ACCA - P5 Study text - Emile Woolf INT

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Chapter 15: Decentralisation and divisional performance

5.2 The potential benefits of EVA

EVA is a measure of performance that is a close approximation of ‘economic profit’.

Economic profit is measured in terms of the addition of economic value. An entity

earns an economic profit only if it creates economic value through its activities. By

creating economic value, a company should add to the wealth of its owners, the

shareholders.

Using EVA to measure performance could therefore have the following benefits:

 It measures the creation of value by a company, and is a more ‘accurate’

measurement of performance than accounting profit.

 Economic value can be created when expectations of future profitability

improve, because economic value can be measured as the net present value of

future profits. EVA therefore recognises the benefit of activities, such as new

investments, that add to longer-term profitability. Unlike accounting measures

of profitability, EVA is not focused exclusively on the short term.

 Management is encouraged to focus on the creation of value (EVA), which is in

the long-term interest s of shareholders.

 Management reward schemes based on EVA are likely to align the interests of

management and shareholders more closely than a bonus system linked to

annual accounting profits.

 It is a simple measure, like profit, and so one that line managers (including those

with limited financial understanding) can understand.

5.3 Measuring economic value added (EVA)

Economic value added (EVA) for a financial period is the economic profit after

deducting a cost for the value of capital employed.

The formula for EVA is as follows:

EVA = Net operating profit after tax – (Capital employed × Cost of capital)

EVA = NOPAT – (Capital employed × WACC).

In practice the computation of EVA involves making adjustments to accounting

profit and the accounting value (book value) of assets. These adjustments can be

complex, and although you are not required to know them in detail, an examination

question may as you to calculate EVA from a given set of simplified data.

NOPAT

The net operating profit after tax is calculated by making adjustments to the

accounting profit in order to arrive at an estimate of economic profit. NOPAT is

similar to ‘free cash flow’ and is an estimate of economic profit before deducting a

cost for the capital employed. The calculation of NOPAT requires a number of

different adjustments to the figure for accounting profit.

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A few of the problems are as follows:

(1)

Interest costs. In calculating NOPAT, interest costs of debt capital should not

be deducted from profit. This is because debt capital is included in the capital

employed. NOPAT should be the profit before deducting interest costs but

after deducting tax. There is tax relief on interest, so to reach a figure for

NOPAT the amount of interest charges in the period less relief on the interest

cost should be added back to the figure for profit after tax.

NOPAT = Profit after tax + [Interest costs less tax relief on the interest]

(2)

Depreciation. Non-cash expenses should not be deducted from profit. The

main item of non-cash expense is usually depreciation of non-current assets.

However, there should be a charge for non-current assets, to allow for the

economic consumption of value that occurs when the assets are used.

NOPAT = Profit after tax + Post-tax interest cost + [Accounting depreciation –

Economic depreciation]

If it can be assumed that accounting depreciation charges are similar to the

loss of economic value in non-current assets, the two items cancel out, and:

NOPAT = Profit after tax + [Interest costs less tax relief on the interest]

(3)

Other non-cash expenses. Other non-cash expenses should also be added

back in order to measure NOPAT. These include additional provisions for

irrecoverable debts and other provisions.

(4)

Investments in intangible items. Investments in intangible items include

spending on promotion activities, investing in a brand name, research and

development spending and spending on employee training (to increase the

economic value of the work force). In conventional accounting systems, these

items of expense are usually written off as expenses in the year that they

occur. However, they are items of discretionary spending by management that

add to the value of the business.

To measure NOPAT, these items of expense that have been written off in the

conventional accounts should be added back.

(They should also be added to the value of the company’s capital. Economic

depreciation charges will be applied as appropriate to this economic capital, in

subsequent years.)

Charge for capital

EVA is NOPAT minus a charge to represent the cost of capital employed. There are

two elements to the capital charge:

 the value of the company’s assets, and

 the cost of capital.

Chapter 15: Decentralisation and divisional performance

Capital employed. The valuation of capital employed should be based on economic

values of the capital employed. In most cases, this means that non-current assets

should be valued close to their current value, rather than at a value based on

historical cost.

In a simplified system for measuring the economic value of a company’s capital

employed, the starting point is the book value of the company’s net assets. This is:

 book value of non-current assets at the beginning of the year, plus

 book value of net current assets at the beginning of the year.

Some adjustments should then be made for:

 Investments in intangibles. Spending on intangible items should be added back

in calculating NOPAT, as explained earlier. In addition, the net book value of

intangible items should be included in capital employed, and so an estimate of

the net book value of the intangibles should be added to the accounting value of

the company’s net assets.

 Provisions and allowances. Additions during the year to allowances for

irrecoverable debts and additions to provisions should be added back to profit in

calculating NOPAT. The total amount of allowances for irrecoverable debts,

provisions for deferred tax and other provisions should also be added to capital

employed.

 Off-balance sheet financing and operational leases. Some companies keep

items of capital off their balance sheet (statement of financial position). A notable

example is assets held on operating leases. The acquisition of leased assets is a

form of debt finance, because the lessor (provider of the leased asset) has

provided the financing for the assets that the company is leasing. The estimated

value of assets held under operating lease agreements (and the value of any

other assets financed ‘off balance sheet’) should be added to capital employed.

Cost of capital. The capital charge is calculated by applying the weighted average

cost of capital (WACC) to the value of capital employed.

WACC is the weighted average of equity capital and debt capital

in the company’s

target debt structure

 If the current debt structure of the company is close to the long-term target debt

structure of the company, the weighted average cost of capital can be calculated

from the current value of equity and debt capital.

 However if the target capital structure is different from the current capital

structure, the weighted average cost of capital is calculated using the target

proportions of equity and debt.

 The cost of equity and the cost of debt can vary from one year to the next. A new

WACC may therefore be calculated each year, with appropriate costs for equity

and debt in each year.

Example

A company currently has equity capital valued at $800 million and debt capital of

$400 million. Its target is to achieve 50% equity and 50% debt in its capital structure.

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In the current year the cost of equity was 15% and the cost of debt was 10%. The rate

of tax is 30%.

The WACC for the purpose of calculating EVA is therefore:

(15%

× 50%) + [10% (1 – 0.30) × 50%] = 11%.

The following example shows the calculation of EVA, at a level of complexity that

you may meet in the examination.

Example

A company’s income statement and statement of financial position for the year just

ended and the previous year are as follows.

Income statement

Year

just

ended

year

Year 2 Year 1

$000 $000

Profit before interest and tax 80,000 62,000

Interest cost 8,000 6,000

Profit before tax 72,000 56,000

Tax at 25% 18,000 14,000

Profit after tax 54,000 42,000

Dividends paid 29,000 24,000

Retained profit 25,000 18,000

Notes

1 Capital employed at the beginning of Year 1 was $410 million.

2 The company had non-capitalised leased assets of $18 million in each of the

past three years. These assets are not subject to depreciation.

Statement of financial position, end of year:

Year

just

ended

year

Year 2 Year 1

$000 $000

Non-current assets 280,000 265,000

Net current assets 200,000 170,000

480,000 435,000

Shareholders’ funds 370,000 345,000

Long-term and medium-term debt 110,000 90,000

480,000 435,000

Chapter 15: Decentralisation and divisional performance

3 The estimated cost of equity in Year 2 was 12% and the cost of debt was 8%.

The estimated cost of equity in Year 1 was 10% and the cost of debt was 7%

4 The company’s target capital structure is 50% equity and 50% debt.

5 It should be assumed that accounting depreciation was equal to economic

depreciation, in each of the two years, and that this was also the amount used

for the calculation of the tax charge in each year. (The purpose of this

assumption is to remove the need to make an adjustment to get from

accounting depreciation and to economic depreciation, and to remove the

need for adjustments to capital employed.)

6 Other non-cash expenses were $16 million in Year 2 and $14 million in Year 1.

Required

Use the information provided to calculate a figure for EVA in each of the two years,

Year 2 and Year 1.

Answer

Net operating profit after tax

Year

just

ended

year

Year 2 Year 1

Profit after tax 54,000 42,000

Add: Interest cost less tax: (8,000 less 25%) 6,000

(6,000 less 25%) 4,500

Add: Non-cash expenses 16,000

14,000

NOPAT 76,000 60,500

WACC

Year 2: (12% × 50%) + [8% (1 – 0.25) × 50%] = 9%.

Year 1: (10%

× 50%) + [7% (1 – 0.25) × 50%] = 7.625%.

Capital employed

Year

just

ended

year

Year 2 Year 1

$000 $000

Book value of total assets less current liabilities 435,000 410,000

Non-capitalised leased assets 18,000 18,000

453,000 428,000

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These figures suggest that in each year the company created value, because the EVA

was positive.

 Financial performance in Year 2 was better than in Year 1 because the EVA is

higher.

 Allowing for the payment of dividends ($29 million in Year 2 and $24 million in

Year 1) some of this created value was retained within the company each year.

5.4 Using EVA

If it is measured with reasonable accuracy, EVA should be a measure, in economic

terms, of how much extra value or wealth has been created by a business operation

during a period.

It can therefore be argued that EVA would be a much more useful measure of

divisional performance – and company performance – than traditional accounting

measures of ROCE and profit.

The problem with EVA however is its complexity. To arrive at an estimate of EVA,

it is necessary to make many adjustments to accounting values for profit and asset

values, and there might be some uncertainty about the reliability of the figure that is

calculated as EVA. It might also be questioned whether the extra cost of calculating

EVA (compared with ROCE or ROI/residual income) is justified.

Example

A company reported the following results in Year 8:

$000

Profit before interest and tax 26,000

Interest 6,000

Profit before tax 20,000

Tax at 25% 5,000

Profit after tax 15,000

Dividends paid 7,000

Retained profit 8,000

EVA

Year

just

ended

year

Year 2 Year 1

$000 $000

NOPAT 76,000 60,500

Capital charge: (453,000 × 9%), (428,000 × 7.625%)

40,770 32,635

Economic value added (estimate) 35,230 27,865

Chapter 15: Decentralisation and divisional performance

The profit is after charging $3,000,000 for depreciation. However, it has been

estimated that the economic cost of depreciation was $3,500,000.

The value of capital employed has been estimated as $120 million and the weighted

average cost of capital is 9%.

Using this information, make the best estimate possible of economic value added in

Year 8.

Answer

$000 $000

Profit after tax 15,000

Add back: Interest 6,000

Less tax relief (25%) (1,500)

4,500

Adjustment for higher cost of economic depreciation (500)

NOPAT 19,000

Capital cost (9% × $120 million) (10,800)

EVA 8,200

EVA and measuring the performance of divisions

EVA can be used as an alternative to ROI or residual income as a method of

measuring the performance of operating divisions. However, using EVA for

performance measurement of operating divisions might make little sense unless the

company as a whole also measured its total performance in terms of EVA.

5.5 Possible problems with EVA

There are several potential problems with the use of EVA.

 It is not easy to use EVA for inter-firm comparisons or inter-divisional

performance comparisons, because it is an absolute measure (in $) rather than a

comparative measure (such as a ratio).

 The adjustments required to get from accounting profit to NOPAT and from

accounting capital employed to economic capital employed can be complex. In

particular, it may be very difficult to estimate economic depreciation.

Paper P5: Advanced performance management

Paper P5

Advanced performance management

CHAPTER

Transfer pricing

Contents

1 Transfer pricing: purpose and objectives

2 The ideal transfer price

3 Finding the ideal transfer price

4 Transfer pricing in practice

Paper P5: Advanced performance management

Transfer pricing: purpose and objectives

 Purpose of transfer pricing

 Definition of a transfer price

 The objectives of transfer pricing

 The motivation of divisional managers

 Goal congruence

 Divisional autonomy

1 Transfer pricing: purpose and objectives

1.1 Purpose of transfer pricing

When a company has a divisionalised structure, some of the divisions might supply

goods or services to other divisions in the same company. Similarly, one subsidiary

within a group may supply goods or services to another of the group’s subsidiaries.

 One division sells the goods or services. This will be referred to as the ‘selling

division’.

 Another division buys the goods or services. This will be referred to as the

‘buying division’.

For accounting purposes, these internal transfers of goods or services are given a

value. Transfers could be recorded at cost. However, when the selling division is a

profit centre or investment centre, it will expect to make some profit on the sale.

1.2 Definition of a transfer price

A transfer price is the price at which goods or services are sold by one division

within an entity to another division in the same entity. Internal sales are referred to

as transfers, so the internal selling and buying price is the transfer price.

1.3 The objectives of transfer pricing

A decision has to be made about what the transfer price should be.

For the purpose of performance measurement and performance evaluation in a

divisionalised organisation, it is appropriate that:

 the selling division should earn some profit or return on sales to other divisions

and

 the buying division should pay a fair price for the goods or services that it buys

from other divisions.

Transfer prices are decided by management. The objectives of transfer pricing

should be to:

ACCA - P5 Study text - Emile Woolf INT - 2010

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