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.
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
Calculating NOPAT and EVA: Operating income 294,000
+ interest income + 1,800 – provision for income taxes – 90,300 – tax shield (= 37,800 ∙ 0.35) – 13,230
= NOPAT 192,270
– capital charges 113,500
Question 4: Calculation of EVA: Microsoft Calculation of the average invested capital:
Invested capital = total assets – NIBL
= total assets – (total current liabilities – short-term debt)
2009 2010 2011
Total assets 77,888 86,113 108,704
- Total current liabilities - 27,034 - 26,147 - 28,774
+ Short-term debt + 2,000 + 1,000 0 = Invested capital = 52,854 = 60,966 = 79,930 Average invested capital (2009/2010) Average invested capital (2010/2011)
Calculation of NOPAT 2010 and 2011:
2010 2011
Total revenues 62,484 69,943
- Cost of Sales - 12,395 - 15,577
- Research and development - 8,714 - 9,043
- Sales and marketing - 13,214 - 13,940
- General and administrative - 4,063 - 4,222
Operating income = 24,098 = 27,161
+ Interest income* + 843 + 900
- Provision for income taxes - 6,253 - 4,921
- Tax shield ** - 38 - 52
NOPAT = 18,650 = 23,088
* As mentioned in Problem Set 1, interest income is not directly disclosed in Microsoft’s Annual Report (see Note 3, p. 51). For simplicity reasons we assume that “Dividends and interest income” equals interest income.
** Effective tax rate (2010):
.
Effective tax rate (2011):.
Tax shield (2011) = 295 ∙ 0,1753 = 52
Calculation of the EVA:
EVA (2010) = NOPAT – capital charges
= NOPAT - WACC ∙ average invested capital = 18,650 – 0.09 ∙ 56,910 = 13,528.1
EVA (2011) = 23,088 – 0.09 ∙ 70,448 = 16,747.7
Question 5: Tax shield
Operating income
+ Interest income (If not already included in operating income)
- Provision for taxes on 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.)
- 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
C
B S r 1 T B S B r B S S W A CC S = market value of equity (stock) B = market value of debt (bonds) rS = cost of equity
rB = cost of debt
Invested capital * WACC
S B B C C B ST
r
r
B
S
B
r
B
S
S
T
1
r
B
S
B
r
B
S
S
B
B
S
B
S
Tax shieldNote: 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.
[However, when the WACC is defined pre-tax, thus S rB B S B r B S S W ACC ,
the tax shield must not be subtracted from operating income to get the EVA.] [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
