DEVELOPMENT OF DIVISIONAL PERFORMANCE MEASURES
Daiva Burkšaitienė
Department of Financial Engineering, Vilnius Gediminas Technical University,
Saulėtekio av. 11, LT-10223 Vilnius, Lithuania, e-mail: db@vv.vgtu.lt
Abstract. This article investigates the financial measures for evaluating divisional performance. At the strategic
business unit level operating profit, return on investment, residual income and economic value added were examined, and these measures should be used for measuring the financial objective of the business unit. There are two
arguments in determining how divisional profitability should be measured – the primary purpose is to measure
the performance of the division (the economic performance of the division) or that of the divisional manager
(managerial performance). In this article divisional profit measurement is based on these two determinants. Finally, the financial performance measures on the basis on recent studies are developed. Nevertheless, financial
measures cannot adequately measure all those factors that are critical to the success of a division. Notice should
also be taken to reporting non-financial measures related to such areas as competitiveness, product leadership,
quality, innovation and flexibility to respond to changes in demand.
Keywords: financial measures, non-financial measures, managerial performance, economic performance, return
on investment, residual income, economic value added, net present value.
1.
approach, which is based on accounting profits and
ratios derived from them, such as return on investment (ROI), or return on assets (ROA), and residual
income (RI). There are a number of issues (Egginton;
Wallace; Bacidore, Boquist, Milbourn and Thakor;
Bromwich and Walker; Christensen, Feltham and Wu;
Drury) that applied these accounting measures of performance [1–6]. During the 1990s was applied the
economic value added (EVA) model and the further
researches are designed for value-based management
approach. Since business performance measurement
has become so topical, so recently. Neely argues that
there are seven main reasons: the changing nature of
work; increasing competition; specific improvement
initiatives; national and international quality awards;
changing organisational roles; changing external demands; and the power of information technology [7].
In accordance with Chenhall and Langfield-Smith,
management accounting has a primary function in
developing performance measures to assist managers
in planning and controlling their organizations [8].
Traditionally, these measures have been internal, aggregate metrics of financial performance. Managers
from other functions as operations, marketing and
human resource management has sought to develop
measures of greater relevance to their areas of management. What has occurred is a proliferation of approaches to the development of performance measures. The results from Hyvohen study show that a fit
between the customer-focused strategy and financial
Introduction
Many companies have business activities in
more than one country. In fact, the operations of some
large corporations involve so many different countries
that they are called multinational businesses. The
problems of managing and accounting for a company
that has international operations can be very complex,
and detailed study of these issues should be required.
Because of the complexity of companies operations, it is difficult for top management to directly
control operations. Therefore a company is divided
into divisions and is allowed divisional managers to
operate with a great deal of independence. When
autonomous divisions are created it arise the danger
that divisional managers might not pursue tasks that
are in the best interests of the company as a whole.
The object of the article is the study of current research relating to divisional performance measurement. The goal of this article is to develop divisional
performance measures that will motivate managers to
pursue those tasks that will best benefit the company
as a whole. The methods of archive and analytical
research were used in the investigation. The basics of
methodology consist of principles of systemic and
comparative analysis of scientific literature.
The problems of companies, as well as divisional, performance measurement had been investigated by most researchers for many years. In the earlier debate had been examined the traditional
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Keating investigated factors affecting firms’ uses
of three types of performance metrics to evaluate division managers, division accounting metrics, firm accounting metrics and firm stock price [21]. Survey
data revealed that division accounting metric use increases with the divisions’ industry’s price-earnings
correlation and decreases with divisional growth opportunities. Firm accounting metric use increases with
the manager’s impact on other divisions and decreases
with growth opportunities and other managers’ impact
on that division. Firm stock price use increases with
relative division size and the correlation between firm
stock returns and market-wide returns.
Bouwens and Lent using a sample of 140 managers investigated the use of various performance
metrics in determining the periodic assessment, bonus
decisions, and career paths of business unit managers
[22]. They showed that the weight on accounting return measures is associated with the authority of these
managers, and they documented that both disaggregated measures (expenses and revenues), and nonfinancial measures play a greater role as interdependencies between business units increase. The results
suggested separate and distinct roles for different
types of performance measures. Accounting return
measures are used to create the proper incentives for
managers with greater authority, while disaggregated
and non-financial measures are employed in response
to interdependencies.
performance measures improves customer performance [9].
The literature relating to EVA begins with the
publication of the book The Quest for Value by Stewart, 1991, in which an author exposed his views about
the usefulness of EVA as the basis of performance
measurement of a company and its management at a
total or a divisional level [10]. In his empirical research he examined the informational content of
EVA. In the same line, the studies by Stewart,
O’Byrne and Grant using American data reached
similar conclusions about the validity of EVA [11–
13]. Zimmerman made three basic points about divisional performance measurement that managers
should keep in mind when attempting to choose between EVA and more conventional, accounting-based
measures [14]. The study using European data by
Peixoto [15] and the latter finding implies that EVA
may perform well as a measure of evaluation of management performance when the goal is the maximisation of shareholders' wealth.
However, several academic empirical studies by
Dodd and Chen, Biddle, Bowen and Wallace, Chen
and Dodd, as well as a more recent work by Fernandez, have offered contradictory results regarding the
superior informational content of EVA over the traditional measures of performance, and the necessity for
its application [16–19]. The paper by Kyriazis and
Anastassis using Greek data investigated the information content of EVA and unadjusted residual income
in comparison with two accounting measures of performance – the net income and the operating income
[20]. Their findings fail to provide support for Stewart’s results [10, 11].
3.
Divisional profit measurement
There are four different alternative profit measures that we can use to measure divisional performance: variable short-run contribution margin, controllable contribution, divisional contribution and
divisional net profit before taxes. In measuring managerial performance the variable short-run contribution
margin is inappropriate for performance evaluation,
because it does not include fixed costs that are controllable by the divisional manager.
The controllable contribution includes controllable fixed costs such as non-variable labour, equipment
rental and the cost of utilities. It is the most appropriate measure of a divisional manager’s performance,
since controllable contribution measures the ability of
managers to use the resources under their control effectively. This measure should not be interpreted in
isolation if it is used directly to evaluate the performance of a divisional manager. Instead, the controllable
contribution reported by a division should be evaluated relative to a budgeted performance, so that market conditions can be taken into account.
The controllable contribution provides an incomplete measure of the economic performance of a
division, since it does not include those costs that are
attributable to the division but which are not controllable by the divisional manager. These noncontrollable expenses (e.g. depreciation of divisional
assets, head office finance and legal staff) that are
2. Determinants of the divisional performance
evaluation
There are two arguments in determining how divisional profitability should be measured – the primary purpose is to measure the performance of the
division (e.g. the economic performance of the division) or that of the divisional manager (e.g. managerial performance). These two determinants may be
quite different.
If the purpose is to evaluate the divisional manager then only those items directly controllable by the
manager should be included in the profitability measure. Thus all allocations of indirect costs ought not to
be included in the profitability measure.
Corporate headquarters will also be interested in
evaluating a division’s economic performance for
decision-making purposes, such as expansion, contraction and investment decisions. To measure the
economic performance of the division many items
that the divisional manager cannot influence, such as
interest expenses, taxes and the allocation of central
administrative staff expenses, should be included in
the profitability measure. In this article author shall
focus on both these determinants.
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attributable to a division, and which would be avoidable if a decision were taken to close the division, are
deducted from controllable contribution to derive the
divisional contribution. This is clearly a useful figure
for evaluating the economic contribution of the division, since it represents the contribution that a division is making to corporate profits and overheads.
Divisional contribution should not be used to evaluate
managerial performance, since it includes costs that
are not controllable by divisional managers.
Many companies allocate all corporate general
and administrative expenses to divisions to derive a
divisional net profit before taxes. From a theoretical
point of view, it is difficult to justify such allocations
since they tend to be arbitrary and do not have any
connection with the manner in which divisional activities influence the level of these corporate expenses
[6]. The divisional contribution would seem to be the
most appropriate measure of divisions’ economic performance, since it is not distorted by arbitrary allocations. Corporate headquarters may wish to compare a
division’s economic performance with that of comparable firms operating in the same industry. The divisional contribution would overstate the performance
of the division. Consequently, companies may prefer
to use divisional net profit when comparing the performance of a division with similar companies.
However, divisional net profit is not a satisfactory measure for evaluating managerial performance.
Despite many theoretical arguments against divisional
net profit, the empirical evidence indicated that this
measure is used widely to evaluate both divisional
economic and managerial performance.
There is also some evidence to suggest that companies hold managers accountable for divisional net
profit because this is equivalent to the measure that
financial markets focus on to evaluate the performance of the company as a whole. Top management
therefore requires their divisional managers to concentrate on the same measures as those used by financial markets.
Thus, there are strong theoretical arguments for
using controllable contribution as the divisional profit
measure for managerial performance and divisional
contribution for measuring economic performance.
Drury have noted that many companies, however, use
divisional net profit (after allocated costs) to evaluate
both divisional managerial and economic performance
[6].
4.
defined as total divisional assets, assets controllable
by the divisional manager, or net assets.
ROI provides a useful overall approximation on
the success of a firm’s past investment policy by providing a summary measure of the ex post return on
capital invested. Kaplan and Atkinson had noted,
however, that, without some form of measurement of
the ex post returns on capital, there is little incentive
for accurate estimates of future cash flows during the
capital budgeting process [23]. Measuring returns on
invested capital also focuses managers’ attention on
the impact of levels of working capital (in particular,
stocks and debtors) on the ROI.
Another feature of the ROI is that it can be used
as a common denominator for comparing the returns
of dissimilar businesses, such as other divisions
within the group or outside competitors. ROI has been
most widely used financial measure for many years in
all types of companies.
Despite the widespread use of ROI, a number of
problems exist when this measure is used to evaluate
the performance of divisional managers. Drury stated
that is possible that divisional ROI can be increased
by actions that will make the company as a whole
worse off, and conversely, actions that decrease the
divisional ROI may make the company as a whole
better off [6]. That is, evaluating divisional managers
on the basis on ROI may not encourage goal congruence.
4.2. The residual income
To overcome some of the dysfunctional consequences of ROI, the residual income (RI) approach
can be used. For the purpose of evaluating the performance of divisional managers, RI is defined as
controllable contribution less a cost of capital charge
on the investment controllable by the divisional manager. For evaluating the economic performance of the
division RI can be defined as divisional contribution
less a cost of capital charge on the total investment in
assets employed by the division.
A reason cited in favour of RI over the ROI
measure is that RI is more flexible, because different
cost of capital percentage rates can be applied to investments that have different levels of risk. Not only
will the cost of capital of divisions that have different
levels of risk differ – so may the risk and cost of capital of assets within the same division. The RI measure
enables different risk-adjusted capital costs to be incorporated in the calculation, whereas the ROI cannot
incorporate these differences.
RI suffers from the disadvantages of being an
absolute measure, which means that it is difficult to
compare the performance of a division with that of
other divisions or companies of a different size.
Bromwich and Walker considered the strengths
and weaknesses of value-based management approaches based upon the RI concept as the basis for
incentive-based reward systems [4]. The objective of
Divisional financial performance measures
4.1. The return on investment
Instead of focusing purely on the absolute size of
a division’s profits, most companies focus on the return on investment (ROI) of a division (that is, profit
as a percentage of the investment in a division). ROI
expresses divisional profit as a percentage of the assets employed in the division. Assets employed can be
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these systems is to encourage optimal corporate investment selection by divisional managers and to encourage them to act as if they were independent owners of their divisions sharing a proportion of all losses
and all profits. The authors considers these systems in
the light of the earlier RI debate in the 1960s and
1970s, which raised a number of problems applicable
to today’s value-based systems. They also considers
recent attempts to solve the major problem generated
in the earlier debate – how to ensure that a single period RI is congruent with project net present value.
Finally, the article provides a brief survey of current
research into incentive systems based on RI.
Christensen, Feltham and Wu considered a setting in which a firm uses RI to motivate a manager’s
investment decision [5]. Textbooks often recommend
adjusting the RI capital charge for market risk, but not
for firm-specific risk. They demonstrated two basic
flaws in this recommendation. First, the capital charge
should not be adjusted for market risk. Charging a
market risk premium results in ‘double’ counting because a risk-averse manager will personally consider
this risk. Second, while investors can avoid firmspecific risk through diversification, a manager cannot.
In the case of profit centres, ROI is a satisfactory
performance measure, because if the ROI is maximized on a fixed quantity of capital, the absolute return itself will also be maximized. However, in the
case of investment centres, ROI appears to be an unsatisfactory method of measuring managerial performance, and in these circumstances the RI is preferable.
Surveys of methods used by companies to evaluate the performance of divisional managers indicate a
strong preference for ROI over RI. The UK survey by
Drury reported that the following measures were used
(%) [6]:
A target ROI set by the group
55
Residual income
20
A target profit before charging
interest on investment
61
A target cash flow figure
43
Why is ROI preferred to RI? Skinner found evidence to suggest that firms prefer to use ROI because,
being a ratio, it can be used for inter-division and inter-firm comparisons [24]. ROI for a division can be
compared with the return from other divisions within
the group or with whole companies outside the group,
whereas absolute monetary measures such as RI are
not appropriate in making such comparisons. A second possible reason for the preference for ROI is that
‘outsiders’ tend to use ROI as a measure of a company’s overall economic performance. Corporate
managers therefore want their divisional managers to
focus on ROI so that their performance measure is
congruent with outsiders’ measure of the company’s
overall economic performance. A further reason, suggested by Kaplan and Atkinson, is that managers find
percentage measures of profitability such as ROI
more convenient, since they enable a division’s profitability to be compared with other financial measures
(inflation rates, interest rates) and the ROI rates of
other divisions and comparable companies outside the
group [23].
4.3. The economic value added
ROI and RI cannot stand-alone as a financial
measure of divisional performance. Short-run profitability is only one of the factors contributing to a
company’s long-run objectives. ROI and RI are shortrun concepts that deal only with the current reporting
period, whereas managerial performance measures
should focus on future results that can be expected
because of present actions.
During the 1990s RI has been refined and renamed as economic value added (EVA) by the Stern
Stewart consulting organization. Although the EVA
model was thoroughly applied by Stern Stewart &
Co., for the first time, in the 19s, economists had contemplated a similar concept for many years before
that. It was the famous economist Alfred Marshall in
1890, who first spoke about the notion of economic
profit, in terms of the real profit that a company
makes when it covers, besides the various operating
costs, the cost of its invested capital.
Based upon the above meaning of economic
profit, Stern Stewart & Co. developed the concept of
the economic value added model. The basic difference
between the notions of economic value and RI concerns the method for calculating profits and invested
capital. The EVA concept extends the traditional RI
measure by incorporating adjustments to the divisional financial performance measure for distortions
introduced by generally accepted accounting principles (GAAP). EVA can be defined as:
EVA = Conventional divisional profit + accounting adjustment – cost of capital charge on divisional
assets.
Adjustments are made to the chosen conventional divisional profit measure in order to replace
historic accounting data with a measure of economic
profit and asset values. Stern Stewart & Co. have developed approximately 160 accounting adjustments
that may need to be made to convert the conventional
accounting profit into a sound measure of EVA.
However, they have indicated that most organizations
will only need to use about 10 of the adjustments.
These adjustments result in the capitalization of much
discretionary expenditure (research & development,
marketing & advertising) by spreading these costs
over the periods in which the benefits are received.
Therefore adopting EVA should reduce some of the
harmful side effects arising from using financial
measures. This is because managers will not bear the
full costs of the discretionary expenditures in the period in which they are incurred if the expenses are
capitalized [6]. Also because it is a restatement of the
RI measure, compared with ROI, EVA is more likely
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performance measures should be based on the value
created by each division. However, direct measures of
value creation are not possible because the shares for
only the business as a whole are traded on the stock
market. Instead, most firms use accounting profit or
ROI measures as a surrogate for changes in market
values. Also, even if market measures could be derived, they may not be ideal performance measures
because they are affected by many factors that managers cannot control (changes in investor expectations, interest rate changes). In contrast, accounting
performance measures are not affected to the same
extent by some of the uncontrollable factors that
cause the volatile changes in share values. Furthermore, using accounting measures such as ROI or RI
as performance measures can encourage managers to
become short-term oriented.
The empirical study by Kyriazis and Anastassis
indicate that the operating profit shows the highest
mean value among the income measures, whereas the
RI has the lowest mean value, because of the high
positive values of the Stern Stewart & Co. adjustments in profits and invested capital [20]. The EVA
has a negative mean value. Apart from the market
value added (MVA), which appears to be the most
volatile variable in their study, net income has the
highest standard deviation among the other profitability measures. Meanwhile, the results of the tests between all the other variables reveal that there is no
‘dominant’ profitability measure in terms of information content.
Ideally, divisional performance should be evaluated on the basis of economic income by estimating
future cash flows and discounting them to their present value. This calculation could be made for a division at the beginning and the end of a measurement
period. The difference between the beginning and
ending values represents the estimate of economic
income.
The main problem with using estimates of economic income to evaluate performance is that it lacks
precision and objectivity. It is also inconsistent with
external financial accounting information that is used
by financial markets to evaluate the performance of
the company as a whole. It is likely that corporate
managers may prefer their divisional managers to
focus on the same financial reporting measures that
are used by financial markets to evaluate the company
as a whole.
Various approaches can be used to overcome the
short-term orientation that can arise when accounting
profit-related measures are used to evaluate divisional
performance. One possibility is to improve the accounting measures. EVA represents such an approach.
EVA is computed by making accounting adjustments
to the conventional divisional profit calculation.
These adjustments (capitalizing research & development and advertising expenditure) represent an attempt to approximate economic income. Incorporating a cost of capital charge is also a further attempt to
to encourage goal congruence in terms of asset acquisition and disposal decisions. The results of Kyriazis
and Anastassis research show that EVA does not appear to outperform the other measures in their analysis in terms of their association to stock returns [20].
Meanwhile, EVA does not appear to have any significant advantage over RI in all their settings, suggesting
that the Stern Stewart & Co. adjustments applied by
the present study do not add significant information to
the RI measure.
Stern Stewart & Co. suggested various adjustments in the financial statements of the firms, in order
to move away from the concept of accounting profits
caused by the application of the GAAP, and approach
the notion of real economic value. Considering this, it
follows that, if the EVA model with the adjustments
that Stern Stewart & Co. proposes is closer to the real
economic value of the firm, then its application will
enable management to monitor and control more efficiently the use of invested capital.
Stern Stewart & Co. developed EVA with the
aim of producing an overall financial measure that
encourages senior managers to concentrate on the
delivery of shareholder value. According to Stern
Stewart & Co. the aim of managers of companies,
whose shares are traded in the stock market, should be
to maximize shareholder value. It is therefore important that the key financial measure that is used to
measure divisional or company performance should
be congruent with shareholder value. They claim that,
compared with other financial measures, EVA is more
likely to meet this requirement and also to reduce dysfunctional behaviour.
According to Stern, Stewart and Chew, EVA is
not just another performance measure, but can be the
main part of an integrated financial management system, leading to decentralised decision making [25].
Thus, the adoption of EVA should indirectly bring
changes in management, which in turn can enhance
firm value.
An article in an issue of Fortune magazine
(1993) described the apparent success that many
companies had derived from using EVA to motivate
and evaluate corporate and divisional managers. The
Economist (1997) reported that more than 300 firms
world-wide had adopted EVA including Coca-Cola,
AT&T, ICL, Boots and the Burton Group, Briggs &
Stratton, Quaker Oats, etc. An UK study by ElShishini and Drury reported that 23% of the responding organizations used EVA to evaluate divisional
performance [6]. In fact, companies, which have
adopted EVA as the basis of management performance measurement, have experienced a significant
increase in their shareholders’ wealth.
5. The development of financial performance
measures
The primary objective of profit-making organizations is to maximize shareholder value. Therefore
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EVA does not outperform significantly the other
measures in their analysis, failing to provide adequate
support to one of Stern Stewart’s & Co. basic claims,
according to which MVA for each period should
equal the current realisation of EVA plus the present
value of all expected future EVAs [20].
EVA, even if it is a good proxy of the real economic value of a firm, reflects a current realisation of
this value, while stock returns, and especially abnormal (unexpected) returns, are a result of a shift in the
market’s expectations for the firm’s future cash flows.
According to Drury, EVA is the long-term counterpart of the discounted net present value (NPV) [6].
Thus, given that maximizing NPV is equivalent to
maximizing shareholder value, then maximizing the
present value of EVA is also equivalent to maximizing shareholder value and Stern Stewart’s & Co.
claim that EVA is congruent with shareholder value
would appear to be justified. Consequently, if divisional managers are evaluated on the basis of the long
run present value of EVA, their capital investment
decisions should be consistent with the decisions that
would be taken using the NPV rule.
Mathematically, discounted EVA, or the economic profit (EF), for few periods is equal to result,
which obtained when discounting cash flows, i.e.
NPV. Author of this article obtains this result from a
sample of Corporation by estimating the business
value (Table 1 and Table 2) [26].
Zimmerman made three basic points about divisional performance measurement that managers
should keep in mind when attempting to choose between EVA and more conventional, accounting-based
measures [14]. First, no divisional performance measure, whether it be EVA, divisional net income, or
ROA, is capable of capturing synergies among divisions – those shared benefits or costs that make the
sum of the parts worth more than the whole. And
EVA is neither more nor less effective than more
conventional financial measures in deterring divisional managers from taking actions that increase divisional profits at the expense of corporate value.
Second, a given performance measure’s degree of
correlation with stock returns should not be management’s sole, or even its most important, criterion in
choosing to adopt a given performance measure. A
better method for evaluating performance measures is
to weigh the behavioral or incentive benefits of a
given measure against all direct and indirect costs
associated with its implementation. Third, the EVA
practice of ‘decoupling’ performance measures from
GAAP accounting, while having have potentially significant incentive benefits, also has potential costs in
the form of increased auditing requirements and the
possibility of litigation.
Kyriazis and Anastassis investigated the relative
explanatory power of the EVA model with respect to
stock returns and market value of companies, compared to traditional accounting measures of performance (net income, operating income), in the case of a
approximate economic income. However, conventional accounting profits are the starting point for calculating EVA and these are based on historic costs,
and not future cash flows, so that EVA can only provide a rough approximation of economic income.
Regarding the relative explanatory power of the
measures under comparison, EVA seems to dominate
net income, operating income and RI. This is in line
with the theory behind EVA, which should equal the
present value of all EVA’s expected to be earned by
the company in the future and therefore should be
more highly correlated with MVA than the traditional
accounting measures.
Dodd and Chen found that EVA appeared to
have higher explanatory power when it was compared
with the return on equity (ROE) and the earnings per
share (EPS), but when it was compared with a simple
measure of RI (without the accounting adjustments of
Stern Stewart) they could not identify any significant
incremental informational content [16]. Chen and
Dodd also offered empirical evidence against the validity of the EVA [18]. However, in the same study
the variable of RI appeared to have a marginally
higher explanatory power than operating income.
In one of the few published studies using European data by Peixoto it was reported that the net income variable has a higher informational content than
EVA and operating profits, when the dependent variable is the market value of the companies [15]. However, EVA appeared to have a superior informational
content when the dependent variable is the MVA. The
latter finding implies that EVA may perform well as a
measure of evaluation of management performance,
when the goal is the maximisation of shareholders'
wealth.
From reviewing a number of other studies it is
clear that when the objective is to examine the performance of firms, which have adopted control measures based on EVA or MVA, then most researchers
(Lehn and Makhija; Kleiman) [27, 28] agree that
EVA has the highest explanatory power of stock returns than any other variable and leads to increased
operational efficiency (Wallace; Zimmerman) [2, 14].
These results imply that EVA may constitute the basis
for establishing an efficient management performance
and remuneration system. This finding fails to provide
adequate support for Stewart’s claim that EVA 'tracks'
changes in MVA better than any other performance
measure, since it appears that the other earnings
measures are equally competent of explaining the
variation in MVA [10]. These results obtained from a
sample of companies with different characteristics
than those of the US market, to be consistent with the
findings of Biddle et al., Chen and Dodd for a sample
of US companies, which also found no evidence of
EVA outperforming various specifications of operating income, with respect to their association with
stock returns [17, 18].
Kyriazis and Anastassis examined the relationship between the firms’ MVA and EVA, to find that
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Table 1. Discounted cash flow (DCF) valuation
Discounted Cash Flow Valuation Summary
Operating Value
7120682
Excess Market Securities
Non-Operating Assets
Excess Pension Assets
1337
9097613
0
Entity Value
16219632
Debt
Capitalized Operating Leases
Retirement Related Liability
Preferred Stock
Minority Interest
Stock Options
8533378
0
878599
11066
1328405
0
Equity Value
5468184
Most Recent Shares Outstanding
Value per Share
Most Recent Close Price
Value Difference
900821,00
6,07
0,00
-100,0%
Free Cash Flow
Free Cash
Flow
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Continuing Value
Discount
Factor
-2560178
-598580
-1029130
-282687
-290208
-683717
-1143257
-331479
-1976594
-2305655
39666145
PV
of FCF
0,893
0,797
0,712
0,636
0,567
0,507
0,452
0,404
0,361
0,322
0,322
-2285873
-477185
-732514
-179653
-164672
-346392
-517151
-133879
-712780
-742359
12771437
Operating Value
Mid-Year Adjustment Factor
6478979
1,099
Operating Value (Disc to Current Month)
7120682
Present Value of Non-Operating Cash Flow
Present Value of Minority Interest Payments
-71113445
1217264
Current Month
4
Table 2. Economic profit (EF) valuation
Economic Profit Valuation Summary
Operating Value
7120682
Excess Market Securities
Non-Operating Assets
Excess Pension Assets
1337
9097613
0
Economic Profit
Economic
Profit
Debt
Capitalized Operating
Leases
Unfunded Pension Liabilities
Preferred Stock
Minority Interest
Stock Options
8533378
0
1998
1999
2000
2001
2002
2003
2004
878599
2005
Equity Value
5468184
Entity Value
16219632
11066
1328405
0
2006
2007
Continuing Value
Discount
Factor
192560
205462
-85389
-1012443
-842061
-890386
-1045696
0,893
0,797
0,712
0,636
0,567
0,507
0,452
171928
163793
-60778
-643426
-477808
-451097
-473020
-1426681
0,404
-576213
-1479315
-1808803
-19925428
0,361
0,322
0,322
-533456
-582386
-6415455
Present Value of Economic Profit
Invested Capital (beginning of forecast)
Most Recent Shares
Outstanding
Value per Share
Most Recent Close Price
Value Difference
PV
of EP
-9877917
16356896
900821
6,07
0,00
-100%
Operating Value
Mid-Year Adjustment Factor
6478979
1,099
Operating Value (Discounted to Current Month)
7120682
Present Value of Non-Operating Cash Flow
Present Val of Minority Interest Payments
Current Month
170
-71113445
1217264
4
FINANCE ENGINEERING
resources by encouraging managers to act as shareholders, without the need for the external control
mechanism of the market [25]. Kyriazis and Anastassis consider that in any market, in which the mitigation of the agency problem cannot occur via hostile
takeovers, the necessity for the application of internal
corporate control mechanisms and EVA based financial management systems is greater [20].
The most widely used approach to mitigate
against the dysfunctional effects that can arise from
relying excessively on financial measures is to supplement them with the key non-financial measures
that evaluate those factors that are critical to the longterm success and profits of the company. Particularly,
performance measures should be developed that support the objectives and competitive strategies of the
company. Financial performance measures should be
seen as one of a range of measures that should be used
to measure and control divisional performance.
Recent studies report an increasing use of nonfinancial measures in performance measurement and
compensation systems. A growing literature suggests
that because current non-financial measures are better
predictors of long-term financial performance than
current financial measures, they help refocus managers on the long-term aspects of their actions. However, little empirical evidence is available on the relation between non-financial measures and financial
performance, and even less is known about performance impacts of incorporating non-financial measures
in incentive contracts. The study by Banker, Potter
and Srinivasan provides empirical evidence on the
behaviour of non-financial measures and their impact
on firm performance [29]. The results indicate that
non-financial measures of customer satisfaction are
significantly associated with future financial performance and contain additional information not reflected
in the past financial measures. Furthermore, both nonfinancial and financial performance improves following the implementation of an incentive plan that includes non-financial performance measures.
An incorporation of non-financial measures creates the need to link financial and non-financial
measures of performance. There is a need for a balanced set of measures that provide both short-term
performance pressure and also leading indicators of
future financial performance from current actions.
The balanced scorecard emerged in the 1990s to meet
these requirements.
small European developing market, namely the Athens Stock Exchange (ASE), in its first market-wide
application of the EVA measure [20].
Relative information content tests revealed that
net income and operating income appear to be more
value relevant than EVA. They had an additional motive to examine if the explanatory power of EVA was
enhanced by this shift in the status of the market,
leaving scope for the firm’s managers and outside
investors to adopt it as a performance evaluation
benchmark in the near future. Incremental information
tests suggested that EVA unique components (capital
charge and Stern Stewart & Co. adjustments) add only
marginally to the information content of accounting
profit measures, suggesting that better estimates of the
cost of capital, or the introduction of different accounting adjustments could add significant information content to the EVA measure, and thus they do not
add greater value relevance to the EVA measure.
EVA does not appeared to have a stronger correlation
with firms’ MVA than the other income measures,
suggesting that – for Greek data set – EVA, even
though useful as a performance evaluation tool, need
not necessarily be more correlated with shareholder’s
value than accounting measures of performance.
Although the EVA model in Kyriazis and Anastassis analysis did not seem to have superiority in explaining the stock returns of ASE listed companies, it
was proved to have some explanatory power in relation to the other traditional accounting measures [20].
This may have serious implications for the managers
of Greek listed companies and institutional foreign
and domestic investors, who might want, in the future,
to make their investment decisions on the basis of
economic profit measures, along with the traditional
measures of performance. Kyriazis and Anastassis
consider that, if their results show that EVA has at
least the same explanatory power of stock returns as
the traditional accounting measures of profits, this
leaves scope for the firm’s managers and outside investors (domestic and foreign fund managers) to further develop EVA in a more elaborate way and adopt
it as a performance evaluation benchmark [20].
Clearly, under the EVA approach performance
measurement gains a new meaning in contrast with
the traditional approach, which is merely based on the
simple notions of accounting profits and the relevant
ratios derived from them, as ROE and ROA. The difference is that the traditional performance measurement benchmarks do not consider the cost of invested
capital (equity and debt) in order to generate the profits made by a company. Thus, under the traditional
approach two companies that have the same ROE
would be considered as equally successful, whereas
under the EVA approach the same conclusion could
not be reached if these two firms had a different cost
of capital, that is if their economic profit or RI was
different.
From the view of Stern et al., the adoption of
EVA should lead to a more efficient use of corporate
6.
Conclusions
The most common methods of measuring divisional performance are absolute profits, profit expressed as a percentage of investment (ROI) and residual income. During the 1990s residual income was
replaced by the EVA measure. Under the EVA approach performance measurement gains a new meaning in contrast with the traditional approach, which is
based on accounting profits and the relevant ratios
171
FINANCE ENGINEERING
10.
derived from them. However, the use of EVA, or
simpler residual income measures, as a tool for internal management control requires further empirical
research.
Author’s of this article result show that discounted economic profit for few periods is equal discounted cash flows, i.e. NPV. Thus applying the discounted cash flow (DCF) approach or the economic
profit (EF) approach the value of the company will be
the same given the same projected financial performance.
Financial performance measures cannot stand
alone as a measure of divisional performance. Profitability is only one of the factors contributing to a
company’s objectives. An incorporation of nonfinancial measures, such as competitiveness, product
leadership, productivity, quality, innovation and
flexibility in responding to changes in demand, creates the need to link financial and non-financial
measures of performance. Divisional performance
measurement should be based on a combination of
financial and non-financial measures using the balanced scorecard approach. The financial performance
evaluation measures examined in this article ought to
be seen as one of the elements within the balanced
scorecard.
11.
12.
13.
14.
15.
16.
17.
18.
19.
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