International Business and
Management
Antonio Majocchi
antonio.majocchi@unipv.it
Associate Professor in international business
Teaching Faculty
Roger Strange, Professor of international
business, Sussex University (18 hours)
 David Needle of Professor of management,
King's College London (4 hours)
 A business case will be discuss under the
supervision of an external business
consultant (Dr. Ucci from Oliver Wyman)
 Attendance even if not compulsory is
highly recommended

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Assessment
The course will be assessed by a final exam
and assignments
 The final exam will cover mainly the theoretical
arguments of the course and will count 50% of
the final mark (this year the exam will be
realised in 2 parts)
 The assignment is a group projects that count
for 40% of the final mark
 The class discussion of the business case
(compulsory) will count for the remaining 10%

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Class assignment
The goal of the class assignment is to
present the international strategy of a
MNCs
 Group should be formed by no more then
3 students
 A lecture (18 of March?) will be devoted to
discuss and present the main criteria to be
followed in the presentation (sources, aim
of the presentation, methodology etc etc.)

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Assignment

The assignment should be completed for
the end of the course and presented
discussed in the last week of the lecturing
period (exact dates to be defined)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Reading materials
There is no single recommended text.
Readings will be assigned to students at
every group of thematic lectures
 The reference book for Professor Strange's
seminars is:

 Bartlett, C.A., Ghoshal, S. and Beamish, P.W.
(2008). Transnational management: text,
cases, and readings in cross-border
management. London: McGraw-Hill (available
in the faculty library)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Course brief Contents: part I
Market selection and Market Entry
 What is “globalisation”: data and trends
 The Strategy and Structure of MNCs
 Control in MNCs

 The balance scorecard
 EVA principles and application
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Course brief Contents: part II

Financial management in MNCs
 International pricing policy
 foreign exchange risk
 foreign exchange management

Market forecast
 Methodology to forecast market potential
 Elasticity and pricing
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
To sum up
Antonio Majocchi
Lectures
Written exam (25%). To be held in the
planned exam dates
Group Assignments
Group presentation (31st May, 1st
June) (40%)
Business case
15 March (tentative date) (10%)
Roger Strange
Written exam (25%). 27th May
Final Mark

if either the Business case or the Group
assignment are missed then the student will
have to sustain the full exam based on the
Bartlett, Ghoshal, and Beamish (2008) book
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Market selection
and market entry
Compulsory Readings:
 Ghauri & Cateora, International
marketing, Mc Graw Hill (2° ed), Chapter 7
and Chapter 11 (530 781)
Barriers to international business
1.
2.
Tariffs
Non Tariff Barriers
1. Specific limitations on trade (Quotas, local
content requirements..)
2. Customs and administrative entry procedures
3. Standards
4. Government participation in trade
Risk (political and economic risk)
4. Knowledge (business, market, consumers,
cultural….)
3.
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Political Risk
The likelihood that a government or
society will undergo political changes that
negatively affect local business activity
 Political risk arises from a variety of
sources:

 Corrupt or poor political leadership
 An unstable political system
 Conflict between races, religions, or ethnic
groups
 Economic problems
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Examples of political risk
Confiscation (take a piece of equipment )
 Expropriation (take the whole company )
 Nationalization (all the companies in a
business sector)
 Political sanctions
 Violence
 Political reprisals
 Corruption…

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Economic Risk
Any economic events that negatively
affect local business activity
 As usual economic risk is measured with
the volatility of economic variables
 Political and Economic risk define overall
“country risk”

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
ICRG Rating Systemof country risk
AnThe
assesment
Financial
Political
%
default
or unnfavourable loan
Economic expectationsLoan
versus
reality
6%
restructuring
Economic planning failures
6%
Delayed payment of suppliers’ credits
Political leadership
6%
Repudiation of contracts by government
External conflict
5%
Losses from exchange controls
Corruption in government
3%
Expropriation of private investments
Military in politics
3%
Total Financial Points
Organized religion in politics
3%
Law and order tradition
3%
Economic
3%
Racial and nationality
Inflation tensions
Political
terrorism
3%of goods and services
Debt
service
as a % of exports
Civilliquidity
war
International
ratios 3%
Political party
development
3%
Foreign
trade collection experience
Quality
of bureaucracy
3%
Current
account balance as %
of goods and services
Total Political Points
50%
Parallel foreign exchange rate
market indicators
Total Economic Points
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
5%
5%
5%
5%
5%
25%
5%
5%
3%
3%
8%
3%
25
%
Country risk agency
 http://www.prsgroup.com/
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
16
www.aon.com/
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
17
Factors Influencing Market Entry
Strategy
International environment:
• economic • cultural • legal •
Firm’s overall strategy
Global market opportunity assessment:
• country screening • industry potential •
• company sales potential •
Entry strategy choices:
• export • licensing • joint ventures •
• manufactures •
Market entry planning
Positioning
Product
adaptation
Pricing
Channel
selection
Customer
service
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Market selection

The market selection process depends on
the kind of investment




resource seeking
market seeking
efficiency seeking
strategic assets seeking
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Market choice
Economic factors
Resources
Market choice
Firms’ costs
Infrastructure
Cultural factors
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
20
Resources (example)
SCHOOL-LEAVING
EXAMINATION
+
GRADUATED
JOB FORCE
HUMAN CAPITAL
STRUCTURES
FOR
INSTRUCTION
PER CAPITAL
INCOME
ROSOURCE ASSETS
MARKET SIZE
GDP GROWTH
TOTAL
POPULATION
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
21
Resources (example)
BANKING
PRODUCTION
RESOURCES
BUSINESS COSTS
Agglomeration
of FF
Industrial
districts
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
22
Infrastructure
ICT
TELEMATICS
AIR TRANPORT
FREIGHT
INFRASTRUCTURE
BASIC
INFRASTRUCTURE
ELECTRICITY
TRANSMISSION
AND DISTRIBUTION
LOSSES
ROADS NETWORK
RAILWAY FREIGHT
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
23
AlternativeMarket
MarketEntry
EntryStrategies
Strategies
Alternative

Exporting

Licensing

Franchising

Joint ventures

Foreign Direct
Investments

Low risk...low
control

High
risk...high
control
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
24
Entry Mode
Financial Capital
0%
100%
Control/flexibility
Control
Licensing
Franchising
Minority
holdings
JV
Flexibility
Export
Agreements
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
FDI
FDI

There are 2 different kind of FDI
 Greenfield investments
 Mergers & Acquisition (M&A)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Data and trends

FDI general trends
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Source: www.unctad.org
Regional trends
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
M&A activity
Antonio
Majocchi Source:
www.unctad.org
International Business and Management, Academic Year 2009-2010
Newcomers
Source: www.unctad.org
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Strategy and Structure
Compulsory Readings:
 Bartlett, Goshal and Beamish, (2008), (510 2368),
• Chapter 1; (pp. 1- 13)
• Chapter 3; (pp. 197 – 209)
• Reading 3-2, G. S. Yip, Global strategy…in a world of
Nations? (pp. 291 – 304)
• Chapter 4; (p. 333- 349) and Case 4- 1 (p.350 – 365)
• Chapter 7 (p. 648 – 660)
Organizational Designs

Types of structures used by companies to
manage foreign activities:
Little/No Formal
Organization
International Division
Global Organizations
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
No formal organisation
Domestic operations assume responsibility
for international activities in the early
stages
 The organizational structure reflects the
increased demands from the international
marketplace
 The export department structure becomes
obsolete as the firm becomes more
involved in foreign markets

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
International division
Centralizes in one entity all of the
responsibility for international activities
 Best serve firms with few products that do
not vary significantly

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Degree of product diversification
The Stopford & Wells Model
Product
Division
Int
division
Grid/Matrix
structure
Improved cost
efficiency is a
major benefit
Follows the
marketing concept
most closely
Area
Divisions
Foreign sales/Total sales
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The international division
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
International strategies
Local Adaptation
Standardization
low
high
low
Global
high
Transnatio
nal
Multidomestic
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
37
Strategy implementation
 Multidomestic
(Decentralized) systems have
loose and simple controls. Subsidiary operates
as a profit center
 Global (Centralized) systems have tight
controls. Strategic decision making is at
headquarters.
 Transnational (Coordinated decentralization)
calls for overall strategy to come from
headquarters
 Subsidiaries are free to implement within
agreed upon range
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
A typical area division
Telefónica has a regional structure
 The different operations of the
Telefónica Group in 25 countries are
organised into three geographical
regions: Spain, Latin America and
Europe.
 The Corporate Centre is in charge of
global strategy and corporate policies,
Telefónica O2 UK,
Argentina, Brazil, Chile, Colombia,
Telefónica O2 Germany,
managementEcuador,
of common
activities
and
El Salvador, United States,
Telefónica
O2
Ireland,
Guatemala, Mexico, Nicaragua,
O2 Czech Republic
coordination of
the
activity
business
Panama,
Peru, Puerto
Rico, Uruguay ofTelefónica
Telefónica
O2 Slovakia
and Venezuela
units.

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
A global company
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Multidomestic
Subsidiaries are managed as a portfolio of
international assets
 Coordination is very limited
 Control is mainly financial
 Subsidiaries have an high level of
autonomy and are focused on localisation
issues

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Global
All value added activities are concentrated
in the MNCs headquarter
 There is no adaptation and the world
market is considered as an homogeneous
market
 The role of subsidiaries is very very
limited

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The transnational model
geographic dispersion
 economies of scale
 interdependence: intense relationships
among units characterised by an high of
cooperation and competition (both
horizontal and vertical)
 formal and informal methods of control
 diversified role for the subsidiaries

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The complexity of the model
Source: Bartlett & Goshal, 1987
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The new role of subisdiaries
Relevance of the local market
Subsidiary
Competences
low
Country organization
a distinctive
CONTRIBUTOR
high with
competence
Most entities hold this
role. It provides
EXECUTOR
low critical mass
high
A competent national
subsidiary that may
STRATEGIC
be serving
as a
partnerLEADER
in developing
and implementing
strategy
The international
company
a low
BLACK has
HOLE
competence country
organization, or none
at all
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
45
The transnational model
The model try to avoid problems of effort
duplication and inefficiency
 Subsidiaries are able to make local
business development decisions within the
global framework
 Subsidiaries can take a leading role with
regard to specific functions/business or
areas

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Control in transnationals
Control evolves in transational corporation
and became a very complex function
 i.e. R&D not only has short-term objectives
(product development) but also medium and
long term ones (patents/research projects)
 Even aspects which cannot be expressed
strictly in quantitative terms are considered

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Strategic Control in MNCs
Compulsory Readings:
 The balanced scorecard.
Measures that drive Performance,
Kaplan R.S. & Norton D.P. 1992 Harvard Business Review,
Jan/Feb, pp. 71-79
 Putting the balanced scorecard to work, Kaplan R.S. & Norton
D.P. 1993 Harvard Business Review, Sept/Oct, p. 71-79
 Balanced scorecard for multinationals, S.P. Landry, W. Y.
Canri Chan, T. Jalbert, Journal of Corporate Accounting &
Finance, 2002, 13(6), p. 31-40
Control
Control refers to the general function of
overseeing business unit performance
 Typically the corporate development
function oversees strategy and the
controllers (financial function) budget and
measure short-term financial performance

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Control

Different categories of control
Personal/Cultural
Direct/
explicit
Indirect/
implicit
Impersonal/Burocratic
Personal
centralised
control
Burocratic
formalised
control
Control by
Socialisation
and Network
Output
Control
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Socialisation and Network

It combines a lot of relatively diverse
mechanisms.
 Socialisation – instrument to ensure that
employees share organisational values and
goals
 Informal, lateral exchange of information –
mutual adjustment, informal communication
 Formalised cross-departmental relations –
temporarily formalised devices such as task
forces, cross-functional teams…
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Performance measurement
The organisation’s measurement system
strongly affects the behaviours of
managers and employees
 However, as the experience of
Multidomestic firms showed, relying only
on financial performance measurements is
a too limited approach

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The Balanced Scorecard (BSC)
“The BSC is a strategic planning and
management system that is used to align
business activities to the strategy of the
organization, improve internal and external
communications, and monitor organization
performance against strategic goals”*
 The BSC includes financial measures but also
operational measures on customer
satisfaction, internal processes and the firm’s
innovation activities

* Kaplan & Norton, 1996
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
BSC and strategy
The BSC is not just a list of performance
indicators but provides executives with a
comprehensive framework that translate
company’s vision and strategy into a
coherent set of performance measures
 Therefore, managers should first define
the company’s goal and then define the
measurement and the goals

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The Strategy process

Given the
firm’s
strategy for
each
perspectives
firm defines




Goals
Measures
Targets
Actions
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
BSC the implementation

BSC Metrics allow the managers to know how
well their business is running
 The financial perspective indicates whether or not
the firm’s strategy and implementation is
contributing to bottom-line improvement
 In the customer perspective managers define the
segments in which the business units will compete
 In the internal perspective executives identify the
internal process in which the firm must excel
 The learning and growth process identify the
processes that the organisation must develop to
create long-term growth and improvement
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Mission
Strategy
4 perspectives
The Strategy process
Measures
(KPI)
Goals
Actions
Goals
Actions
Goals
Actions
Measures
Goals
Actions
Measures
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Measures
The Strategy process
“A scorecard makes sense primarily for
business unites and divisions with a well
defined strategy”
 A corporate-level scorecard can be defined
only after a BSC has been defined at a
business level
 This explain the difficulties in
implementing BSC for MNCs and multibusiness firm

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Goals & measures: examples

The customer perspective goal: time to
market





lead time (existing products)
time to market (new products)
on-time delivery
……
The internal business perspective goal:
cost saving



production time
safety
defect rate
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Goals & measures: examples

Innovation and learning perspective goal:
tech leadership




Employee turnover
Job satisfaction
Training/Learning opportunities
The financial perspective goal: profitability


ROE
Shareholders value
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
How to choose the goals for each
perspective
Building a balanced scorecard should
encourage managers to define the
objectives according to corporate strategy
 By this point of view the objectives of the
4 perspectives should be part of a
coherent framework

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Financial perspective
Financial goals could differ considerably at
each stage of a business’s life cycle
 Let’s just consider three stages:

 Growth
 Sustain
 Harvest
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Financial perspective

The growth stage is generally a cash burning
phase
 Growth rate in sales
 Number of new market segments
 % of sales from new products introduced within a
specific period

The sustain stage is the most common stage
and typical profitability measure are used
 Operating income (Ebit)
 Return on capital employed
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Financial perspective
The harvest phase is the mature stage when
firms try to harvest the investments made in
the two previous phases
 The goal is typically to maximize cash flow
back to the corporation

 Operating cash flow
 Reduction in working capital requirements
 Cash-to-cash cycle
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Example: Cash-to-cash cycle

It is the sum of days cost-of-sales in inventory
+ days sales in account receivables less days
purchases in accounts payables
Raw materials
from suppliers
Sell
product/services
Days inventories
Days payables
Pay suppliers
Days Receivables
Cash to cash cycle
Collect cash
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Cash-to-cash cycle


The case of a construction company
Cash-to-cash=
89 days
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The Customer perspective
The customer perspective of the BSC is
aimed at identifying the customer and the
market segment in which they have to
compete
 The core measurement group includes
measures of






Satisfaction
Market share
Retention
Acquisition
Profitability…
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The Customer perspective
Market share
Is the proportion in a given market in terms of sales,
customers, unit volume that a business sells
Acquisition
Measures, in absolute and relative terms, the rate at which a
business unit attracts or win new customers or business
Retention
Tracks, in absolute and relative terms, the rate at which a
business unit retains ongoing relationships with customers
Satisfaction
Assesses the satisfaction level of customers along specific
performance criteria
Profitability
Measures the net profit of a customers after allowing for the
unique expenses required to support the customers
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Customer profitability
In order to have measure of customer
profitability firms should have
implemented an activity-based cost
system
 Not all clients’ demand can be satisfied in
ways that are profitable to an organisation

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The internal business perspective
For the internal business perspective
managers identify the process that are
most critical for achieving customers and
shareholders objectives
 Typically firms concentrate on things such
as quality, time, productivity

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The internal business perspective

The BSC framework identify three main
business processes:
 Innovation
 Operations
 After-sales services
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Innovation

Measures for basic and applied research
 % of sales from new products
 % of sales from proprietary products
 New product introduction vs competitors or vs
plan
 Time to develop next generation products
 Productivity measure
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Operations
Operations start with receipt of a
customer order and finish with the
delivery
 Typical measures are:





Standard costs
Machine efficiency
Operating processes’ quality
Cycle time
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Post sales

Measures:
 Cycle times from customers requests to
resolutions of the problems
 Costs of after-sales services
 Dispute resolution time
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Learning & growth perspective
This perspective develop objectives and
measures to drive organisational learning
and growth
 The previous three perspectives identify
where the organisation must excel to
achieve breakthrough performance
 Forward looking investments are generally
treated as period expenses so that
cutbacks in these investments are an easy
way to produce incremental short-term
earnings

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Learning & growth

The BSC identify 3 main categories for this
perspective:
 Employee capabilities
 Information system capabilities
 Motivation, empowerment and alignment
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Employee capabilities

Core employee measurement group are:
 Employee satisfaction (typically through
survey)
 Employee retention (key staff turnover
measurement)
 Employee productivity (ranging from simple
measures such as revenue per employee to
value-added per employee
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Information system capabilities
The information system is nowday a
critical resource
 It not only interlink all the activities of the
firm worldwide
 It supply also rapid, timely and accurate
information and feedback on the product
just made or the services just delivered

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Motivation empowerment

Measures of motivation
 Suggestions made and Suggestions implemented
 Implementing a reward structure for
implemented suggestions

Measures of improvements




Late deliveries
Number of defects
Scraps
absenteeism
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Alignment

Alignment focus on whether or not units
and individuals have their objectives
aligned with the company goals (as
articulated in the BSC)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Alignment
In the implementation process a typical
initial measure is the percentage of top
managers exposed to BSC then the same
ratio considering all the staff employees
 At a later stage it is considered the degree
of accomplishment of the BSC goals
introducing incentives to achieving these
targets
 Incentive can be referred to single
employees (pay raise) or to subunit and
division (resources, autonomy)

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
A tentative strategy map
Objective
Financial
KPI
Customer

share
increase larger
benchmark
 positive EVA

premium p on
competition
 complaints

> 10% vs
comp price



Retention &
Satisfaction
Premium
price
Internal
< 5% of
clients

workforce
retention
 av. Time < 5
days after 1°
contact

> 90%

> 90%
% workforce
stockholders
 % trained


Improve service &
contact time
Learning

Sales force
empowerment
Actions
share value
EVA

Saherholder
value
Targets
% workforce
stockholders
standardis.
product program
 p
discrimination
Loyalty
program
 targeted sales
force
Continuos
learning
program
 Contact centre

Stock
ownership plan
 training

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
BSC web-service solutions
The BSC is now implemented through web
services applications
 At http://www.bscdesigner.com/download
you can find a freeware version (BSC
Designer Light) of one - among the
thousands – available applications

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
A practical example

Tata Tea started building EVA as a key
performance indicator in the balanced
scorecards, so that the performancemanagement system centres around EVA
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Economic value added (EVA®)
Compulsory Readings:
 Journal of Applied Corporate Finance
• EVA Momentum: The One Ratio That Tells the Whole Story G.
Bennett Stewart III, 21(2), pp. 74-86, (Spring 2009);
• How To Fix Accounting—measure And Report Economic Profit, G.
Bennett Stewart III, 15 (3), pp. 63-82 (Spring 2003);
• The Eva Revolution, Al Ehrbar, G. Bennett Stewart III, 12 (2), pp
18 – 31, (Summer 1999);
• (SUGGESTED) Specific Knowledge and Divisional Performance
Measurement, M. C. Jensen, W. H. Meckling, pp. 49-57, 21(2),
(Spring 2009)
Shortcomings of accounting
numbers
The classical ratios considered for
businesses control such as EPS, ROI or
ROE have a series of limitation as
standards for measuring business
performance
 Standard earning numbers are sensitive to
accounting methods, do not measure
proper cash inflow and ignore the “time
value of money”

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Cash flow estimation

Cash flow from operation (CFFO) may be
calculated as follows:
CFFO = sales-op expenses - tax +
Depreciation (& other noncash items)
– incremental working capital
investments – Capital expenditures
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Incremental Working Cap
Any increments in Net working capital is a
cash absorption activity

NWC increase =
+ increase in receivables
+ increase in inventories
- increase in payables
- increase in deferred taxes
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
EPS
A Subsidiary is planning a new investments
of € 15M which will generate a 10%
increase of sales
 Consider that:

 Subsidiary has no debt
 the cost of equity is 12%
 The business is a mature business and the profit
could be consider a perpetuity

Remember that the present value of a
perpetuity is: Perpetuity  Annual _ Cash _ Flow
Rate _ of _ Re turn
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
EPS
Even if earnings increase the equity value
of the investment does not change
 EPS fails to measure changes in economics
value

Sub A with no debt
Sub A + 10%
Sales
€ 200
€ 220
Op expenses
€ 170
€ 187
Earnings before tax
= € 30
= € 33
Income tax (0.4%)
€ 12
€ 13.20
Earnings
€ 18
€ 19.80
Equity value (CF/CoE)
18/0.12=150
19.8/0.12-15=150
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Roi
Roi & Roe are popular financial performance
indicators. Roi is a frequently used measure
of division’s performance
 Roi remains a good indicator of business
profitability but still is an accrual accounting
return and not a full economic measure
 This is true even when Roi is compared to an
hurdle rate that generally equals the
business unit cost of capital

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
ROI
Roi is computed by a wide variety of
methods
 This is one:

EBIT
Net Book value of FA + Net Working Capital

In this case the “tax shield” effect is not
considered
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
ROI
 Moreover,
both the numerator and the
denominator are affected by arbitrary
accounting assumptions
 The recent drive towards “fair value”
accounting has mitigated the problem
 Nonetheless, operating income (EBIT)
is not the CF generated by the
business
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
ROI
Roi depends on capitalisation and
depreciation policies that are strictly
accounting decisions
 For example, R&D expenses are customarily
expensed in the current period and not
considered as an investment (thus
increasing the Roi rate)
 Thus, using Roi to compare R&D intensive
and not intensive business can be highly
misleading

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
ROI

Overall Roi has 3 main additional
shortcomings:
 It depends on the investments base of the
business unit considered (the larger the
investment base the lower the accounting
return)
 Aggressive strategies (R&D spending, new
investments…) typically lower Roi while
harvesting strategies increase Roi
 Does not take in account the overall risk (i.e
the cost of capital)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
ROE
Roe is the ratio of net profit on total
shareholder capital
 Roe is seldom used at the divisional level
where debt is rarely allocated but is more
widely used at the corporate level
 Roe has all the shortcomings of Roi but in
addition it is sensitive to leverage
 Roe increases as more then optimal debt
is issued

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Time value of money

Earning calculations ignore the time value of
money i.e. the risk free rate, the cost of risk
compensation and the expected rate of inflation

This is not the case with NPV calculation (CF=
cash flow; r=interest rate)
n
CFn
CFt
CF1
CF2
NPV 

 ......

1
2
n
t
(1  r ) (1  r )
(1  r )
(
1

r
)
t 1
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The risk/return relationship
Expected return
Risk free rate
(Rf)
Return
Risk
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
EVA®
EVA (Economic Value added) is a
methodology aimed at measuring
shareholder value creation
 EVA is increasingly becoming the global
standard for measuring business
performance
 Shareholder value is created only if a
business earns a rate of return on
investments greater than the rate
investors can expect to earn by investing in
alternative, equally risky, securities

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
EVA®
Eva take in account both the real cash
flow generated by the business divisions
and the overall risk of the business
 By this point of view Eva is an “economic”
profit measure as opposed to the typical
accounting measures
 Eva can be calculated for any entity
including divisions departments, products
lines…

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Eva balance sheet
Regular Balance Sheet
Cash
Short term
Debt
EVA Balance Sheet
Cash
Short term
Debt
NWC
Short term
Receivables
Not Interest+ Inventories
+ Prepayments bearing
liabilities
Long term
Debt
Fixed Assets
SH Equity
Long term
Debt
Fixed Assets
SH Equity
Net Assets Invested Capital
Nopat
Wacc
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The EVA® approach
Eva = NOPAT – (WACCInvested Capital)
Net
operating
profit after
tax
Weighted
average cost
of capital
Net Fixed
asset + net
working
capital
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The EVA®
The return on net assets is defined as the
ratio of Nopat on Net Assets (RONA)
 Eva will be positive if :

RONA>WACC

Eva can be also be expressed as:
Eva=(RONA-WACC)Invested Capital
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
NOPAT
Nopat is the firm’s profit assuming that the
firm has no debt
 The term “net” means that Nopat is net of
amortization (which is a real economic cost)
 The idea is that Nopat captures the profit
that accrue to all capital holders (both
lenders and shareholders)

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
NOPAT adjustments

The main adjustment is the reclassification
of some expenses as investments
(typically R&D) and the subtraction of
provision and extraordinary expenses i.e.
all non-monetary costs such as provisions
(except amortization!)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
NOPAT

Nopat is equal to:
Ebit (adjusted)-corporate taxes (without
debt)=
or more precisely
profit(adjusted)+interest expenditures(1-t)
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Nopat: the formulas
Ebit (+)
100
Option 1
Interest cost (-)
20
Ebit (+)
100
PTP (=)
80
Interest cost (-)
==
Tax rate = 50%
40
Tax rate = 50%
50
Profit
40
Nopat
50
Option 2: Profit + IC(1-t)
Option 3: Ebit (1-t)
Profit (+)
40
Interest cost (1-t) (+)
10
Ebit (+)
100
Nopat
50
(1-t) (-)
50%
Nopat
50
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Income statement (basic)
Sales (+)
100
Costs of Goods and Services (-)
20
Labour Costs (-)
10
Earnings before Interests, Taxes & D&A - EBITDA (=)
70
Depreciation & Amortization - D&A (-)
20
Interest costs (-)
10
Pre-tax profit (t=40%) PTP (=)
16
Profit
40
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Adjusted Profit
In order to estimate the adjusted profit
exceptional costs (i.e. integration costs)
should be deducted and R&D costs should be
amortised according to the amortisation period
considered

Profit
40
Integration costs (+)
5
Research cost capitalised
50
n. of years of capitalisation of R&D costs
10 years
Costs to be added and deducted
+50 and + 5
Adjusted Profit
90
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Nopat

Nopat is not affected by the firm’s capital
structure choices
Unlevered firm
levered firm (1)
levered firm (2)
Invested capital
10,000
10,000
10,000
Equity
10,000
5,000
2,000
Debt
0
5,000
8,000
Sales
16,667
16,667
16,667
Cogs
13,000
13,000
13,000
Depreciation
2,000
2,000
2,000
EBIT
1,667
1,667
1,667
Interests (i=5%)
0
250
400
Pre-tax Profit
1,667
1,417
1,267
Tax (0.4 tax rate)
667
567
507
Net Profit
1,000
850
760
Nopat=NP+Int*(1-t)
1,000
1,000
1,000
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
EVA BS at the divisional level

When Eva is measured at the divisional levels,
cash is typically excluded from invested capital
(cash is typically managed centrally)
EVA Balance Sheet
Cash
Short term
Debt
EVA BS at the
Divisional Level
NWC
NWC
Long term
Debt
Long term
Debt
Fixed Assets
Fixed Assets
ST debt
SH Equity
SH Equity
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The Cost of capital
The cost of capital is the rate of return a
capital provider would expect to receive if
the capital were invested in a
project/division of comparable risk
 Therefore, the cost of capital is an
opportunity cost
 Since risk is a crucial element investors
require higher returns from equity capital
than they do from debt

RE>RD
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
WACC

The WACC is calculated as follows:
 D 
 E 
WACC  
R
(
1

t
)

R
d
e



D  E
D  E
Where the cost of debt is the pretax rate the
company pays to its lenders (since interest
payments are – as a rule – tax deductible)
 The cost of equity should be estimated and
depends on the overall risk of the investment

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
WACC

If the market value of debt is = € 30M; the
market value of equity is = € 50M, the cost
of debt= 9% and the cost of equity is 15%
then, geiven a tax rate of 40% the weighted
cost of capital is equal to…..
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
CAPM

The CAPM (Capital Asset Pricing Model)
offers is one of the methodologies (among
others!) to estimate the cost of equity

Re  R f    Rm  R f


The cost of equity is equal to the return on
riskless assets plus a risk premium which
reflect the price paid by the stock market to
all equity investors, adjusted for beta which
is a specific risk factor
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Beta
Beta is the volatility of a company stock
price with respect to the overall stock
market
 Therefore Beta is the company-specific risk
that the asset adds to a market portfolio
 Analytically Beta equals:

i 
Covi ,M

2
M
 i i , M
or 
M
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Riskless rate

The only securities that have not default risk
are government securities. Nonetheless they
bear interest rate risk. The most common
rates used are:
 T-bill rate
 Treasury notes rate
 Inflation-indexed Treasury rate
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Equity risk premium
Risk premium should measure what
investors on average demand as extra
return for investing in the market portfolio
relative to a risk free assets
 RP is usually estimated looking at the
historical premium earned by stocks over
Treasury bills and bonds

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
US Equity risk premium
Arithm. Av.
Stock
T bill
T bond
1928-2003
11.82%
3.90%
5.28%
1963-2003
12.10%
6.01%
7.40%
1993-2003
12.63%
4.20%
7.76%
Stock
T bill
T bond
1928-2003
9.85%
3.86%
5.02%
1963-2003
10.82%
5.97%
7.00%
1993-2003
10.87%
4.19%
7.30%
Geom. Av.
Source: www.Damodaran.com
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Some Beta Examples
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Some Beta Examples
BETA
AD.BE
TA
MIB30
0,96
0,97
0,13
M
SXXE
1,24
1,16
0,25
31.1.97 - 28.6.02
M
MIB30
0,86
0,92
0,12
FIAT
31.1.97 - 28.6.02
M
SXXE
0,98
0,99
0,15
FIAT
1.1.93 - 26.12.97
W
MIB30
0,90
0,93
0,06
FIAT
1.1.93 - 26.12.97
W
SXXE
1,08
1,05
0,13
FIAT
3.1.97 - 26.7.02
W
MIB30
0,90
0,93
0,07
FIAT
31.1.97 - 28.6.02
W
SXXE
STOCK
PERIODO
RETURN
FIAT
29.1.93 - 28.11.97
M
FIAT
29.1.93 - 28.11.97
FIAT
INDEX
0,96
STDE
0,97
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
0,09
Some Beta Examples
BETA
AD.BE
TA
MIB30
0,76
0,84
0,06
M
SXXE
0,76
0,84
0,16
30.1.98 - 28.6.02
M
MIB30
0,61
0,74
0,11
GENERALI
30.1.98 - 28.6.03
M
SXXE
0,68
0,79
0,13
GENERALI
29.1.93 - 26.12.97
W
MIB30
0,81
0,87
0,04
GENERALI
29.1.93 - 26.12.98
W
SXXE
0,71
0,80
0,10
GENERALI
2.1.98 - 26.7.02
W
MIB30
0,85
0,90
0,05
GENERALI
2.1.98 - 26.7.03
W
SXXE
STOCK
PERIOD
RETURN
GENERALI
29.1.93 - 31.12.97
M
GENERALI
29.1.93 - 29.11.97
GENERALI
INDEX
0,82
0,88
STDE
0,06
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Some Beta Examples
STOCK
PERIOD
RETURN
INDEX
MONDADORI
29.1.93 - 28.11.97
M
MIB30
0,56
0,71
0,15
MONDADORI
31.12.92 - 31.12.97
M
SXXE
0,70
0,80
0,25
MONDADORI
31.12.97 - 31.7.02
M
MIB30
1,55
1,36
0,23
MONDADORI
30.1.98 - 28.6.02
M
SXXE
1,86
1,57
0,23
MONDADORI
1.1.93 - 26.12.97
W
MIB30
0,41
0,61
0,09
MONDADORI
1.1.93 - 26.12.98
W
SXXE
0,56
0,71
0,16
MONDADORI
2.1.98 - 26.7.02
W
MIB30
0,94
0,96
0,09
MONDADORI
2.1.98 - 26.7.02
W
SXXE
BETA
1,04
AD.BETA
1,03
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
STDE
0,11
Beta for divisions

The procedure for estimating betas for
operating divisions within firms depends
largely on whether the divisions are
organized by product line or geography
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Geographical divisions

In this case the cost of equity is set adding
to the company cost of capital a risk
premium equals to
 the rate of return on local bonds if the division is
mainly funded in the home currency
 A measure of country risk if financing comes
mainly from the parent company
 Typical measure of country risk are spread on
local government bond denominated in foreign
currency or DCS
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Product divisions
When division are based on product line
betas can be estimated from comparable
firms in the same or similar industries
 This simple approach assumes that the
capital structure of all the firms in the
industry is similar (beta increases when the
D/E ratio increases)

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The levered Beta
If our capital structure is different from the
industry average structure then we have to
unlevered and then “relevered” the Beta
 Since we know that:

D

 L  U  1  (1  t ) 
E

then
U 
L
D
1  (1  t )
E
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Estimating business Beta

If the average industry beta is 1.27 and the
average industry D/E ratio is 0.45, assuming
t=0.4, then the unlevered industry beta is:
1.27
1  (1  0.4)0.45
U  1.00
U 

This means that if the average industry beta
is 1.27, if all the firms had been all-equity
firms, with no debt, their average beta would
be 1.00
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Estimating business Beta


Now to derive the beta for our division we just have
to take the unlevered beta and then lever it back up
again to out capital structure
Let’s assume that our D/E ratio is 0.25, then
D

 L  U  1  (1  t ) 
E

 L  1.0  1  (1  0.4)0.25  1.15
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Eva guidelines

Given that Eva is:
Eva=Nopat-(WACC)Invested Capital
The main indications of EVA methodology to
managers is that they should implement
action either to increase Nopat or the
decrease the invested capital
 Wacc depends on overall risk and capital
structure (a financial decision)

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
EVA and time value of money
EVA is much better than conventional
measures in explaining the market value
of a company
 The market value of a company depends
directly on the future EVA-values:

The market value of a company
= Book value of equity + present value
of future EVA
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
MV and EVA
If the company produces a return that is
equal to capital costs then the market
value of the company will equal the book
value of equity
 I.e. when EVA = 0, then company´s
market value of equity equals its book
value of equity

Antonio Majocchi - International Business and Management, Academic Year 2009-2010
The firm MV
Market value
premium
Market value
of the firm
Book value
of equity
MVP 
EVA3
EVAn
EVA1
EVA2



.....

(1  wacc)1 (1  wacc) 2 (1  wacc)3
wacc
Firm’s market value=
equity book value + NPV
of future EVA
Positive EVA builds up a
premium to the market
value of equity, since
investors pay for excess
return
Antonio Majocchi - International Business and Management, Academic Year 2009-2010
Marginal EVA and pricing
When EVA is computed at the division level,
the computation requires estimation at the
divisional level
 This will involve allocation mechanisms and
allocation of fixed headquarters expenses
becomes an issue
 The initial estimates of EVA are likely to reflect
the allocation mechanisms used and the
mistakes made in those allocations
 Changes in EVA over time are more useful
measures than the initial EVA estimates
themselves

Antonio Majocchi - International Business and Management, Academic Year 2009-2010