the shareholder and the

stakeholder value approach
1.3 Strengths and weaknesses of the shareholder and
the stakeholder value approach
1.4 Combining the shareholder and the stakeholder
value approach
1.5 Objectives of value-based management concepts
The growing predominance of the shareholder wealth culture is

largely a consequence of several major developments
Major Developments
Consequences
The globalization and deregulation of

capital markets
The end of capital and exchange controls
Capital has attained

a high degree of
mobility
Companies must
be competitive in
both commercial
markets as well as
capital markets
Operating costs
and capital costs
must be considered
Advances in information technology

More liquid securities markets
Improvements in capital market regulation

Generational changes in attitudes toward
savings and investment
The expansion of institutional investment
In Europe these developments were hampered by institutional

and cultural characteristics
Strong protectionism against American and Japanese competitors until the 1980s
Relational capitalism (old school ties, long-standing business practices and
strong personal relations between shareholders and company managers) in many
European countries
Preservation of privilege and the status quo instead of value creation
Growing European integration and liberalized trade which opens more choices to
customers has increased the degree of competition
European companies responded to these challenges of free trade: Strong export
performance of many European firms
The pressure of capital markets on companies is increasing

The advent of the EURO makes performance comparisons easier
Trend towards greater institutional investments:
Growth of capitalized pension funds because of the aging population and the
unsustainable safety net
The younger generation is more willing to accept risks of capital markets when
making their decision of provisions for old age
Portfolio managers withdraw the equity-capital from the companies that do not
gain competitive returns
Growing menace of hostile takeovers
European firms are learning to communicate with and satisfy the demands of their
capital providers
Outline
Value
Maximization
and
Corporate
Objectives

value approach
There are two conflicting paradigms for managerial decision

making
Managers regularly evaluate competing actions and strategies
Example: Should Daimler improve the quality of their cars?
Actions and strategies have implications for different groups that have a
relationship to the company
What should be the relevant objective?
Shareholder value: Maximize value to shareholders

Stakeholder value: Maximize value to all stakeholders of a company
The shareholder value and the stakeholder value strongly differ in

many respects
Shareholder Value
Stakeholder Value
Stakeholders are all parties that
are affected by a firms actions,
e.g. shareholders, customers,
suppliers, workers, local
communities
Maximize the market value of a

firm (single objective)
Shareholder is residual claimant

on the company
Supported by a powerful
theoretical result:
All stakeholders have claims on the

company
Multiple objectives:
Which one is relevant?
Conflicting objectives?
Social welfare is maximized,

when all firms in a society
maximize their own firm value
Stakeholder value approach does

not provide a guideline for
managerial decision making
But: strong assumptions

necessary
10
Outline
Value
Maximization
and
Corporate
Objectives

1.3 Strengths and weaknesses of the shareholder
and the stakeholder value approach
value approach
11
The shareholder value debate controversial statements

Few trends could so thoroughly undermine the very foundations of our free society
as the acceptance by corporate officials of a social responsibility other than to make
as much money for their stockholders as possible. (Milton Friedman, Economist, 1962)
Topmanager knnen mit wenigen Entscheidungen viel Wert schaffen oder
vernichten.(Josef Ackermann, former CEO Deutsche Bank, in Welt, Oct. 2005)
On the face of it, shareholder value is the dumbest idea in the world Shareholder
value is a result, not a strategy Your main constituencies are your employees, your
customers and your products. (Jack Welch, former CEO of General Electric, Financial Times, Mar. 08)
Unternehmen, die nur kurzfristigen finanziellen Kennzahlen wie Shareholder-Value
oder Quartalsrenditen hinterher rennen, mssen nun erkennen, dass sie damit einem
Gtzen gedient haben. (Wendelin Wiedeking, former CEO Porsche, Comment in FTD, Apr. 2009)
Wer allein am Aktienkurs die Leistung von Managern misst,
verliert seine Glaubwrdigkeit. (Bishop Wolfgang Huber)
12
Two questions need to be answered to discuss whether value

maximization is the right objective
(1) Should firms have a single-valued objective?
Value maximization: single-valued objective
Stakeholder value maximization: multiple objectives
(2) If so, should that objective be value maximization or something else?
Possible objectives:
Maximizing (shareholder) value,
Maintaining employment,
Improving the environment, etc.
13
But: The financial crisis of the past years has emphasized the
biggest challenge for value maximization
Should Daimler improve the quality of
their cars?
The trade-off for managerial decisions

Maximizing quality and profits at the
same time is not possible
profits
Conflicting interests between

shareholders and customers
Reasoned managerial decisions
require a single-valued objective
function
A single-valued objective can also be

the result of a weighting of multiple
objectives
quality
14
Issue 2: Value Maximization makes society better off

Social welfare is maximized, when all firms in a society maximize their own firm
value
Assumptions:
No monopolies
Perfect markets
No externalities
Firms use inputs in the form of labor hours, capital, and material to produce outputs
of goods or services
Social welfare is increased, if the prices at which it sells the goods more than cover
the costs it incurs in purchasing this goods
As long as the firm maximizes its profits (revenues minus costs), social welfare is
maximized
15
But: The financial crisis of the past years has emphasized the
biggest challenge for value maximization
Commerzbank and the crisis
Implications for shareholder value approach
Stock prize [ in EUR ]
Banks, like the german Commerzbank,

were one of the first to fully incorporate
value maximization as their main goal
-91%
23,90
However, banks initiated the financial

crisis leading to global value destruction of
more than 50 trillion USD.1)
Focus on short term value creation led to
very high levels of risk in the market
2,27
May 2nd
2008
The goal of value maximization must

always be from a long term perspective
March 6th
2009
1) Source: Asiatische Entwicklungsbank, 2009
16
Additional reasons against value maximization as the corporate

objective do exist
Monopolies
Value maximization harms customers
Externalities (e.g. pollution)
Value maximization harms the environment

Imperfect markets (e.g. specific
investment of suppliers or employees)
Value maximization harms suppliers
or employees
Under these conditions, the corporate objective
of value maximization must be carefully analyzed
17
By prioritizing the shortterm we have exhausted

non-renewable resources
and devastated the
environment. Sustainable
development cannot be
achieved if immediate
profit and shareholder
value are our sole
criteria.
Nicolas Sarkozy (2009)
Stakeholder theory fails to provide a criterion for decisionmaking

Competing interests between stakeholders
Customers want low prices and high quality
Employees want high wages, high-quality working conditions, and fringe
benefits
Suppliers of capital want low risk and high returns
Communities want high charitable contributions
Etc.
Any decision criterion must specify how to make the tradeoffs between these
demands
Stakeholder theory provides no criterion for decisions to solve these tradeoffs

Consequence: Managerial decisions cannot be evaluated
18
Outline
Value
Maximization
and
Corporate
Objectives

value approach
19
There is a strong association between shareholder value creation

and a companys reputation as well as employee focus
Reputation
Employee focus
2014 Fortunes ranking of Americas most

admired companies and the 2013 BCG Top
25 sustainable value creators:
Many of the top US value creators were
among the most admired companies of the
study
Among the eight criteria for the most admired
companies:
innovation
quality of management
community and environmental
responsibility
the ability to attract, develop, and keep
talented people
the quality of products or services
20
A study of the Boston

Consulting Group of German
companies in 10 industrial
sectors from 1987 to 1994
reveals:
Companies that focus most in
human resources (training
expenditures, importance of
staff according to the corporate
mission etc.) and
intrapreneurship produce
better shareholder returns
than their competitors (and also
create more jobs!)
The value perspective is unique in that it is the only one that

incorporates all information about a company
Relations with
suppliers
Product liability
Customer
satisfaction
Value
perspective
Sales and growth

in market share
Return on
invested capital
Reputation with
banks and other
lenders
Interest and
principal payments
to lenders
Labor
productivity
Taxes
Regulatory or judicial actions

taken by governments for
environmental damage, tax
evasion, or securities fraud
It is essential to take all stakeholders into account in an appropriate manner. By

neglecting one constituency the goal of value creation is no longer pursued, like e.g.:
talented employee who does not feel promoted leaves the company
customer who is not satisfied by the product quality changes to competitors
21
Example: The fundamental business principles and strategic

priorities of the Allianz Group reflect value orientation
Fundamental business principles
Strategic priorities
We believe that we can best serve our

shareholders by giving priority to our
clients
We realize that our continued success is
based on our reputation, our acceptance
by society and our ability to attract and
retain the best people.
We foster the entrepreneurial spirit of our
local Group companies while providing
the leverage of a global institution.
We recognize that a sustainable
performance requires primary focus on
operational excellence and organic
growth, supported by profitable
acquisitions.
We aim to rank among the top five
competitors in the markets in which we
choose to participate.
Optimizing the Economic Value

Added of our Group, based on riskadequate capital requirements and
sustainable growth targets.
Exploiting the opportunities offered
by high-growth markets by leveraging
our traditional risk management
expertise.
Strengthening our leading position in
life and health insurance and in asset
management, especially in private
and corporate retirement insurance
plans.
Increasing our asset gathering
capabilities by building customerspecific, multi-channel distribution
platforms.
Expanding our investments and
capital market expertise.
22
Strategic management of CSR activities can enhance competitive

advantages and therefore shareholder value
Corporate Social Responsibility
Michael Porter1):
Approached strategically, CSR generates opportunity, innovation, and competitive

advantage for corporationswhile solving pressing social problems.
Toyota Prius
Early response to public concerns about auto emissions
Development of a hybrid-engine Prius
Significantly reduced pollutants
Enviable lead over rivals in hybrid technology
Procter & Gamble: Pampers One Pack = One Vaccine program
In February 2009 P&G and UNICEF launched the vaccination program
Annual Report 2010: 4% sales growth in Baby Care segment, total
company 3%
1) Source: Harvard Business Review, 2006
23
Outline
Value
Maximization
and
Corporate
Objectives

value approach
24
Large companies need measures of performance that represent

value creation
Value maximization might not be the top priority for senior corporate executives of
a company of which they own no more than a small percentage.
Managers pursue other goals that sometimes conflict with the creation of
value, like market share, volume growth, customer satisfaction or the old
standby strategic reasons.
To create shareholder wealth companies must earn returns on invested capital that
exceed the cost of capital and, by doing so, fulfill the demands of capital markets
for value creation.
Companies need measures of performance that

track managements success in creating value for shareholders and
motivate employees throughout the firm to work for the same goal.
25
Objectives of value-based management concepts

Value-based management requires performance measures that are able to support
the following objectives
Strategic planning:
Does the concept support strategic decision-making?
Providing incentives:
Is it possible to tie management compensation to the performance measure?
Measuring performance at the divisional level:
Does the concept adequately report value creation within the organization?
Communicating value creation:
Does the concept help to communicate value creation internally to line
managers as well as to the external capital markets?
26
Lecture 2:
Measuring Income: Financial Statements
Overview

28
Suggested Readings
Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried: The Analysis and Use of
Financial Statements, 3/e Wiley 2003
Gabriel Hawawini and Claude Viallet: Finance for Executives: Managing for Value
Creation, 3/e, South-Western Thomson Learning, 2007.
29
Outline
2.1 Balance sheet
Measuring
Income:
Financial
Statements
2.2 Income statement

2.3 Cash flow statement
2.4 Purpose and use of ratio analysis
30
The financial reporting system

Three principal financial statements:
1. Balance sheet (statement of financial position)
2. Income statement (statement of earnings)
3. Statement of cash flows
Footnotes
Supplementary data
31
International Accounting Standards

Differences in accounting and reporting standards make it difficult to compare
companies from different countries
Need for global accounting standards
The International Accounting Standards Board (IASB) was established to harmonize
the accounting standards of different nations
A number of European multinationals have adopted either U.S. standards (U.S.
GAAP) e.g. DaimlerChrysler even before the merger or International Accounting
Standards (IAS) / International Financial Reporting Standards (IFRS)
As of 2005 / 2007 European companies that are quoted on the stock exchange
have to report their consolidated financial statements using IFRS
Tendency towards a harmonization of U.S. GAAP and IAS/IFRS
32
The balance sheet: definition, format, and classification

Definition
The balance sheet reports the categories and amounts of assets (firm resources),
liabilities (claims on those resources), and stockholders equity at specific points in
time.
Assets
Liabilities and stockholders equity
Current assets
Current liabilities
Long-term assets
Long-term liabilities
Stockholders equity
33
Measurement of assets and liabilities

Most components of the balance sheet are
reported at historical costs
Valuation allowances adjust the originally
recorded amount to an approximation of net
realizable value (e.g., accounts receivable,
reserve for uncollectible receivables)
Lower of cost or market and impairment
rules may require writedowns
The balance sheet does not report all assets
and liabilities of the firm, but reflects only
those meeting specific recognition criteria
(e.g., R&D)
34
A balance sheet does

not report the market
value of a firms
assets, liabilities, or
equity, although the
information provided
can be useful when
estimating the market
value of the firm or its
securities
Uses and limitations of the balance sheet

Uses
Limitations
Starting point for the analysis of a

firm
Selective reporting: Important

assets and liabilities may be
omitted from the balance sheet
(e.g., operating leases)
The balance sheet reports on a

firms earnings-generating ability
Forecasts of the firms sales
and profitability
Efficiency measurement
Measurement: Some assets and

liabilities are carried at historical
costs, others at market value
Delayed recognition: GAAP permits
companies to delay recognition of
value changes (e.g., employee
benefit plans)
Forecasts about a firms future

cash flow needs
Starting point for the preparation
of an adjusted balance sheet
35
Example: Siemens Annual Report 2014
36
37
Outline
2.1 Balance sheet
Measuring
Income:
Financial
Statements

38
Income statement
Revenues from the sales of goods and services
-
Operating expenses
Operating income from continuing operations
Other income and revenues
Recurring income before interest and taxes from continuing operations
Financing costs
Recurring (pretax) income from continuing operations
+/- Unusual or infrequent items

=
Pretax earnings from continuing operations
Income tax expense
Net income from continuing operations
+/- Income from discontinued operations (net of tax)

+/- Extraordinary items (net of tax)
+/- Cumulative effect of accounting changes (net of tax)
=
Net income
39
Accounting Income: Revenue and Expense Recognition

Two revenue and expense recognition issues must be addressed:
1. Timing. When should revenue and expense be recognized?
2. Measurement. How much revenue and expense should be recognized?
Revenue recognition: Two conditions must be met (SFAC 5):
1. Completion of the earnings process

2. Assurance of payment
Expense recognition is affected by the following accounting issues:
Deferral of marketing expenses and sales commissions
Accrual or deferral of the cost of periodic major maintenance projects
Bad debt expense
Warranty expense
40
41
Outline
2.1 Balance sheet
Measuring
Income:
Financial
Statements

42
Statement of cash flows: definition and classification

Cash flow data supplement the information provided by the income statement as
both link consecutive balance sheets
Important: classification of cash flows among operating, financing, and investing
activities
Cash flow from operating activities (CFO) measures the amount of cash generated
or used by the firm as a result of its production and sales of goods and services
Investing cash flow (CFI) reports the amount of cash used to acquire assets such
as plant and equipment as well as investments and entire businesses
Financing cash flow (CFF) contains the cash flow consequences of the firms
capital structure (debt and equity) decisions
Only firms with significant foreign operations: Effect of exchange rate changes on
cash
43
Direct and indirect method cash flow statements

U.S. GAAP and IAS/IFRS both permit firms to report cash from operations either
directly or indirectly
Direct method: firms report major categories of gross cash receipts and payments
Indirect method: firms reconcile accrual-based net income to CFO. Adjustments
are necessary for
Noncash revenues and expenses (e.g., depreciation expense)
Nonoperating items included in net income (e.g., gains from property sales)
Noncash changes in operating assets and liabilities (receivables, payables)
Important drawback of indirect method cash flow statements:
Because the indirect format reports the net cash flow from operations, it does not
facilitate the comparison and analysis of operating cash inflows and outflows by
function with the revenue and expense activities that generated them.
A majority of firms prepare the SoCF using the indirect method
44
45
46
Outline
2.1 Balance sheet
Measuring
Income:
Financial
Statements

47
Purpose and use of ratio analysis

Financial ratios are used to compare the risk and return of different firms
Ratios can also provide a profile of a firm, its economic characteristics and
competitive strategies, and its unique operating, financial, and investment
characteristics
Four broad ratio categories measure the different aspects of risk and return
relationships:
1. Activity analysis: evaluates revenue and output generated by the firms assets,
e.g. inventory turnover, total asset turnover
2. Liquidity analysis: measures the adequacy of a firms cash resources to meet its
near-term cash obligations, e.g. current ratio
3. Long-term debt and solvency analysis: examines the firms capital structure,
including the mix of its financing sources and the ability of the firm to satisfy its
long-term debt and investment obligations, e.g. debt to equity
4. Profitability analysis: measures the income of the firm relative to its revenues and
invested capital, e.g. operating margin, return on assets
48
Example: Siemens 2014

Activity ratios:
Inventory turnover
cost of goods sold

51,165
3.34
average inventory 0.5 15,100 15,560
Total asset turnover
sales
71,920
0.70
av. total assets 0.5 104,879 101,936
48,076
current assets
1.31
current liabilities 36,598
Liquidity ratios:
Current ratio
Solvency ratios:
Debt to equity
total debt 19,326 1,620 0.68

30,954
total equity
Profitability ratios: Operating margin
operating income
sales
49
5,400
0.075
71,920
Ratio analysis: cautionary notes

Economic assumptions
economic relationship between numerator and denominator does not depend on
size ignores the existence of fixed costs
Benchmarks
What is the relevant benchmark?
Timing and window dressing

management can manipulate ratios to show the firm in a more favorable light
Negative numbers
Example:
Company A
Company B
Income
$10,000
(10,000)
Equity
$100,000
(100,000)
ROE
10%
10%
Accounting methods
ratios are not comparable between firms with differing accounting methods
50
Common-size statements
Problem:
The comparison of a firms performance over time is difficult, because the firms
size is always changing
Firms of different sizes are also difficult to compare
Solution: Common-size statements
Common-size statements are used to standardize financial statements by
expressing them as a percentage of a relevant base
Examples:
Balance sheet components as a percentage of total assets
Revenues and expenses as a percentage of total sales

Components of cash flow from operations as a percentage of cash collections
Common-size statements also provide useful information in developing insights into
the economic characteristics of different industries and of different firms in the
same industry
51
Example: comparative income statements

As Reported
Pfizer
Takeda
(Millions of $)
Sales
Cost of goods sold
Gross profit
Selling, general, and administrative expenses
Research and development expenses
Other operating expenses (income)
Income from operations
Other income (expense)
Income before interest and taxes
Interest expense
Income before taxes
Provision for taxes
Income from continuing operations
16.204
2.528
13.676
6.351
2.776
-130
4.679
0
4.679
236
4.443
1.244
3.199
52
Common Size
Roche
Pfizer Takeda Roche
(Millions of Yen) (Millions of CHF)

844.643
435.787
408.856
189.149
77.487
0
142.220
40.981
183.201
1.059
182.142
89.019
93.123
27.567
8.874
18.693
10.194
3.782
-14
4.731
4.057
8.788
1.237
7.551
1.902
5.649
100%
16%
84%
39%
17%
-1%
29%
0%
29%
1%
27%
8%
20%
100%
52%
48%
22%
9%
0%
17%
5%
22%
0%
22%
11%
11%
100%
32%
68%
37%
14%
0%
17%
15%
32%
4%
27%
7%
20%
Lecture 3:
Measuring Value Creation:
Value-Based Performance Measures
Overview

54
Required readings
Practical Guide to Implementation, New York et al. 2001, chapter 2, 9 and 10.
Ewert, R. and Wagenhofer, A.: Interne Unternehmensrechnung. 7/e, Berlin et al.
2008, 521 540, 551 - 555.
Friedl, Gunther and Deuschinger, Lena: A Note on Economic Value Added (EVA),
www.finexpert.info, Mnchen 2008. Also available on
http://www.controlling.wi.tum.de
Arbeitskreis internes Rechnungswesen (2010): Vergleich von Praxiskonzepten zur
wertorientierten Unternehmenssteuerung. In: zfbf, volume 62, issue 7.
55
Outline
3.1 Discounted Cash Flow as a starting point
Measuring
Value Creation:
Value-Based
Performance
Measures
3.2 Value-Based Performance Measures An Overview

3.3 Relationships between EVA, MVA, and DCF
3.4 EVA and RONA

3.5 Calculating EVA
56
Having accepted value creation as corporate goal you need a

methodology for valuing capital investments
Investment = commitment of cash today for gaining profit in the future
Need to know todays value of future cash flow stream
Factors influencing this

present value
Magnitude of the cash
flows (the greater the
better)
A discounted cash flow approach (DCF):

The net present value (NPV)
CFt
t
t 1 1 r
n
NPV
n = economic life of the investment
Timing (the earlier the

better)
CFt = expected cash flow in period t
Degree of uncertainty of
future cash flows (the
less risky the better, all
other things equal)
r = discount rate that reflects timing and

perceived riskiness of the cash flows (equals
the investors cost of capital = the return
expected for alternative investments with similar
risk)
57
The relevant cash flows for valuing capital investments: free cash
flows
Free cash flows = amount of cash flows that will accrue to the investors from the
companys operating activities after expected investments have been made
Cash outflow from
operations
Capital expenditures
for replacement
Income tax payments
Cash
inflow from
operations
Operating
cash flow
Capital expenditures
for additional fixed
assets and additional
working capital
Interest expenses
Free cash flow

Flow to equity
58
The income statement is the starting point for calculating free

cash flows
Calculating free cash flows
Earnings before interest, taxes, depreciation, and
amortization (EBITDA)
Subtracted solely to
calculate the corporate
taxes, added back after
calculation of taxes
- Depreciation and amortization

- Taxes
= Net operating profit after tax (NOPAT)
+ Depreciation and amortization
- Capital expenditures
- Changes in the working capital requirement (WCR)
= Free cashflow
59
WCR = short-term operating

assets (inventories etc.), net
of short-term operating
liabilities
Mini case: Calculating free cash flows
Invest 3.4 million today in a capital project:
2.4 million for a tangible asset that is expected to last for 4 years and is
depreciated using the straight-line method
1 million for the working capital requirement (WCR) that will be constant over
the 4-year investment horizon and will be released at the end of year 4
The cost of capital for the investment is 10 %, the tax rate: 30 %

Net operating profits, before depreciation (EBITDA) are expected to be 1 million, 1.1
million, 1.2 million and 1 million in the years 1 to 4
today
year 1
year 2
year 3
year 4
EBITDA
1,000
1,100
1,200
1,000
- Depreciation and amortization
0,600
0,600
0,600
0,600
= EBIT
0,400
0,500
0,600
0,400
- Taxes
0,120
0,150
0,180
0,120
= NOPAT
0,280
0,350
0,420
0,280
+ Depreciation and amortization
0,600
0,600
0,600
0,600
- Capital expenditures
2,400
- Changes in WCR
1,000
= Free cash flow
-3,400
-1,000
0,880
0,950
1,020
1,880
The NPV of the free cash flows amounts to 0.236 million
60
Outline
Measuring
Value Creation:
Value-Based
Performance
Measures

3.4 EVA and RONA

3.5 Calculating EVA
61
Value-based performance measures an overview
Absolute measures, based on accounting numbers:

EVA Economic Value Added
(Stern Stewart & Co.)
Economic Earnings (A.T. Kearney)
Economic Profit (McKinsey)
ERIC Earnings less Riskfree Interest Charges
(KPMG)
CVA = Gross Cash Flow (GCF)

Economic Depreciation (ED)
r Invested Capital
Absolute measures, based on cash flows:

CVA Cash Value Added (BCG)
Rate-of-return measures, based on accounting

numbers:
ROI, ROCE, RONA, ROE etc.
Rate-of-return measures, based on cash flows:

CFROI (BCG, PriceWaterhouseCoopers,
Deloitte & Touche)
Economic Profit =
Income r Invested Capital
62
Income
Invested Capital
CFROI= =
CFROI
GCF
GCF ED
ED
Invested
InvestedCapital
Capital
Empirical results on the use of value-based

performance measures (1/2)
Use of value-based performance measures in German companies listed in
DAX 100 (KPMG, 2003)
Performance measure
1999/2000
2002/2003
EVA (and similar versions)
39 %
54 %
DCF
4%
9%
CVA (and similar versions)
3%
7%
CFROI (and similar versions)
3%
5%
ROE
9%
6%
RORAC, RAROC
4%
1%
ROI, RONA, ROIC, ROCE
22 %
6%
ROS and other profitability ratios
2%
3%
63
Empirical results on the use of value-based

performance measures (2/2)
Value-based performance measures used for period planning*
Company
Value added measure
Rate-of-Return
measure
RWE
Value added before taxes
ROCE
ThyssenKrupp

(ThyssenKrupp Value Added)
ROCE
Volkswagen
Value added after taxes
ROI
BASF
EBIT after cost of capital
ROCE
BOSCH
CFROI

* Source: Arbeitskreis internes Rechnungswesen 2010
64
Performance measurement and incentive compensation systems

aim to make managers choose the positive NPV-projects
Goal: make managers responsible for seeking out and implementing positive NPVprojects as well as for realizing the economic benefits promised by these projects
Attention: when the performance measures and the compensation system are not
chosen carefully, managers might be paid to do the wrong things
Select measurement techniques that are conceptually linked with the free cash flow
model of valuation
Evaluation of managers consistent with the way that the capital markets will
evaluate the firms
65
Outline
Measuring
Value Creation:
Value-Based
Performance
Measures

3.4 EVA and RONA

3.5 Calculating EVA
66
The link between EVA and Discounted Cash Flow

Economic Value Added is defined as the difference between accounting income
(Net Operating Profit After Tax) and the cost of capital:
EVA = NOPAT (WACC x Invested Capital)
Value is created, if EVA is positive
The present value of future EVAs plus the value of the invested capital is equal to
the present value of future free cash flows:
T
1 WACC
EVA t
t 1
Invested Capital t 0
1 WACC
t 1
FCFt
Using EVA for investment decisions arrives at the same investment decision as
using free cash flows
EVA can also be used for periodic performance evaluation and for management
compensation
67
The link between EVA and Discounted Cash Flow Simple

example without taxes
Cash Flows (CF) of an investment project:
Date
CF
100'
+55'
+55'
NPVi10% CF 100'
55' 55'
4.545,45
1,1 1,12
Accounting-based measures:
Date
Sales
55'
55'
Depreciation
50'
50'
= EBIT
5'
5'
Capital charges
10'
5'
= EVA
5'
NPVi10% EVA
5' 0
4.545,45
1,1 1,12
EBIT provides wrong incentives

Full capital charges (including those for equity) have to be taken into account
68
EVA can be expressed as a part of a firms market value (1)

The market value of a firm is a function of the capital markets expectations of
future EVAs:
Market value = invested capital + present value of future EVAs
Market value added = present value of future EVAs
Choosing the strategies that maximize current market value added (MVA) is equal
to the maximization of EVA
MVA = Present value

of future EVAs
EVAs
Invested capital
0
1
69
year
EVA can be expressed as a part of a firms market value (2)

Dividing the future EVAs into the continuation of the EVA performance already
achieved and future improvements of EVA gives:
Market value = invested capital + capitalized value of current EVA
+ capitalized value of expected EVA improvement
When does a companys share price rise? By excess EVA improvement: Doing
better than capital markets expected in a given (the current) year
Capitalized value of
expected EVA
improvement
Capitalized value of
current EVA
EVA
improvement
Invested capital
Current EVA
0
1
70
year
Outline
Measuring
Value Creation:
Value-Based
Performance
Measures

3.4 EVA and RONA

3.5 Calculating EVA
71
Another definition of EVA: The relation between the return on net

assets (RONA) and the WACC
The return on net assets (RONA):
RONA
NOPAT
net assets
EVA = (RONA WACC) invested capital

with net assets = invested capital
Why should we not use RONA (as percentage return) by itself instead of EVA (as
monetary return)?
Risk of motivating managers to undertake value-destroying projects to increase
RONA if RONA is less than WACC
Example: Japanese companies in 1997 had an average RONA of nearly zero

Risk of giving the management the incentive to forego profitable future projects
because their RONA is below the present RONA of the company
Example: Apple Computer in the early 1990s had a RONA of 30 % and

systematically left out new profitable investments with a lower RONA
72
Outline
Measuring
Value Creation:
Value-Based
Performance
Measures

3.4 EVA and RONA

3.5 Calculating EVA
73
Daimler AG Annual Report 2013

Calculation of EVA
74
BMW AG - Annual Report 2013

Calculation of EVA
75
Economic Value Added (EVA) as a measure of economic profit

The EVA represents the companys profit after full cost of capital:
Calculation of EVA
Net sales
Operating expenses
Operating profit (EBIT, earnings before interest and taxes)
Taxes
Net operating profit after tax (NOPAT)
Capital charges (Invested capital cost of capital)
EVA
EVA can be calculated for any entity of a company if its NOPAT, invested capital
and WACC are known
76
Calculating the invested capital: The EVA balance sheet differs

from the regular balance sheet
Cash
Receivables
+
inventories
+
prepayments
Fixed
assets
Short-term debt
Short-term NIBL
(non interest-bearing
liabilities)
Cash
Working capital
requirement (WCR)
Long-term
debt
Other long-term
liabilities
Fixed
assets
Shareholders
equity
Regular balance sheet
Short-term debt
Long-term
debt
Other long-term
liabilities
Shareholders
equity
EVA balance sheet
In the EVA balance sheet short-term NIBL are netted against short-term operating
assets to obtain the WCR
The left side of the EVA balance sheet represents the net assets the right side
the invested capital
77
The working capital requirement (WCR) represents the

companys net investment in the operating cycle (1)
The operating cycle of a company consists of
the inventory period, during which the products in the form of acquired
materials, work-in-progress, or finished goods stay within the firm until they
are sold (manufacturing period + sales period)
the receivables period which indicates the length of time it takes to collect cash
from the customers
Operating cycle
Inventory period
Manufacturing period
Materials
acquired
Receivables period
Sales period
Products
completed
Products
sold
78
Cash collected
from customers
The working capital requirement (WCR) represents the

companys net investment in the operating cycle (2)
Total investment in the operating
cycle
Investments by others like

suppliers or government
Inventories (materials, work-in-progress,

finished goods)
Receivables (also nontrade receivables like
money owed by employees)
Prepaid expenses (like the -amount for a
lease contract of a warehouse for the next
year) and other current assets
Operating cash (level of cash to support
the day-to-day operations)
Accounts payable (credit granted

to the company from suppliers)
Accrued expenses (like unpaid
wages and taxes)
Advances from customers
The companys own investment in the operating cycle (WCR)

WCR = (inventories + receivables + prepaid expenses + operating cash)
(accounts payable + accrued expenses + advances from customers)
79
What are the possibilities to increase EVA and create shareholder

value?
Interpreting EVA as follows gives some hints about what to do to increase EVA
EVA = (RONA WACC) invested capital
Increase returns on existing capital (while holding WACC and invested capital
constant)
Reduce the cost of capital (WACC)
Make new investments that earn returns greater than the WACC (profitable growth)
Divest value-destroying activities (the reduction in invested capital will be more than
compensated for by the greater spread between RONA and WACC)
Sustain the competitive advantage (technological or cost leadership, for example)
which enables the company to generate above-normal returns (RONA > WACC), for
a longer period
80
What does EVA contribute to value-based management?

A first rsum
EVA provides a link between the future-oriented valuation of a company by the
capital markets and the ex post-evaluation of performance
EVA helps to evaluate and select future projects and therefore to plan the
required budgets as well as allowing companies to measure, evaluate and
reward past performance
EVA, as measure of performance and base of managerial compensation, gives the

managers the right incentives to
seek potentially positive NPV investments (and therefore create competitive
advantages),
choose those projects that create shareholder value,
rapidly and efficiently implement these projects to create the expected cash
flows as soon as possible,
use the acquired assets as efficiently as possible (optimally run the day-to-day
business after the investments have been made).
81
Lecture 4:
Management Compensation:
Objectives and Alternatives
Overview

83
Required reading
84
Outline
Management
Compensation:
Objectives and
Alternatives
4.1 Fundamental objectives of management

compensation
4.2 Bonus plan design

4.3 Limitations of EVA-based compensation plans
85
Management compensation aims at balancing four sometimes

conflicting fundamental objectives
Alignment
Wealth leverage
Choosing the right

performance measures in
order to align managers and
shareholders interests
Giving management
sufficient incentives to work
hard and to take the
necessary risks in order to
maximize shareholder value
Management
compensation
Retention
Shareholder cost
Giving good managers

sufficient total compensation
to retain them even during
periods of poor performance
caused by market or industry
factors
Limiting the cost of

management compensation
to levels sufficient to
maximize the wealth of
current shareholders
86
How to create a greater wealth leverage as key measure of

management incentives some simple examples
Wealth leverage ratio =
% change in managerial wealth

% change in shareholder wealth
Compare the incentives to increase shareholder value of a manager to those of an entrepreneur

who has his total wealth invested in his business
1. Stock ownership
1. Wealth leverage result
Consider a manager with an annual salary of

100,000, a home with personal equity of
100,000 and company stock worth a
certain amount:
value of human capital*

home
company stock
total managerial wealth
100 %-increase in company

(=shareholder) value:
value of human capital*
home
company stock
800,000
100,000
100,000
1,000,000
800,000
100,000
200,000
1,100,000
Wealth leverage ratio

=
10 %
= 10 %
100 %
* The value of human capital in this example represents the future value of salary and
pension and is assumed to be worth eight times annual salary
87
Create entrepreneurial wealth leverage for the manager by

(leveraged) stock ownership
Possible alternatives for increasing managerial wealth leverage
2. Higher stock ownership

value of human capital
home
company stock

home
company stock
800,000
100,000
1,000,000
1,900,000
800,000
100,000
2,000,000
2,900,000
Wealth leverage ratio = 52,63 %
3. Leveraged equity position
stock ownership financed by loan

home
company stock
loan

home
company stock
loan
800,000
100,000
1,000,000
(900,000)
1,000,000
800,000
100,000
2,000,000
(900,000)
2,000,000
Wealth leverage ratio = 100 %

88
Create entrepreneurial wealth leverage for the manager using

stock option grants
Suppose the company grants a 10-year at-the-money option on 3.5 million of
stock and the manager achieves a 100 percent increase in shareholder wealth.
4. Stock option grants
At-the-money stock option

home
company stock option*
*

home
company stock option*
800,000
100,000
2,200,000
3,100,000
800,000
100,000
5,400,000
6,300,000
Wealth leverage ratio 103,23 %
Assumption: The Black-Scholes value of the option is 2.2 million and 5.4 million after a doubling in
shareholder wealth.
In this case of a 10-year at-the-money option a manager holding options on stock

worth 35 times base salary has entrepreneurial wealth leverage.
This result depends on the assumptions about the volatility of company stock and the interest rate when
calculating the Black-Scholes value of the option.
89
Example for an existing leveraged equity position of

management: the case of management buyout
Definitions:
Leveraged buyout (LBO) = The acquisition of a company, subsidiary or unit by

another, financed mainly by borrowings
Management buyout (MBO) = Public or private company buyout in which long
term, experienced, inside management is involved
Management taking part in an MBO has a bigger ownership interest (some studies reveal an
average CEO ownership of 6.4 %)
alignment because of managers being shareholders themselves and higher wealth leverage
(as in example 2 on slide 7)
The equity position of management is highly leveraged because it is financed mainly by

borrowings
higher wealth leverage as in example 3 on slide 7 (incentives to focus on shareholder value
creation, to sacrifice other objectives and to take unpleasant tasks like working harder, cutting
staff if necessary, enforcing more demanding performance standards, punishing poor
performers etc.)
Incentives also stem from the need to increase profitability to pay down the debt
90
Some shortcomings of the MBO model

Management participating in an MBO has strong incentives for wealth creation but
debt burden considerable risk of bankruptcy,
drop in stock price net value of the managers share holdings falls to zero
the shares would have to be sold to cover the debt incentives are lost,
MBO does not provide the same strong incentives at the business unit level.
EVA can create a highly leveraged compensation plan without the risk of
bankruptcy
by indirectly imposing interest in the form of a capital charge and principal

payments in the form of a depreciation expense
while maintaining full financial flexibility (without the need to meet a bankers
repayment schedule)
and providing wealth incentives also at the business unit level.
91
Does a high percentage of variable target total compensation

automatically provide high wealth leverage? (1/2)
Suppose the manager receives, above the base salary of 100,000
a target annual bonus of 100% base salary = 100,000 ,
an option each year on stock worth 300,000
Target annual compensation of 380,000
(assuming the Black-Scholes value of the option is 60% of stock value)
Highly variable compensation

home
Doubling in stock price:
3,040,000
100,000
100,000
company stock
Wealth leverage result
3,240,000
increase in stock value

increase in option value*
100,000
276,000
increase in bonus paid*
153,000
74% of target total compensation

increase in total wealth
529,000
tied to performance (part of the value
Wealth leverage ratio 16 %
of human capital tied to performance)
* Assumptions: The Black-Scholes value of the option increases by 153% after a doubling in
shareholder wealth and the managers bonus beats the target by the same percentage.
92
Does a high percentage of variable target total compensation

automatically provide high wealth leverage? (2/2)
Competitive pay model = Compensation program annually adjusting option shares and
operating performance targets to maintain competitive compensation levels
Current year performance has no impact on future compensation
Rise in stock price no effect on the worth of contractual payments in the next
year (next years option on the same -amount of stock)
Operating performance target adjusted (remains 100% of fixed base salary)
Weak wealth leverage effect because only current (but not the future)
compensation is at risk.
Improvement of wealth leverage of competitive pay policies on the corporate level through
front-loaded option grants (granting the options normally granted in future

years already upfront in the first year),
annual fixed-share grants (granting a fixed number of shares instead of a fixed
-amount).
Attention: Higher wealth leverage and minimization of retention risk are strongly conflicting
goals!
93
Outline
Management
Compensation:
Objectives and
Alternatives

compensation

94
Bonus plan design: threshold levels and caps on bonus payout

Unrewarded
performance
Key features and objectives:
Target bonus paid for achieving

target financial performance
limits retention risk if target
performance level is well chosen
Target bonus
Performance
measure
Unpenalized
performance
Threshold level of performance to

attain before any bonus is paid
and cap on the bonus payout
limits shareholder cost
Target
performance
Shortcomings:
No further incentives to implement value-creating projects or to work hard for
managers being in the area of unrewarded performance or deeply in the area of
unpenalized performance
Threshold and cap create incentives to time revenues or expenses
95
Bonus plan design: An example of a typical modern EVA bonus

plan including a bonus bank (1/2)
Bonus = target bonus + y (EVA - expected EVA improvement)
Bonus earned is
credited to the bonus
bank
Excess EVA improvement

Bonus earned
Typical payout rule:

100% of bonus bank
balance (if positive)
up to the amount of
the target bonus
Bonus banked
Target bonus
Bonus bank
Bonus paid
+ one third of bonus
bank balance in
excess of target
bonus
EVA interval
96
Bonus plan design: An example of a typical modern EVA bonus

plan including a bonus bank (2/2)
Bonus = 100,000 + 2 % (EVA - 5 million)
Example of an EVA bonus plan

Year
0
-30,000 -15,000 -20,000
-5,000
EVA improvement
Expected EVA improvement
15,000
-5,000
15,000
5,000
5,000
5,000
10,000 -10,000
10,000
EVA
Target bonus
Share of excess EVA improvement
100
2%
100
2%
100
2%
Bonus earned
300
-100
300
Bonus earned + bonus bank
300
33
300
Bonus paid
167
33
167
Ending bank
133
133
Cumulative bonus earned = cumulative bonus paid + ending bonus bank

97
The calibration of a bonus plan (based for example on EVA) an

overview
Bonus plan calibration = annual process to reset the EVA targets
Three key parameters:
Target bonus: based on competitive compensation analysis
Attention: Annual reset of performance target may undermine leverage and
weaken alignment if superior (poor) performance results in higher (lower) new
targets performance penalty.
Expected EVA improvement: target bonus earned if companys shareholders
provided with a cost-of-capital return on the market value of their investment
EVA interval: sensitivity of the EVA bonus to excess EVA improvement
98
EVA bonus plan design: Some tools to provide business unit

incentives that achieve the basic compensation objectives
Purpose
Tools
Fixed-percentage interests that align managers and
shareholders trade off between current and future
performance
Deferred compensation (bonus banks)
Closer managershareholder alignment
Fixed-percentage interests and formula targets hold

constant (no annual resets)
Stronger wealth leverage
Careful analysis of competitive compensation levels

Careful risk modeling to ensure a large enough
target bonus or small enough leverage
Tolerable retention risk
Performance targets consistent with a cost-ofcapital return on the market value invested
Guaranteed compensation limited
Sharing the cost of strong incentives
Reasonable shareholder
cost
99
Outline
Management
Compensation:
Objectives and
Alternatives

compensation

100
Some limitations of EVA-based compensation plans (1/3)

Highly cyclical
industries
Startups and
emerging markets
Cross-cultural
differences
Different risk
preferences
Nonmonetary
preferences
Highly cyclical industries
Startups and emerging markets
Difficulties calibrating EVA bonus

plans when performance varies
dramatically from year to year
Growth and building market share

considered more important as indicators of
long-term value
Trade off between retention problems

during down cycles or excessive
shareholder cost of competitive
compensation
Relatively high investments in the sort of

market infrastructure
Investments made in stages in risky

markets to await achievement of specific
sales or profit goals
yearly improvement of (eventually
negative) EVA by up front investments too
risky
101

Highly cyclical
industries
Startups and
emerging markets
Cross-cultural
differences
Cross-cultural differences
Different risk
preferences
Nonmonetary
preferences
Compensation practices
Power distance: acceptation of unequal

distribution of power
Compensation based on status

or seniority
Uncertainty avoidance: degree to which

uncertainty and unpredictability are
tolerated
Compensation based on
individual performance
Social benefits and programs
Employee ownership programs
Individualism versus collectivism

focus on own interests / family?
loyalties to ones in-groups?
group-based responsibilities
Masculinity (materialistic behavior) versus

femininity (caring for others)
102

Highly cyclical
industries
Startups and
emerging markets
Cross-cultural
differences
Different risk
preferences
Nonmonetary
preferences
Different risk preferences
Nonmonetary preferences
Working conditions, colleagues,

technologies used etc.
But: Management should think in monetary

terms of value creation to promote
shareholder interests
Managers are typically more risk

averse than fully diversified
shareholders
Older managers tend to hedge their
existing wealth
103
Lecture 5:
Calculating the Cost of Capital
Overview

105
Required/suggested readings
Required readings:
Suggested readings:
Brealey, R. A., Myers, S. C., and Marcus, A. J.: Fundamentals of Corporate
Finance, 9/e Boston 2007.
106
Outline
5.1 Calculating the cost of equity: The CAPM
Calculating the
Cost of Capital
5.2 Calculating the relevant beta

5.3 Alternatives to the CAPM: The APT
5.4 The capital structure choice
107
Measuring the cost of capital is mainly a question of how to

measure the cost of equity
Cost of capital = opportunity cost that reflects the returns investors expect from
other investments of similar risk
Different forms of financing (equity, debt) carry different risks for investors and
therefore different costs weighted-average cost of capital (WACC)
WACC
S
B
rB
TC
rS
S
B
rS
rB (1 TC )
SB
SB
= market value of equity (stock)

= market value of debt (bond)
= cost of debt
= corporate tax rate
= cost of equity
Alternative approach: target weightings (target capital structure) instead of marketbased weightings
How to get an estimate of the cost of equity?
108
The Capital Asset Pricing model (CAPM) delivers an estimate of

how risky assets like a firms equity are priced by capital markets
The expected return on a risky asset is given by the following equation:
E(R i ) R f i [E(R M ) R f ]
Market risk premium
E(Ri)
Rf
E(RM)
i
= expected return on risky asset i

= return on a risk-free asset
= expected return on the stock market
covRi ,RM
= measure of risk of asset i (company risk factor) with i
Var RM
The CAPM gives the return expected by the capital markets for investing in a risky
asset like a companys stock
Main assumptions of the CAPM:
Either quadratic utility functions of investors or normally distributed returns
Investors have a unique planning horizon and homogenous expectations
concerning the means, variances and covariances of the asset returns
No capital market restrictions like transaction costs or restrictions of short sales
109
The total risk of a companys equity can be separated into the

market risk and the company-specific risk
Total risk = market risk + company-specific risk
Company-specific risk
Market risk
Also called unsystematic, diversifiable,

idiosyncratic risk
Also called systematic, nondiversifiable

risk
Examples: management errors,

production downtimes (only a few (or
one) companies are concerned)
Examples: GDP, inflation, interest rates

(almost the whole market is concerned,
to more or less extent)
Can be eliminated by diversification
Cannot be eliminated through

diversification
Bearing that risk is not paid

for by the capital market
Capital market pays investors for

bearing that risk
i measures the volatility of a companys stock price with respect to the overall
stock market (reflects market risk)
i =1 for companies with a risk identical to the overall market risk, i > 1 for more
risky, i < 1 for less risky companies
110
Graphical representation of the security market line

Security market line
E(R i )
E(R i ) R f i [E(R M ) R f ]
E(R M )
Rf
i
M 1
111
covRi ,RM
Var RM
Industry Survey
KPMG 2014
112
Sample and scope of

KPMG (2014): Cost of Capital Study 2014
Data collected between May and September 2014
Survey among 130 companies in Europe (Germany, Austria Switzerland)
Main industries of the survey:
Automotive
Chemicals & Pharmaceuticals
Consumer Markets
Energy & Natural Resources
Financial Services
Health Care
Industrial Manufacturing
Media & Telecommunications
Real Estate
Technology
Transport & Leisure
113
Average WACC by year and industry
Source: KPMG (2014): Cost of Capital Study 2014
114
Average cost of debt by year and industry
115
Average cost of equity by year and industry
116
Average beta by year and

industry
117
Average risk free rate and market risk premium by period
118
Average risk free rate and its determination
119
WACC estimations for EON, Thyssen & Metro Group

(Source: Annual Reports 2013, 2010 & 2008)
Company
WACC 2013
WACC 2010
WACC 2008
7,5%
8.3%
9.1%
Thyssen
9%
8.5%
8.5%
METRO
Group
9,6%
7.2%
6.5%
EON
WACC - Thyssen Business Segments (Source: Annual Reports)
Services
Elevator
2008
Technologies
2010
Stainless
2013
Steel
7
7,5
8,5
120
9,5
10
WACC estimations for Metro Group

(Source: Metro Group Annual Report 2010, p. 087)
121
Outline
Calculating the
Cost of Capital

122
Calculating the companys beta some problems to cope for

Beta can be calculated by regressing monthly or weekly returns of the company on
the returns of the whole stock market
Problems of conceptual as well as practical relevance in calculating beta:
Choice of the return interval (monthly, weekly, daily etc.)
Time period for data (5 years of data, 10 years of data etc.). Attention: Betas
may change over time!
Choice of market? Which market index is the appropriate proxy?
Choice of the risk free rate of return (government bonds etc.)
Conceptual problems of the CAPM:
CAPM based on expectations of future returns, not on historical returns (model
really testable?)
CAPM theoretically based on the overall market which isnt observable in reality
each index as a proxy will fail in representing the overall market
Empirical work shows varying results concerning a confirmation of the models
implications, sometimes depending on the periods employed
123
Calculating the beta of private firms and divisions without data of

observable returns requires a more pragmatic approach
The procedure depends on how the divisions are organized:
Organized geographically
Organized by product line
Division funded in the divisions home

currency
Estimate betas from comparable firms in

the same or similar industries
Add company or product line risk

premium to the rate of return of the
divisions local government bonds
Adjust for different capital structure that

influences the beta (the more leverage
through debt the more risky the equity!)
Division not self-financing (financing

mainly from parent)
Add risk premium to the government

bond rate in the parent companys
home currency, eventually plus an
additional risk premium for
undeveloped market economies
Calculate a fictitious unlevered beta by

adjusting the levered beta of the other firm
for its debt-to-equity ratio:
Lother
other
U
other
1 1 TCother B
S
Adjust the fictitious unlevered beta of the
other firm for the own divisions debt-toequity ratio:
own
Lown Uother 1 1 TCown B

S
Choose a target capital structure to

calculate the WACC
124
Outline
Calculating the
Cost of Capital

125
The Arbitrage Pricing Theory (APT) as an alternative to compute

the companys cost of equity
Multi-factor model that assumes that returns on securities are generated by a
number of industry- and market-wide factors and therefore supposed to explain a
greater percentage of stock price movements than the CAPM
Return on asset = expected return + unanticipated return (surprise)
Example: Using inflation (FINF), gross domestic product (FGDP) and interest rate
(FRATE) as possible systematic risk factors influencing asset return, the return on a
risky asset is given by:
Ri E(Ri ) i,INF FINF i, GDP FGDP i,RATE FRATE
E(Ri) = expected return on risky asset i
= unsystematic portion of stock returns

i
= volatility associated with risk factor
Problems:
Which are the relevant risk factors? Not given in the theory
Does not resolve the problem of the use of historical data for beta estimation
More difficult to apply in practice (estimation of betas)
126
Outline
Calculating the
Cost of Capital

127
A company should choose the appropriate capital structure to

minimize the cost of capital
Choose the financing alternatives that reduce the firms cost of capital
Financing alternatives
Factors for debt-equity choice
Straight debt
Tax shield from interest payments
Short-term debt (bank-loans or money

market instruments)
Costs of financial distress
Agency costs because of
Long-term debt (fixed- or floating-rate

bonds or bank loans)
shareholder-debtholder conflicts
manager-shareholder conflicts
Straight equity
Retained earnings
New equity issues (public or private
placement)
Asymmetric information (capital

structure serving as informative signal
for the market)
Hybrid instruments
Convertibles
Preferred shares
Warrants
128
Because of the tax-deductibility of interest payments a higher

leverage may result in a higher firm value
Capital structure does not matter in a world without taxes and bankruptcy costs and with
perfect capital markets (Modigliani-Miller)
Increase in leverage replaces equity with cheaper debt but also raises the risk and therefore
the costs of the remaining equity
Sufficient taxable income and tax-deductibility of interest payments:
Tax shield = i B TC
i
B
TC
VU (VL)
= interest rate
= book value of debt
= corporate tax rate
= value of unlevered
(levered) firm
Firm
value
VL
Present value
of tax shield
VU
Debt/equity
Inclusion of personal tax rates complicates the theory: Personal tax rate (of bondholders) on
interest is in general higher than the effective personal tax rate on equity distribution (share
buybacks etc.)
Personal tax penalties to bondholders (partly) offset the tax benefits of debt at the corporate
level (bondholders must be offered higher yields) Problem: How can the tax shield be
valued?
129
The risk of financial distress gives rise to a theory of an optimal

capital structure balancing benefits and costs of debt financing
Direct costs of financial distress:
Payments to lawyers, accountants
etc. for reorganization, debt
renegotiation and other necessary
activities to avoid bankruptcy
Firm
value
Present value
of financial
distress costs
VU
Indirect costs of financial distress:

Loss of reputation and confidence
in the firm by customers and
suppliers Declining sales and disruptions in the supply chain
Managerial effort devoted solely to survival
Inability to raise necessary capital for new profitable projects
VL
Debt/equity
Problem:
Quantifying the costs of financial distress
Differing opinions about importance of these costs (difference between financial
distress and economic distress caused by economic shocks, operating
inefficiencies or strategic failure)
130
Conflicts with managers and bondholders give rise to agency

costs for the shareholders depending on the capital structure
There are two different types of conflicts concerning the capital structure:
Shareholders vs. managers
Shareholders vs. bondholders
Managers are generally more risk

averse than the more diversified
shareholders
Managers, bearing a high risk in the

company tend to have the company
underleveraged, since they are not
rewarded for that risk by the market (in
contrast to the shareholders)
Managers might spend the free cash

flows for their own purposes
A higher debt burden decreases free

cash flows due to interest and principal
payments
131
Limited liability of the shareholders

and limited profit of the bondholders
causes a gambling strategy of the
shareholders (mainly when in financial
distress) at the cost of the
bondholders
They might invest in high risk projects

when there is the chance of a high
profit if, in the other case, the
shareholders outcome (as residual
stake) is worthless even for low risk
projects creditors cope with this
through higher yields
Asymmetric information between capital markets and the firms

or their managers gives capital structure the role of a signal
Empirical work supports the hypothesis that announcements of actions that change
the companys capital structure have an informational content:
Equity issues tend to have a negative effect on stock prices
Share buybacks are mainly interpreted as a positive signal by the market
Straight debt issues are sometimes interpreted as a positive signal
Some reasoning of theoretic research:
Managers with private information might issue equity only when they assume
that company stock is overpriced (otherwise preferring internal financing in the
first place or debt issues: pecking order of financing alternatives)
A company that buys back shares might assume its shares undervalued
Managers might issue debt (and accept a higher risk of bankruptcy) only when
they have reliable information of high future prospects of an investment
Disadvantage of these theories:
Only descriptive approach, explaining possible capital market reactions
Does not give an explicit advise for specific financing decisions

132
The capital structure choice is an ongoing process a decisionframework of how to achieve a chosen target capital structure
Firm overlevered
Firm underlevered
Under threat of
takeover?
Under threat of
bankruptcy?
Yes
No
Reduce debt quickly:

Sell assets and use
proceeds to pay off
debt
Renegotiate debt
terms
Debt/equity swaps
Reduce debt
gradually
Increase debt
quickly:
Leveraged
recap
Positive NPV
projects available?
Yes
Finance projects
with internally
generated cash
flows or new equity
issue
Yes
No
Increase debt
gradually
Positive NPV
projects available?
No
Pay off debt with
cash flows
Issue new equity
and use proceeds
to pay off debt
Cut dividends
133
Yes
Finance
projects with
debt
No
Increase regular
dividends
Special dividend
Buy back shares
Lecture 6:
Accounting Adjustments: Overview
Overview

135
Required readings
136
Outline
6.1 Objectives of accounting adjustments

6.2 Effects of depreciation on performance
Accounting
Adjustments:
Overview
6.3 Expenses with investment character: Successful

efforts accounting and R&D costs
6.4 Capitalizing operating leases
6.5 A framework for thinking about EVA and accounting
adjustments
137
Numerous accounting adjustments are proposed for performance

measurement with different and sometimes even conflicting objectives
Examples of adjustments
Purpose of adjustment
Choose economic depreciation instead of the

straight-line method (6.2)
Make the accounting ROI a

better approximation for the
economic (internal) rate of
return
Abandon successful efforts accounting and

capitalize R&D expenditures (6.3)
Recognize future period cash costs on a
present-value basis (6.5)
Recognize off-balance-sheet debt like
operating leases (6.4)
Increase accountability for

shareholder funds
Eliminate accruals for warranties and bad

debts (6.5)
Limit managements ability to

manage earnings
Exclude non-operating income and assets
Make EVA a better measure

of market value
Choose relative-benefit depreciation instead of

other depreciation methods (7)
Incentivize value-maximizing
investment decisions
138
Outline

Accounting
Adjustments:
Overview

adjustments
139
Depreciation patterns (1) straight-line depreciation

A company invests 5 million into equipment which generates constant expected
earnings before depreciation of 2 million for the next 5 years. The tax rate is 0 %.
The cash flows generated by the project (in thousand ) and its IRR
Year
Equipment purchase
Cash operating margin
Cash flow
Internal rate of return
0
-5.000
-5.000
28,65%
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
Straight-line depreciation: Increase in accounting ROI as well as in EVA

Year
0
Depreciation expense
NOPAT
Invested capital
Return on invested capital
EVA (WACC = 10%)
0
5.000
1
2.000
1.000
1.000
4.000
20%
500
2
2.000
1.000
1.000
3.000
25%
600
3
2.000
1.000
1.000
2.000
33%
700
140
4
2.000
1.000
1.000
1.000
50%
800
5
2.000
1.000
1.000
0
100%
900
Depreciation patterns (2) sinking-fund depreciation

The sinking-fund depreciation charge is the amount left over after the economic
return on the investment is provided:
Depreciati on t cash operating margin t IRR invested capital t 1
Year 1: 2.000 28,65% 5.000 = 568

Sinking-fund depreciation: Each periods ROI is equal to the projects IRR
Year
0
NOPAT
Invested capital
EVA (WACC = 10%)
0
5.000
1
2.000
568
1.432
4.432
28,65%
932
2
2.000
730
1.270
3.702
28,65%
827
3
2.000
939
1.061
2.763
28,65%
690
4
2.000
1.208
792
1.555
28,65%
515
5
2.000
1.555
445
0
28,65%
290
Decreasing EVA because of decreasing invested capital

Necessary to implement new projects to maintain current EVA level
But: NPV of EVAs is the same as with straight-line depreciation (theorem of
Preinreich-Lcke)
141
Depreciation patterns (3) straight-line depreciation and a declining

cash operating margin
Straight-line depreciation can make the accounting return on capital equal to the
economic return in one unique case of a declining cash operating margin
Declining cash operating margin and straight-line depreciation
Year
Equipment purchase
Cash flow
Internal rate of return
0
-5.000
-5.000
20%
2.000
2.000
1.800
1.800
1.600
1.600
1.400
1.400
1.200
1.200
3
1.600
1.000
600
2.000
20%
4
1.400
1.000
400
1.000
20%
5
1.200
1.000
200
0
20%
Year
0
NOPAT
Invested capital
0
5.000
1
2.000
1.000
1.000
4.000
20%
2
1.800
1.000
800
3.000
20%
142
Depreciation patterns (4) some consequences of using sinking-fund

depreciation
Sinking-fund depreciation needs a forecast of future cash flows
EVA improvement on the current capital basis harder to achieve when sinking-fund
depreciation is used
In case of an non-constant cash operating margin the depreciation is called
economic depreciation.
The economic depreciation might be negative in the early years of the project, if the
increase of the cash operating margin high enough.
When tax and accounting treatments differ, we might get an up-and-down
pattern of amortization to make the return on invested capital equal to the projects
economic return
143
Outline

Accounting
Adjustments:
Overview

adjustments
144
Successful efforts accounting: Write off assets that are of no future

value to the firm
Assume an oil exploration company investing 5 million in 5 oil wells expecting one
of it to hit a pool of oil creating 2 million of annual oil revenue for 5 years
Successful efforts approach: The projects cash flows (in thousand )
Year
Exploration costs
Oil revenue
Cash flow
Internal rate of return:
0
-5.000
-5.000
28,65%
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
2.000
Writing off unsuccessful oil wells yields a bad measure of performance

Year
0
Oil revenue
Exploration expense
NOPAT
Invested capital
4.000
-4.000
1.000
1
2.000
200
1.800
800
180%
2
2.000
200
1.800
600
225%
145
3
2.000
200
1.800
400
300%
4
2.000
200
1.800
200
450%
5
2.000
200
1.800
0
900%
Strongly
increasing
ROI on a very
high level!
Abandon successful efforts accounting: Capitalize and amortize

expenditures that are an essential part of an investment project
Capitalizing dry-hole costs (straight-line depreciation)

Year
0
Oil revenue
Exploration expense
NOPAT
Invested capital
0
5.0
1
2.0
1.0
1.0
4.0
2
2.0
1.0
1.0
3.0
3
2.0
1.0
1.0
2.0
20%
25%
33%
4
2.0
1.0
1.0
1.0
5
2.0
1.0
1.0
0
50% 100%
Using sinking fund depreciation

Year
0
Oil revenue
Exploration expense
NOPAT
Invested capital
0
5.000
1
2.000
0.568
1.432
4.432
2
2.000
0.730
1.270
3.702
3
2.000
0.939
1.061
2.763
4
2.000
1.208
0.792
1.555
5
2.000
1.555
0.445
0
29 %
29 %
29 %
29 %
29 %
146
Conventional R&D accounting treats R&D costs as operating expense

and not as investment
Assume a company earning a 15 % return on invested capital, with a NOPAT of
12 million and constant capital of 80 million; assumption of 0 % tax rate
New investment of 15 million in R&D, with expected incremental cash flows of 6
million for each of the next 5 years ( IRR: 28.65 %)
New total return in year 1 should be a weighted average:
80
15
15 %
28 .65% 17 .16%
95
95
Effects of conventional accounting on the return on investment

Year
Steady state NOPAT
NOPAT R&D project
Adjusted NOPAT
Invested capital
RoI (R&D project)
RoI (company)
0
12.000
-15.000
-3.000
80.000
-100%
-3,75%
1
12.000
6.000
18.000
80.000
40%
22,5%
2
12.000
6.000
18.000
80.000
40%
22,5%
147
3
12.000
6.000
18.000
80.000
40%
22,5%
4
12.000
6.000
18.000
80.000
40%
22,5%
5
12.000
6.000
18.000
80.000
40%
22,5%
Capitalize any operating expense that is not intended to create income

in the current period but in future periods
Capitalizing the R&D expenditure (straight-line amortization)
Year
0
12.000
12.000
12.000
12.000
12.000
12.000
Amortization R&D project
3.000
3.000
3.000
3.000
3.000
NOPAT R&D project
3.000
3.000
3.000
3.000
3.000
Steady state NOPAT
Adjusted NOPAT
12.000
15.000
15.000
15.000
15.000
15.000
R&D capital
15.000
12.000
9.000
6.000
3.000
Invested capital
95.000
92.000
89.000
86.000
83.000
80.000
20,00%
25,00%
33,33%
50,00%
100,00%
15,79%
16,30%
16,85%
17,44%
18,07%
ROI (R&D project)

ROI (company)
15,00%
Return on R&D
investment
alone rising from
20 % in year 1
up to 100 % in
year 5
Capitalizing the R&D expenditure (sinking-fund amortization)

Year
0
12.000
12.000
12.000
12.000
12.000
12.000
Amortization R&D project
1.703
2.190
2.818
3.625
4.664
NOPAT R&D project
4.298
3.810
3.182
2.375
1.336
Steady state NOPAT
Adjusted NOPAT
12.000
16.298
15.810
15.182
14.375
13.336
R&D capital
15.000
13.298
11.107
8.289
4.664
Invested capital
95.000
ROI (R&D project)

ROI (company)
15,00%
93.298
91.107
88.289
84.664
80.000
28,65%
28,65%
28,65%
28,65%
28,65%
17,16%
16,95%
16,66%
16,28%
15,75%
148
Return on R&D
investment
remaining at
28.65 % but
loosing weight in
total investment
until year 5
Adjusting R&D for EVA calculations a simple example

General Motorss disclosure of R&D expenditures in million $ in its annual reports,
expensed as incurred:
Year
2007
2006
2005
2004
2003
R&D expenditures
5,500
5,400
5,800
6,500
6,200
Calculate EVA for 2007 Adjusting NOPAT and invested capital:

Increase NOPAT by the $ 5,500 million current years R&D costs
Decrease NOPAT by the estimated (hypothetical) amortization expense
(assuming straight-line depreciation over five years in this example):
(5,500 + 5,400 + 5,800 + 6,500 + 6,200) / 5 = $ 5,880 million
Increase invested capital by unamortized R&D from 2007 and previous years:
0.8 5,500 0.6 5,400 0.4 5,800 0.2 6,500 $ 11,260 million
149
Some remarks on capitalizing R&D expenses
The idea of capitalizing R&D expenses (and the procedure) is the same for other expenses with
investment character like marketing expenses etc.
Year
Starting with a new $15M
R&D project each year, the
return on invested capital
rises to a constant (but not
the same!) percentage for
both, straight-line (example
on the right) and sinkingfund depreciation
Steady state NOPAT

Year 0 R&D project
Year 1 R&D project
Year 2 R&D project
Year 3 R&D project
Year 4 R&D project
Year 5 R&D project
Adjusted NOPAT
Year 0 R&D capital
Year 1 R&D capital
Year 2 R&D capital
Year 3 R&D capital
Year 4 R&D capital
Year 5 R&D capital
Year 6 R&D capital
Invested capital
RoI (company)
0
12.000
12.000
15.000
1
12.000
3.000
15.000
12.000
15.000
2
12.000
3.000
3.000
3
12.000
3.000
3.000
3.000
4
12.000
3.000
3.000
3.000
3.000
5
12.000
3.000
3.000
3.000
3.000
3.000
18.000
9.000
12.000
15.000
21.000
6.000
9.000
12.000
15.000
24.000
3.000
6.000
9.000
12.000
15.000
27.000
0
3.000
6.000
9.000
12.000
15.000
6
12.000
3.000
3.000
3.000
3.000
3.000
27.000
0
3.000
6.000
9.000
12.000
15.000
95.000 107.000 116.000 122.000 125.000 125.000 125.000
15,79% 16,82% 18,10% 19,67% 21,60% 21,60%
The accounting ROI for the

single R&D project equals
the projects IRR only
under sinking-fund
depreciation
Using sinking-fund depreciation for R&D expenses might be complicated because of the even
greater uncertainty of future cash flows of R&D projects compared to other projects
150
Outline

Accounting
Adjustments:
Overview

adjustments
151
Accounting for leases: Capital leases vs. operating leases

Two common methods of accounting for long-term leases:
capital leases (US-GAAP) / financial leases (IFRS)
the related asset and debt are initially capitalized on the balance sheet
(valued at the present value of future lease payments)
future periods: depreciation of the asset and interest expenses on the debt
operating lease method
lease payments treated as rental expense (no recognition of asset or debt)
Lessees have to classify their lease contracts as either financial (capital) or
operating leases
Finance (capital) leases: leases that transfer to the lessee substantially all the
risks and rewards incidental to ownership of the leased asset
All other leases are classified as operating leases
Critics
Operating leases are an important (unrecognized!) source of financing
Leased asset is necessary for the companys operations
152
Operating leases represent a form of off-balance-sheet debt whose

capitalization has only minor impact on EVA
Operating lease: Secured borrowing with

the lease payments treated as a rental expense in accounting,
Understatement of NOPAT (implied interest costs of the lease included in
operating profit)
the related debt not appearing on the balance sheet
Understatement of invested capital (lease is debt)
Basic principle of adjustment
Capitalize any operating expenses that are a disguise for financial costs
153
Adjusting for operating leases: The example of Pfizer

Minimum noncancellable operating lease payments as of
December 2012
2013
2014
2015
2016
2017
After 2017
184 million $
162 million $
132 million $
85 million $
74 million $
618 million $
December 2013
2014
2015
2016
2017
2018
After 2018
204 million $
168 million $
130 million $
98 million $
80 million $
771 million $
Pretax borrowing cost of the company: 5.5 %, companys tax rate: 27.4 % (2013)
Adjustment of invested capital and NOPAT for 2013 EVA:

Increase invested capital by the present value of the lease payments: $ 628.1 million
(assumption: lease payments payable at the beginning of each year; payments after 2018
not taken into consideration)
Increase NOPAT by the pretax cost of borrowing of the average value of operating leases
during the year:
0.055 628.1 588.3 2 $ 33.5 million
Decrease NOPAT by the tax shield on the interest: $ 9.2 million
154
There is no effect of adjusting for operating leases on EVA when the

company has a zero market value added
Zero market value added
Adjusting for operating leases
Market value and book value of equity

Market value and book value of debt
80 M
60 M
Pretax cost of debt

Corporate tax rate
Cost of equity
NOPAT
8%
40%
12%
20 M
Assume operating leases with a present

value of 30 million (constant throughout the
year) and implied interest rate of 8 %
+ Interest portion of lease payments
2.40 M
- Tax shield on interest expense
0.96 M
As market value = book value MVA = 0
WACC = 8.188 %
Calculation of EVA:
Calculation of EVA:
EVA
21.44 M
Adjusted NOPAT
WACC = 8.914 %
NOPAT
Capital charges (140 8.914 %)
20.00 M
NOPAT
20.00 M
12.48 M
7.52 M
155
Adjusted NOPAT
EVA
21.44 M
13.92 M
7.52 M
Having a positive market value added EVA decreases slightly after

adjusting for operating leases
Positive market value added
Assume invested capital is 90 million

instead of 140 million MVA = 50 million
Calculation of EVA:
Calculation of EVA:
Adjusted NOPAT
21.44 M
9.83 M
EVA
11.61 M
NOPAT
20.00 M
8.02 M
EVA
11.98 M
Adjustment results only in a modest decline

of EVA
Negative market value added
Assume invested capital is 160 million

MVA = 20 million
Calculation of EVA:
Calculation of EVA:
Adjusted NOPAT
NOPAT
EVA
20.00 M
14.26 M
EVA
21.44 M
15.56 M
5.88 M
Adjustment results in a modest increase of

EVA
5.74 M
156
Outline

Accounting
Adjustments:
Overview

adjustments
157
Companies should act conservatively when making accounting

adjustments
Accounting adjustments should be evaluated carefully and company-specific
before being used
Based on sound finance theory?
Significant impact on the EVA measure used for incentive compensation?
Significant improvement of EVAs ability to explain returns and market values?

Significant impact on managerial decision making?
Some general comments about accounting adjustments:
Elimination of noncash charges is not based on sound finance theory
Capitalizing leases has a very minor impact on the EVA measure

Sinking-fund depreciation is a very complex adjustment and needs compelling
statistical evidence
Corporate users and investments analysts pursue different purposes with EVA and
therefore have a different perspective concerning EVA adjustments
158
Changes in accounting standards: A careful analysis of their impact on

performance measures is necessary (1/2)
Accounting standards change over time:
IFRS: changes from 2003 to 2008:
1
2003
2
2004
2005
2006
15
1
1
6
2
2007
2008
New IFRS
Amendment of IFRS
New IFRIC
Exposure Draft IFRS
total:
2 changes
total:
6 changes
total:
20 changes
total:
13 changes
total:
6 changes
total:
24 changes
total:
71 changes
Discussion Paper IFRS
Bilanzrechtsmodernisierungsgesetz (BilMoG) has changed fundamental

accounting rules for German companies concerning for example the recognition
of goodwill or the valuation of long-term provisions
159
Changes in accounting standards: A careful analysis of their impact on

performance measures is necessary (2/2)
Examples of changes in IFRS in 2008 (IFRS 3: business combinations):
Different measurement of minority (noncontrolling) interests
New measurement of old interests in a company in case of a new acquisition
with change of control: option to disclose the difference in the income statement
or to form a reserve without influence on profit
Example of one of numerous ongoing projects of the IASB:
IASB proposes new treatment of lease contracts: Recognition of asset and
liability on the balance sheet for all lease contracts (no operating leases any
more)
Changes in accounting rules change the basic data for the calculation of
performance measures:
NOPAT and/or invested capital changes changes in EVA (and ROA etc.)
Implementation/cancellation of accounting adjustments or
Adaptation of performance targets necessary
160
Some notes to REVA as a market value-based alternative to accountingbased EVA

REVA (refined EVA): invested capital (and therefore the capital charges) based on
market value instead of book value
Total market value, beginning of year
Invested capital, beginning of year
Net operating income
WACC
EVA
100 million
50 million
8 million
10 %
3 million
Positive EVA even though no acceptable return on capital is earned (capital

providers would have expected a return of 10 million). REVA = 2 million
Drawbacks
Market values usually available only at the corporate level
Problem of confusing market values (incorporated expectations) with singleperiod measures of last year operating performance
REVA highly negative for companies successful in creating future growth
opportunities (future growth value, high excess return)
161
Interpreting given EVA measures is sometimes difficult because of

accounting adjustments and other reasons
Accounting adjustments can cause different EVA measures of the same company
to differ substantially from each other, even turn negative EVAs positive and the
other way around
Different estimates for the cost of capital
Problem of the WACC as a market-weighted average of the cost of equity and the
cost of debt:
A higher market value ( higher MVA) leads to a higher WACC and therefore
increases the capital charge
An increase in the equity market-to-book ratio might transform a positive EVA
company into a negative EVA company (when the companys future growth
value exceeds its market equity value)
162
Lecture 7:
Accounting adjustments
Goal Congruent Performance Measures
Overview

164
Literature
Reichelstein, Stefan (1997): Investment Decisions and Managerial Performance
Evaluation, Review of Accounting Studies 2, pp. 157-180.
Rogerson, William P. (1997): Intertemporal Cost Allocation and Managerial
Investment Incentives: A Theory Explaining the Use of Economic Value Added as a
Performance Measure, Journal of Political Economy 105, pp.770-795.
Dutta, Sunil and Reichelstein, Stefan (2005): Accrual Accounting for Performance
Evaluation, Review of Accounting Studies 10, pp. 527-552
The slides are partly borrowed from Stefan Reichelsteins presentation at the
University of Vienna, June 2004 and June 2008
165
Outline
7.1 Necessity of designing accounting rules

7.2 Goal Congruent Performance Measures
Goal congruent
performance
measures
7.3 Depreciation of fixed assets

7.4 Multi-year construction contracts
7.5 Further transactions & concluding remarks
166
A more sophisticated approach to set the right incentives:

Goal congruent performance measures
So far:
Assumption: discount rate of the manager equals the discount rate of the owner
Measuring the actions of the manager on the basis of residual income
performance measures leads to decisions on behalf of the manager,
independent of accruals (accounting rules) theorem of Preinreich and Lcke
Compare chapter 3 slide 14/15
In reality:
Discount rate of the manager differs from those of the shareholders due to a
shorter time horizon, risk averseness and not the same access to capital
markets
Different time preferences might lead to decisions that are not in the interest of
the owners
Necessity to design performances measure that solve the problem of different
time preferences
167
Achieving goal congruence by designing accruals (accounting

rules)
Goal congruence: Managers should have incentives for value increasing decisions
independently of managers planning horizon, discount rate or the particular
compensation rules
Proper performance measures should induce goal congruence between managers
and owners
The performance measure should project long-term value creation early on and
in a temporally consistent fashion.

David Solomons (1965):
We are entitled to judge them the performance measures as if a different

manager were in charge in each year. The question we have to ask is: How well
does each years profit reflect the success of that years manager?
Approach: designing accruals to achieve goal congruent performance measures

168
By using inappropriate accruals, residual income might lead to

wrong decisions: an illustrative example (1/2)
Potential investment project
Discount rate of the owner: 5%
Discount rate of the manager: 15% (not known by the owner)
Following cash flow pattern is exclusively known by the manager
Period
Cash flows
-1000
160
320
656
NPV (5%) = 9,31

acceptance of the project is in the interest of the owner
169
By using inappropriate accruals, residual income might lead to

Calculation of the residual income using straight-line depreciation
Revenue
160
320
656
Depreciation
-333,33
-333,33
-333,33
Operating Income
-173,33
-13,33
322,67
666,67
333,33
50
33,33
16,67
-223,33
-46,67
306,00
Book Value
1000
Capital Charge
Residual Income
PV (residual income; 15%) = - 28,29

manager would not undertake the project, neither if he plans to stay in the
company the entire project life time, nor if he plans to leave earlier
Arising question: How could we design the accounting rules depreciation in this
example to set proper incentives?
170
Outline

Goal congruent
performance
measures

171
Analyzing goal congruence on a mathematical basis:

The model setup
Owner delegates decision-making to better informed managers
Owners objective: Maximize the stream of expected cash flows, discounted
at the cost of capital r
Discount factor:
1
1 r
Manager has to decide to accept or reject the project at date 0

Exclusive information of the manager about the projects profitability at date 0
represented by q
Focus on residual income as a performance measure:
RIt Inct r BVt 1
172
Goal Congruence: different definitions

A managerial performance measure that is goal
fulfils the criterion
congruent when
of ...
the managers time preferences are the same as

those of the shareholders
weak goal congruence
preferences are different of

those of the shareholders
and
maximizes the NPV also

maximizes managers utility ...
T
~
E kt RI t
t 1
for kt equal to those of the owner.
there is no uncertainty
the managers time
and the decisions that
or the manager is risk
strong goal congruence
neutral
there is uncertainty
and the manager is risk-
for arbitrary, non-negative constants kt
robust goal congruence
~
~
E[ U RI1 ,..., RI T q]
for any function U () that is weakly
averse
T
~
E kt RI t
t 1
increasing in each of its T arguments
173
Outline

Goal congruent
performance
measures

174
Depreciation of Fixed Assets: The setting (1)

Manager can invest into a T-period project today
Initial cash outflow of b required.
t
If undertaken, project returns cash inflows of c t x t ~
in year t
X x1 ,..., x T represents the intertemporal pattern (structure) of the projects

cash inflows. The noise term ~t represents events beyond the managers
control.
q is a project-specific parameter known only to the manager

Private information
175
Depreciation of Fixed Assets: The setting (2)

Ignore noise terms
NPV
~
t
at first. c t x t
Tt 1 c t t b where 1 r 1
Performance measures based on intertemporal cost allocations:
t ct z t b I
where I 0,1 .
Alternatives include:
Cash Flow
Operating Income
Residual Income
176
Relative Benefit Cost Allocation Rule

The Relative Benefit Cost Allocation Rule assigns a share of the current years cash
flow to the performance measure
z*t X
xt
i 1
Then
c t z*t X b x t
xt
i 1
x i i
x i i
T
z*t X x i i b z*t X NPV

i 1
Conclusion: The R.B. cost allocation rule generates a time consistent performance
measure. A Positive (negative) NPV project makes a positive (negative) contribution
to the managers performance measure in every period
Strong Goal Congruence.
177
The Relative Benefit Cost Allocation rule leads to goal

congruence: an illustration on the former example
Calculation of the residual income using the relative benefit calculation rule
Period
160
320
656
zt
0,15853
0,31705
0,64995
Allocated Cost
158,53
317,05
649,95
1,47
2,95
6,05
Revenue
Residual Income
PV (residual income; 5%) = 9,31

verifies the Preinreich-Lcke-theorem
Residual Income is positive in each period
undertakes the project, independently of his timing horizon
178
Accounting implementation: Separating the allocated cost to a

depreciation and a capital charge part
Charge depreciation dt b in period t with
d
t 1
Let Bt denote the remaining book value of the asset Bt Bt 1 d t b

Residual Income
RI t c t d t b r Bt 1
Solve for the Relative Benefit (RB) Depreciation charges dt:
t 1
z t d t r 1 d i
i 1
1-1 mapping between depreciation and cost allocation schedules.
Special cases:
Uniform cash flows
Geometrically declining cash flows over an infinite horizon
179
Calculating annual depreciation and capital charges: continuing

our example
Calculation of the residual income using the relative benefit calculation rule
Period
160
320
656
Allocated Cost (slide 16)
158,53
317,05
649,95
Depreciation
108,52
272,47
619,00
891,48
619,00
50
44,58
30,95
1,47
2,95
6,05
Revenue
Book Value
Capital Charge
Residual Income
1000
The relative benefit cost allocation rule apportions the projects NPV so that each
periods residual income is proportional to the projects NPV
180
Comments on the solution

Informational Requirements: Inter-temporal pattern of project cash flows. Not their
absolute values! Accounting is forward looking.
No need to verify actual cash inflow in period t
RB Depreciation ensures that ROA (Return on Assets) exceeds the cost of capital in
each period, if NPV > 0.
RB Depreciation leads to conservative accounting Fair value of the project
exceeds the remaining book value at each point in time
Impossibility of achieving goal congruence with accounting income
See Reichelstein (1997) for stronger uniqueness results.
181
Outline

Goal congruent
performance
measures

182
Multi-year Construction Contracts: The setting

Manager can enter today into a T-year contract
Customer has agreed to pay $ p in T years upon completion of project
If undertaken, project requires cash outlays of c t x t ~

t in year t
x t represents the share of project costs incurred in year t.
The noise term ~
t represents events beyond the managers control
183
Analysis of the current accounting rules

GAAP calls for the percentage-of-completion method
Revenue recognized in year t: Revt p
xt
i 1
xi
Thus contribution to income in year t from the contract becomes:

Inc t p
xt
i 1
Let
xi
xt
i
T
i 1
i1 x i
xt
1
. The projects NPV is:
1 r
T
T
NPV T p i x i T p T i x i
i 1
i 1
184
Percentage of completion revenue recognition might lead to

Potential investment project
Discount rate of the owner: 5%
Discount rate of the manager: 15% (not known by the owner)
Following cash flow pattern is exclusively known by the manager
Period
Cash outflows
330
283,8
440
Cash inflow
1100
NPV (5%) = -1,57

project is not in the interest of the owner
185
Percentage of completion revenue recognition might lead to

Calculation of the residual income using straight-line depreciation
Period
Percentage of completion (POC)
0,31315
0,26931
0,41753
Revenue according POC-method
344,47
296,24
459,29
Expenses = cash outflow
-330
-283,8
-440
Operating Income
14,47
12,44
19,29
Invested Capital (receivables)
344,47
640,70
1100
17,22
32,04
14,46
-4,78
-12,74
Capital Charge
Residual Income

manager would undertake the project, no matter whether he plans to stay in the
company the entire project life time, nor if he plans to leave earlier
If the performance measure is accounting / residual income calculated according to
the percentage-of-completion-method, the manager is likely to overinvest
186
Designing the accrual for revenue recognition to achieve goal

congruence
Arising question: How to design the accrual for revenue recognition to set proper
incentives?
Some EPP advocates recommend cash accounting for multi-year construction
contracts Risk of underinvestment
Alternative accounting policy:
Present-Value-Percentage-of-Completion Method (PVOPC)
Revt T p
xt
i 1
i x i
r AVt 1 T p z*t X r AVt 1
The corresponding asset value is: AVt AVt 1 Revt

T
Substitution yields
Rev
t 1
T p z T 1 r z T 1 1 r
T 1
z1 p
For the revenue recognition rule, income becomes: Inct T p z*t X r AVt 1 x t
187
Designing the accrual for revenue recognition to achieve goal

congruence
Residual Income in period t now becomes:
RI t T p z*t X x t
T
T
z X p i x i
i 1
*
z t X NPV
*
t
The PVOPC method apportions the projects NPV so that each periods Residual
Income is proportional to the projects NPV
Strong Goal Congruence
188
Applying the Present Value Percentage of completion (PVPOC)

method : continuing the example
Calculation of the residual income using the PVPOC-method
Period
zt
T p z t
0,3467
0,2982
0,4629
329,46
283,33
439,28
Book Value (AV)
329,46
629,26
1100
r AVt 1
16,47
31,46
Revenue
329,46
299,81
470,74
Expenses = cash outflow
-330
-283,8
-440
Operating Income
-0,54
16,01
30,74
16,47
31,46
-0,54
-0,47
-0,72
Capital Charge
Residual Income = z t NPV
PV (residual income; 15%) = -1,3

manager would not undertake the project, independently of his time preferences
189
Comments on the above solution

No need to verify actual contract cost in period t Issues of jointness
PVOPC is the mirror image of the RB depreciation rule
Under PVOPC, revenue recognition is tied to the pattern of anticipated costs

Under RB depreciation, expense recognition is tied to the pattern of anticipated
cash flows
190
Outline

Goal congruent
performance
measures

191
Further accounting topics

Long-term leases
Asset disposals
Research & development

Deferred Taxes
Pensions
192
Concluding Remarks
Accrual accounting essential in obtaining performance measures that encourage
present value maximizing decisions irrespective of the managers inter-temporal
preferences.
Goal congruent accounting policies are broadly consistent with the matching
principle. Specific form of matching differs from GAAP.
In contrast to GAAP, accounting rules must be compatible with present value
considerations.
Contrary to many EPP consultants recommendations, our results suggest that
proper adjustments to GAAP should not result in less conservative accounting. Nor
should accounting be more cash based.
193
Lecture 8:
Valuing and Managing Real Options

Overview

195
Literature
Friedl, Gunther (2005): Incentive Properties of Residual Income when there is an
Option to Wait, in: Schmalenbach Business Review, Vol. 57, 3 21.
196
Outline
8.1 Different types of real options
8.2 Valuing real options
8.2.1 Introductory example
8.2.2 Valuation approaches for real options
Valuing and
Managing
Real Options
8.3 Managing real options: Goal congruent

performance measures
8.3.1 Introduction
8.3.2 Model setup
8.3.3 Comparison of different design
alternatives
8.3.4 Discussion and conclusions
197
Managers have to consider future decision opportunities when

deciding about implementing a project: real options
Forms of real options
Decision
Real Option
When is the best moment to invest?
Option to wait
Is there a possibility to cancel the project?
Option to abandon
Can operations/investment temporarily

shut down and be resumed later?
Option to suspend investment /

operations
Can capacity be expanded or reduced?
Growth option / option to reduce

capacity
Relevant questions:
How do we measure the value of real options?
How do we incentivize management to make the right decisions in the
presence of real options?
198
Outline
Valuing and
Managing
Real Options

8.3.1 Introduction
8.3.2 Model setup
alternatives
199
The Mobile Phones Business Entering the mobile phones market

Entering the mobile phones market:
Con@ction is evaluating its entry into the mobile phones market
The net present value (NPV) of the project Universal under consideration
appears to be 50 million
Management has to make a now-or-never decision. If the project is not
undertaken now, competitors will do so and the opportunity is gone
Are there reasons for pursuing this project despite its negative NPV?
Follow-on project:
There seems to be a follow-on project Premium in a few years with even a
higher risk and an expected NPV of 150 million
This NPV is based on the following possible market outcomes with equal
probabilities
if mobile phones are a great success
+ 300 million
if mobile phones are a moderate success
250 million
if mobile phones flop
500 million
200
Right Strategy for Con@ction: View Universal as an Option

Right decision: Undertake project Universal, because project Premium is so risky
Undertaking project Universal means
learning how the mobile phones
market turns out to evolve
300
Total
Payoff
200
100
With project Universal

Con@ction gets an
option to undertake
project Premium,
if conditions are
favorable (see
option profile in
the figure)
-500 -400 -300 -200 -100
NPV Premium
100 200 300
-100
NPV of
Universal
-200
-300
-400
-500
201
Exercise: Calculate the Option Value of Premium

Possible outcomes of project Premium if viewed as an option
300 million
Thus, the expected payoff of Premium is
100 million
Viewing project Premium as an option means: Undertake project Universal and

acquire the option on Premium
202
Uncertainty Increases the Option Value

Suppose, project Premium is more risky
+ 600 million
250 million
800 million
Expected net present value is still
150 million
But upside potential increases while downside risk being constant

600 million
203
Outline
Valuing and
Managing
Real Options

8.3.1 Introduction
8.3.2 Model setup
alternatives
204
Definition of Real Options

Real options are real investment projects with all of the following characteristics
Irreversibility Payouts for investments are sunk costs
Uncertainty Payoffs are subject to some form of (market) risk
Flexibility Management possesses certain degrees of freedom in allocating
corporate funds or assets
205
Valuation of Real Options Using Decision Trees

Structure of the decision
problem represented by
decision trees:
Invest in
Universal
Invest in
Premium
Would be the right decision,

if mobile phones turned
out to be a great success
Dont invest
Dont invest
Would be the right decision,

if mobile phones turned
out to be only a moderate
success or even a flop
Time
Different valuation methods:

Discounting of certainty equivalents with riskless interest rate
Problem: calculation of certainty equivalents requires knowledge of the
decision makers attitude towards risk
Discounting of expected values with risk-adjusted interest rate
Problem: determination of risk-adjusted interest rates suffers from circularity
problem
No risk premium in case of a risk neutral decision maker or in case of a risk averse
decision maker and fully diversifiable risk
206
Valuation of Real Options Using Option Pricing Theory

Option pricing theory based on arbitrage considerations (law of one price)
Calculation of real option value using approaches borrowed from financial option
valuation: Black-Scholes model, binomial model etc.
Adoption requires existence of an appropriate underlying
market price
hypotheses on future (stochastic) movement (i.e. Brownian motion, mean
reverting)
Construction of duplication portfolio replication of real options possible payoffs
by underlying
Value of the real option equals the value of the duplication portfolio because of
arbitrage considerations
Idea: whatever generates the same payoffs under the same conditions and in the
same states of nature must have the same value
207
Relationship Between the Different Approaches to Real Option

Valuation
Under the assumption of perfect and complete markets decision tree methods and
option pricing theoretic methods both result in the same value of the real option
and also in the same strategy
No conceptual advantage of option pricing theory compared to decision tree
approaches
Advantages concerning the application depend on the concrete situation:
Relationship to assets already valued by the market Apply option pricing theory
No relationship to market (mainly company- or project-specific risks instead of
systematic risks etc.) Apply decision tree approach
208
Outline
Valuing and
Managing
Real Options

8.3.1 Introduction
8.3.2 Model setup
alternatives
209
Motivation
Widespread use of residual income in corporate practice for planning and control
purposes
Academic literature came up with theoretical arguments supporting the use of
residual income for performance evaluation purposes
Very simple view of investment opportunities:
At each point in time, there is a set of investment opportunities
The manager can pick the project she likes and leave the projects undone she
does not like
Once a project is rejected, the opportunity is gone forever
More realistic view: Investment can be postponed real option (option to wait)
210
Research Questions
Research Questions:
Starting Point
Does residual income, as usually

defined, still achieve goal
congruence?
Main assumptions:
Existence of the option to wait

Manager is better informed
about the profitability (cash
flows) of investment decisions
than headquarters
Manager is impatient
If not, can the residual income

measure be adapted to achieve a
goal congruent solution?
Can the prevalent practice of
raising the capital charge rate
above the cost of capital be
explained in this framework?
Residual income still a

good measure?
211
Outline
Valuing and
Managing
Real Options

8.3.1 Introduction
8.3.2 Model setup
alternatives
212
Description of the Model

The model consists of headquarters and a divisional manager
The divisional manager faces an investment opportunity that can be postponed for
one period
The project consists of an initial investment outlay and cash flows from operations
The project can be carried out either immediately or in the next period option to
wait
Possible conflict of interests arises from the fact that the time preferences of the
manager are different from those of headquarters
213
Decision Tree and Sequence of Events

c1
invest
Decision tree
for the
divisional
manager
invest
c2
not invest
not invest
Sequence
of events
1
if investment in t = 0,
c1 realized;
Otherwise manager
privately learns c2
manager
privately
learns c1
214
if investment
in t = 1,
c2 realized
Project and Option Value

Net present value of the project, if
carried out immediately
V0 c1 b c1
1
1 r
Net present value of the project in t = 1,

if postponed
V1 c2 b c2
1
1 r
W1 E maxV1 c~2 , 0
Value of the option to invest

in t = 1
V0 c1
Condition for optimal investment

decision in t = 0
U c1
Managers utility with compensation

being a linear function of residual
income
1
k RI1 c1
1 rM
215
1
W1
1 r
1
k E RI 2 c~2
2
1 rM
Outline
Valuing and
Managing
Real Options

8.3.1 Introduction
8.3.2 Model setup
alternatives
216
Comparison of Different Design Alternatives

Simple depreciation policy
Fully depreciate the investment outlay during the useful life of the project
Use the companys cost of capital to determine the capital charges
Capitalization of the option value

Capitalize the option value as long as it exists
Depreciate, when the option is exercised or the option value has vanished
Raising the hurdle rate

Use a capital charge rate that is different from the companys cost of capital
217
Simple Depreciation Policy

Residual
income
RI1 c1 c1 b r b c1 1 r b
RI 2 c2 c2 b r b c2 1 r b
Managers condition for optimal investment

in t = 0
1
1
k c1 1 r b
k Emaxc~2 1 r b, 0
1 rM
1 rM 2
V0
1
W1 0
1 rM
Headquarters condition for

optimal investment in t = 0
V0
1
W1 0
1 r
Coincidence, if and only if the managers discount rate is the same as

headquarters
If the managers interest rate is higher, the manager invests too early
218
Capitalization of the Option Value

Residual income based on a simple
depreciation policy does not take into
account the change in option value
Residual income in t = 0
1
1
RI1 c1 c1 b
W1 r b
W1
1 r
1 r
c1 1 r b
W1
1 r
Idea: Use the option value in the

residual income measure
Treat the option as an interest bearing
asset that has to be depreciated
when exercised or expired
Residual income in t = 1
Investment
RI 2 c2 c2 b W1 r b W1
c2 1 r b W1
No investment
RI 2 c2 1 r W1
219
Capitalization of the Option Value

Headquarters
condition

in t = 1
1
1
k c2 1 r b W1
k 1 r W1
1 rM
1 rM
V1 0

in t = 0
1
1
k c1 1 r b
W1
1 rM
1 r
V0
1
k Emaxc~2 1 r b W1 , 1 r W1
2
1 rM
V1 0
Headquarters
condition
1
W1 0
1 r
V0
1
W1 0
1 r
Goal congruence achieved

220
Raising the Hurdle Rate

A more prevalent adjustment:
Optimal hurdle rate in t = 1
2 r
Raising the capital charge rate above

the value that is given by the cost of
capital
Optimal hurdle rate in t = 0

Headquarters objective
b
Maintaining the simple depreciation

policy
Question: Can goal congruence be
achieved by simply changing the
hurdle rate?
1
1
c1*
W1
1 r
1 r
Managers objective
1
1
k c1* 1 1 b
k Emaxc~2 1 2 b, 0
2
1 rM
1 rM
1 r
221
rM r W1
1 rM b
Discussion of a Hurdle Rate Policy

Goal congruent solution requires different hurdle rates in each period
Constant hurdle rate in general does not achieve goal congruence
Keeping the simple depreciation policy and raising the hurdle rate uniformly can
improve the decentralized investment policy, if the manager has a higher interest
rate than headquarters
Quantifying this improvement and calculating the exact value of the increased cost
of capital requires a specification of the expectations of headquarters
222
Outline
Valuing and
Managing
Real Options

8.3.1 Introduction
8.3.2 Model setup
alternatives
223
General Discussion: Capitalization of the Option

Two alternative ways to achieve a goal congruent residual income measure in the
presence of a timing option
Advantage of capitalizing and depreciating the option value: no knowledge of the
managers discount rate necessary
However: Headquarters must have an estimation of the option value
Disadvantage: If uncertainty resolves in a bad state of nature in the second period,
then no investment occurs, and the expected compensation ex ante results in a
negative realized compensation ex post incentive to leave the company
224
General Discussion: Hurdle Rate Policy

Adjusting the hurdle rates avoids the problem of the managers incentive to leave
the company
There is no negative compensation even in a bad state of nature
However, headquarters informational requirements are much more demanding
Exact knowledge of the managers discount rate as well as the option value
necessary
Conditions for choosing one of the two alternatives:

Specific knowledge of the manager
retention is important hurdle rate policy
Manager can easily be replaced
capitalization and depreciation of the option value
225
Conclusions
Contribution to the literature:
Complementing the literature on real option valuation by decentral investment
decision making
Considering the arrival of new information in the literature on goal congruent
performance measures and investment incentives
Empirical implications:
Companies with residual income based reward system and valuable waiting
options use capital charge rates that are higher than the cost of capital
This should be more likely in industries, where investments can be relatively
easily postponed without giving competitors the opportunity to undertake the
investment themselves
Further theoretical research:
Analysis of a waiting option with a longer expiration time
Incentive properties of residual income for different types of real options
Extending the results to an optimal contract setting
226
Lecture 9:
Implementing Value-Based Management:
Identifying the Drivers of Value Creation
Overview

228
Required readings
Practical Guide to Implementation, New York et al. 2001, chapter 3 and 7.
Suggested readings
Kaplan, Robert S. and Norton, David P. (1996): Linking the Balanced Scorecard to
Strategy, California Management Review 39, No. 1, pp 53-79.
229
Outline
9.1 Synergies and controllability
Implementing
VBM: Identifying
the Drivers of
Value Creation
9.2 Financial and non-financial value drivers

9.3 Process-based performance measurement
9.4 The implementation process
230
Calculating EVA for divisions assumes the independence of the

divisions and neglects synergies
Calculating EVA at the business unit level or even deeper in the organization
requires that one can construct an income statement and a balance sheet for the
considered unit.
To create value companies try to achieve synergies through interaction of their
divisions in two possible ways:
Several divisions share facilities like R&D, IT,
Company
Human resource management, product design,
marketing.
Product Line A
Product Line B
R&D
Problem of the allocation of costs (and
shares of the invested capital) to the divisions.
Purchasing
Production
Sales
Vertical integration to help the company
better control its value chain.
Requirement of transfer prices for assets and services to establish business
unit revenues (always arbitrary to a certain degree).
EVA implementation therefore is of little use when large percentages of the
business unit assets are shared facilities or a large part of the costs of goods sold
is represented by intercompany transactions.
231
ThyssenKrupp AG - Annual Report 2012 / 2013

Components of ThyssenKrupp Value Added (TKVA)
232
Some practices representing potential solutions to the synergy

problem
Solution approach
Idea and drawbacks of the approach
Creation of groups of divisions
Solves partly the allocation or transfer pricing

problem between the grouped divisions but not
between different groups
Measurement problem remains for divisional
managers performance
New bureaucratic hurdle for divisional managers
and free-rider problem
Linking part of the EVA bonus

to EVA in another division
Encourages cooperation and reduces the conflicts

due to overhead allocation or transfer pricing
Cost allocation on the basis of

divisional profitability
Addresses cost allocation and transfer pricing

problem by rewarding cooperation
Might give incentives not to care enough for the
own divisions profitability
Activity-based costing
Identifies cost drivers to better allocate overhead

costs
Other approaches to transfer

pricing like an internal auction
Tries to more accurately capture the prices that the

units would observe if they were truly independent
233
Outline
Implementing
VBM: Identifying
the Drivers of
Value Creation

234
Managers cannot be judged for decisions they are not

responsible for: the controllability problem
Companies engage in operating, investing, and financing activities
The manager of a responsibility center has significant decision-making authority
over some aspects of these activities:
Cost center
Profit center
Investment center
Decision-making
authority
Controls only
inputs/expenses
Controls input and

output
Controls operating
profit and capital used
Performance
evaluation
Input-output
productivity measures
Operating profit, gross

margin
RONA, EVA
EVA is a total factor measure of performance as it incorporates the income

statement as well as the balance sheet
EVA is fully appropriate only as a performance measure for investment centers
When EVA is inappropriate management must use value drivers that are strongly
correlated with EVA, easier to measure and more controllable by the unit
manager to evaluate the business units value creating performance
235
Financial and non-financial value drivers identifying the Key

Performance Indicators (KPIs) (1/3)
Financial drivers: Components of EVA like RONA or components of RONA itself like
working capital ratios (for example the DuPont Analysis)
EVA
( RONA WACC ) invested capital
Profit margin
(profitability)
NOPAT
Contribution
(margin)
Sales
Sales
Financing decisions
(optimal capital structure)
Asset turnover
(activity)
Sales
: Invested capital
Fixed costs
production overhead
administrative overhead
distribution and
marketing overhead
Fixed assets
fixed asset turnover
Working capital
inventory period
receivables period
payables period
Variable costs
Investment decisions
(capital allocation)
236

Some shortcomings of financial drivers:
Short-term performance might be achieved at the cost of the long run
(maximizing the present value of future EVAs must be the objective)
milking assets, reduced production quality at the cost of customer satisfaction
and future revenues etc.
Financial ratios are of historical nature (lagged indicators)
Non-financial drivers might help to cope with these problems:
Leading indicators of future EVA like market share, customer satisfaction,
product innovation, the number of new customers or employee skills and
employee satisfaction
might be more under control of operating managers and
capture problems quicker (customer complaints as signal of problems of
product quality or distributional problems).
237

While business unit managers rely on more global performance measures,
department managers need more specific work flow measures which they can
control on a day-to-day basis.
Production employees, for example, should be given rather weekly incentive
bonuses (based on productivity targets, for instance) for an immediate feedback
than yearly bonuses based on profit measures
Examples of value drivers / KPIs for different departments of a company which
usually are not organized as investment centers:
Materials department: order fill rate, time from receipt of material to delivery to
production, damaged scrap, obsolete excess etc.
Production department: production cycle time, inventory, in-process scrap etc.

Distribution department: percentage of problem-free installs and deliveries (time
and quantity), number of returns etc.
Marketing department: sales per product / employee, customer satisfaction and
customer loyalty, market share per region etc.
238
A balanced scorecard combines financial as well as non-financial

value drivers
Apart from the financial perspective (with the EVA as the top level performance
measure, for instance) other, non-financial perspectives are explicitly taken into
account as a means of supporting shareholder value creation
Financial Perspective
To succeed financially,
how should we appear to our shareholders?
objectives measures
targets
initiatives
Internal Business Process
Customer Perspective
To achieve our vision,
how should we appear to our customers?
objectives measures
targets
initiatives
To satisfy our shareholders and customers,

what business processes must we excell at?
Vision and
Strategy
objectives measures
targets
initiatives
Learning and Growth

To achieve our vision, how will
we sustain our ability to cange and improve?
objectives measures
targets
initiatives
Figure adapted from Kaplan / Norton (1996)
239
Examples of possible performance measures in the four classic

dimensions of the balanced scorecard
Financial Perspective
Customer perspective
Economic value added

Market value added
Return on investment / return on
net assets
Growth in sales
Internal business process
Learning and growth
Dealer quality
Process cost
Nb. of units requiring reworking
Length of operating cycle
Volumes of goods shipped
Optimal asset utilization
Customer profitability
Repeat customers
Customer surveys
Number of customer complaints
On-time delivery
Service response times
240
Employee motivation
Employee empowerment
Information systems capabilities
Employee capabilities
Number of employee suggestions
Hours spent on training employees
Customers
Internal
Business
Processes
Learning
and Growth
Operating
expenses
Accounts
receivable
Customers
satisfaction
Shorter
cycle time
On-time delivery
Process quality
Employee
skills
Lower
rework
Employee
suggestions
Employee morale
241
Leading
Financial
The Leading-Lagging Continuum
Economic value added
Lagging
The strategy map presents the Key Performance Indicators in a

causal chain
Use of non-financial performance measures even in top

management compensation
Study of Ittner / Larcker / Rajan (1997): 36 % of the firms in their sample (114 of
317 US companies) employ non-financial measures in evaluating CEO performance
Non-financial performance measures of those 114 firms:
Choice of performance measure
Performance measure
Percentage
depends on the corporate strategy Customer satisfaction
36.8 %
of the firm:
Employee satisfaction
8.7 %
Cost leadership (importance of
Product or service quality
21.0 %
operating efficiency)
Efficiency or productivity
14.9 %
Operating profit, RONA
Employee safety
16.6 %
and EVA are relatively
Market share
11.4 %
informative measures
Non-financial strategic objectives
28.0 %
Differentiation (importance of
Process improvements and re-engineering
8.7 %
long-term value creation for
New product development
6.1 %
innovators and prospectors)
Innovation
2.6 %
Leading indicators of longterm value creation necessary
Employee development and training
7.0 %
Other non-financial measures
242
65.5 %
Outline
Implementing
VBM: Identifying
the Drivers of
Value Creation

243
Processes involving several operating units require performance

measures focusing on processes instead of organizational boundaries
The performance measurement system for so called core processes must
consider the critical elements of the process by setting concrete operating
objectives
Core Processes are processes that cut horizontally through a company and
have no organizational boundaries like profit centers:
Core Processes are, for example, new product development, customer
service, supplier management or order fulfillment
Developing a performance measurement system for a core process
Map the process, identify the sequence of activities and the key players
Determine the areas where performance indicators are critical to the success of
the process
244
Example: Performance pyramid for a computer manufacturer

Vision:
To provide fault-tolerant computer
solutions to financial service companies
Objectives defined on
business unit level
Market (i.e.
Share
Growth)
Critical elements of a core

process (customer
satisfaction, flexibility,
productivity) and their
global measures
Goals on
department
level
Corporate
Vision
Customer
satisfaction
No. of
complaints
Survey results
Repeat sales
Quality
Financial
(i.e. EVA)
Flexibility
Responsivene
ss to order or
configuration
changes
Delivery
245
Core processes
Productivity
Inventory
turns Cycle
Times
Cycle Time
Waste
The core process order fulfillment: Specific workflow/operating

measures for each department with a key role in the process
Core process
order fulfillment
Customer
satisfaction
Quality
Department measures
Materials
department
Good parts
Flexibility
Productivity
Delivery
Cycle Time
Order fill rate (no

line outs)
Time from receipt

of material to
delivery to
production
Incoming inspection
Scrap, damaged
Rehandling
Load on the plant
Excess, obsolete
Cycle count
accuracy
Waste
Production
department
% functional
% with
complete
information
% on time:
to schedule
to special request
Production cycle
time
Rework
Inspection
Inventory
In-process scrap
Distribution
department
% problemfree installs:
plug and play
% problem-free
deliveries (time,
quantity, place):
to schedule
to special request
Material
throughout time
% rework time
246
Number of returns
Order throughout
time
Penalties for late

delivery
Outline
Implementing
VBM: Identifying
the Drivers of
Value Creation

247
EVA is an instrument for changing managerial behavior and

corporate culture
Implementation of VBM requires acceptance and understanding of sound financial
theory and value-based principles like NPV by all managers
Value creation is everyones responsibility in the company
Finance departments should
provide transparency in the finance and accounting functions in order to help the
operating departments understand and achieve their financial goals and
communicate clear goals to the employees and achieve their buy-in because
the real value creators are the operating divisions
248
The EVA implementation process is intensely company-specific

and might follow 4 steps
Step 1:
Establish total acceptance at the board and top management levels as basis
for further implementation
Define the EVA measurement centers, for example on the basis of existing
profit centers with the advantage that
profit centers have the necessary responsibilities
the required financial reporting systems exist
Fix the frequency and the way of how to calculate EVA:
Possible adjustments to the companys accounting system for a better
EVA (attention to also growing complexity!)
Consideration of IT constraints
Divisional versus corporate cost of capital
Design the management compensation system (decision to be made by top
management):
Who will be covered initially and at a later date?
Sensitivity of bonuses to EVA performance
Will there be a deferred component?
Role of stock options in the compensation program
Divisional versus company-wide or group EVA bonuses
Relation to nonfinancial measures
Step 2:
Major
strategic
decisions
on the
EVA
program
249
The EVA implementation process is intensely company-specific

and might follow 4 steps
Step 3:
Development of an implementation plan

working out the technical details
Necessary to get the commitment to value creation from the companys

employees
Select the persons that need the training
Number and concept of training sessions, for example:
Step 4:
Set up a
training
program
First session to introduce the employees to the concept of EVA
Second session to give more details about the calculation and

interpretation of the EVA numbers and some ideas of how to increase the
EVA of the divisions
Subsequent sessions to introduce the compensation plan
250

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Technische Universitt Mnchen

Technische Universitt Mnchen

4. Management Compensation: Objectives and Alternatives

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

1.1 Development of the shareholder value view

1.2 Differences between the shareholder and the

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

The growing predominance of the shareholder wealth culture is

The globalization and deregulation of

Capital has attained

Advances in information technology

Improvements in capital market regulation

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

In Europe these developments were hampered by institutional

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

The pressure of capital markets on companies is increasing

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

1.1 Development of the shareholder value view

1.2 Differences between the shareholder and the

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

There are two conflicting paradigms for managerial decision

Shareholder value: Maximize value to shareholders

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

The shareholder value and the stakeholder value strongly differ in

Maximize the market value of a

Shareholder is residual claimant

All stakeholders have claims on the

Social welfare is maximized,

Stakeholder value approach does

But: strong assumptions

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

1.1 Development of the shareholder value view

1.2 Differences between the shareholder and the

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

The shareholder value debate controversial statements

Value-Based Management: Lecture 1

Gunther Friedl SS 2015

Technische Universitt Mnchen

Two questions need to be answered to discuss whether value

Gunther Friedl SS 2015

Technische Universitt Mnchen

The trade-off for managerial decisions

Conflicting interests between