VALUE-BASED MANAGEMENT - SS 2014
Prof. Dr. Gunther Friedl
Question 2: Relative Performance Measures
ROA is a relative performance measure calculated similar to ROI. In the following
reasoning you can substitute ROI for ROA or any other return on investment ratio.

Manager has incentives to underinvest:
Each new project with a Return on Investment (ROI) smaller than the current ROI
of the company would decrease the whole company’s ROI, even if the project had
a positive NPV and thus should be undertaken.
o Example:
A company’s current projects will result in an estimated ROI of about 20 % in
the next periods because of a constant estimated EBIT of 200 € and average
invested capital (assets) of 1,000 € (which also is relatively constant because
investments in replacements are made almost continuously). The company’s
cost of capital is 10 %.
There exists another project with a positive NPV. Thus, it would be
advantageous for the company’s shareholders to implement the project. The
implementation of the project requires an investment in working capital of 500
€ and will presumably result in an increase of the company’s EBIT of 80 €. This
new project thus has a ROI of 16 %.
The whole company’s ROI therefore will fall from 20 % to 18.67 % (=280/1,500).
If the manager’s performance is measured by the whole company’s ROI, he
thus won’t have an incentive to implement the new project.
Another but similar reasoning: Assume that four projects are available and that
there are enough means to finance all of them. Even if all of them had a positive
NPV and thus should be implemented the manager would only undertake one of
them: the most profitable one. Otherwise, his overall ROI would be only the
weighted average of the most profitable project and the other projects, the latter
being less profitable.

Manager might have incentives to overinvest:
Assume the current ROI of the company is less than its cost of capital. The
manager would have incentives to undertake value-destroying projects (NPV < 0)
as long as their ROI (being smaller than the cost of capital) is above the current
ROI of the company.
All relative performance measures have these potential disadvantages.
Suggested Solution Problem Set 2: EVA calculation
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VALUE-BASED MANAGEMENT - SS 2014
Prof. Dr. Gunther Friedl
Question 3: Calculation of EVA
Some “definitions”:
Invested capital = Total assets – non-interest-bearing liabilities (NIBL)
With NIBL = total current liabilities – short-term debt
Ad on: NIBL are short-term liabilities with zero cost of capital. In the case of
supplier credits this might be questionable. But the financing cost for supplier
credit is already included in the cost of sales.
Invested capital = long-term assets + short-term assets – NIBL
Invested capital = long-term assets + working capital requirement (WCR)
Add on: Sometimes the WCR doesn’t include the whole cash position of the
company but only the “operating cash” (cash hold for operating activities of the
company). The rest of the company’s cash position is called “excess cash” (cash
not necessary for the company’s operating activities). In this case, the excess
cash has to be taken into account separately: Invested capital = long-term
assets + WCR + excess cash.
Example: Company needs 20’ € cash for its operating activities (for example
cash in a supermarket) but has cash worth 50’ €. The WCR includes only the 20’
€ necessary for operating activities. Excess cash = 30’ €.
Calculating the invested capital and the capital charges:
WCR2010 = current assets – NIBL = 700,000 – (600,000 – 50,000) = 150,000
Inv. capital2010 = long-term assets + WCR = 900,000 + 150,000 = 1,050,000
Inv. capital2011 = total assets – NIBL = 1,800,000 – (660,000 – 80,000) = 1,220,000
Average inv. capital = (1,050,000 + 1,220,000)/2 = 1,135,000
Capital charges = 10 % ∙ 1,135,000 = 113,500
Suggested Solution Problem Set 2: EVA calculation
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VALUE-BASED MANAGEMENT - SS 2014
Calculating NOPAT and EVA:
Prof. Dr. Gunther Friedl
Operating income
+ interest income
– provision for income taxes
– tax shield (= 37,800 ∙ 0.35)
= NOPAT
– capital charges
= EVA
294,000
+ 1,800
– 90,300
– 13,230
192,270
113,500
78,770
Question 4: Calculation of EVA: Pfizer
Calculation of the average invested capital:
Invested capital = total assets – NIBL
= total assets – (total current liabilities – short-term debt)
Total assets
- Total current liabilities
+ Short-term debt
= Invested capital
Average invested
capital (2011/2012)
2011
2012
188,002
185,798
- 28,909
- 29,186
+ 4,016
+ 6,424
= 163,109
= 163,036
163,109 + 163,036
= 163,027.5
2
Average invested
capital (2012/2013)
2013
172,101
- 23,366
+ 6,027
= 154,762
163,036 + 154,762
= 158,899
2
Calculation of NOPAT 2010 and 2011:
Total revenues
- Cost of Sales
- Research and development
- General and administrative
Operating income
+ Interest income
- Provision for income taxes
- Tax shield **
NOPAT
2012
54,657
9,821
7,482
- 15,171
= 22,183
+
382
2,221
301
= 20,043
2013
51,584
- 9,586
- 6,678
- 14,355
= 20,965
+
403
- 4,306
- 387
= 16,675
** Effective tax rate (2012):
Provision for income taxes
2,221
=
= 19.76%
Income before income taxes 11,242
.
Suggested Solution Problem Set 2: EVA calculation
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VALUE-BASED MANAGEMENT - SS 2014
Effective tax rate (2013):
Prof. Dr. Gunther Friedl
4,306
= 27.40%
15,716
Tax shield (2012) = interest expense x effective tax rate = 1.522 x 0,1976 = 301
Tax shield (2013) = 1.414 x 0,2740 = 387
Calculation of the EVA:
EVA (2010)
= NOPAT – capital charges
= NOPAT - WACC x average invested capital
= 20,043 – 0.09 x 163,072.5 = 5,366
EVA (2011)
= 16,675– 0.09 x 158,899= 2,374
Question 5: Tax shield
Operating income
+ Interest income
- Provision for taxes on income
- Tax shield
(If not already included in operating income)
(The provision for taxes on income is influenced
by debt financing. Under full equity financing the
taxes to be paid would be higher by the amount
of the tax shield.)
The influence of debt financing on the income
taxes is neutralized.
= NOPAT
The NOPAT is independent of the company’s
capital structure.
- WACC ∙ invested capital
The tax shield is generally taken into account for
in the WACC (see the definition below).
= EVA
WACC 
S
B
 rS 
 rB  1 TC 
S B
SB
S = market value of equity (stock)
B = market value of debt (bonds)
rS = cost of equity
rB = cost of debt
TC = corporate tax rate
Suggested Solution Problem Set 2: EVA calculation
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VALUE-BASED MANAGEMENT - SS 2014
Prof. Dr. Gunther Friedl
Invested capital * WACC
B
 S

 S  B   
 rS 
 rB  1  TC 
S B
S  B

B
 S

 S  B   
 rS 
 rB   B  rB  TC
S B 
S  B
Tax shield
Note: for invested capital we assume market values = book values
► When the after tax cost of debt is used in the WACC (usual approach), the tax
shield has to be subtracted from operating income like it is done above. The
effect of debt-financing on taxes is neutralized for NOPAT but taken into account
when calculating the capital charges.
S
B
 rS 
 rB ,
S B
SB
the tax shield must not be subtracted from operating income to get the EVA.]
[However, when the WACC is defined pre-tax, thus WACC 
[Attention: This question and its solution aims at getting the idea/role of the tax
shield when calculating EVA. The formula-based part of the solution can be
criticized and is not totally correct in general. This is because defining invested
capital as equal to (S+B), the market values of equity and debt, assumes that the
market values equal the book values. This is generally not the case, at least not for
equity. This is a conceptual problem of the EVA concept. It is discussed in the
scientific literature as well as in practice, whether one should use book values or
market values for invested capital. It is also discussed whether one should use the
WACC as cost of capital or a higher interest rate or the risk-free interest rate. But, to
my best knowledge, there exists no unique result so far for both problems (maybe it
never will) which takes into account every aspect of residual income used as
performance measure in practice.]
Suggested Solution Problem Set 2: EVA calculation
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