Author: Patrick Cote,Contributors: Kate McGreevy Julian Critchlow,bc,Corporate Performance Measurement,April 1999,Copyright 1999 Bain Invested capital = All debt equity invested in format at book value; WACC = Weighted average cost of capital ROIC = Return on invested capital = (NOPAT / invested capital) also known as: Return on Net Assets (RONA) or Return on Capital employed (ROCE),EP can be calculated beginning with either profits, NOPAT, or returns, ROIC, depending on the availability of data. The NOPAT method is more commonly used,EP Calculation,Using ROIC,Using NOPAT,EP = NOPAT - Capital Charge,EP = (ROIC - WACC) * Invested Capital,Spread between what is achieved and what is required,Invested Capital * WACC,Discount Rates - Framework,Economic Profit,59,CorporatePerformanceMeasurement,* May be referred to as Return on Capital (ROC) or Return on Investment (ROI),There are two different frames of reference for calculating the “economic value” of any business - analogous to the perspectives used in ROI and ROE analysis,Total Capital Perspective,Equity Capital Perspective,Banks and Shareholders,Shareholders,EP = NOPAT - (Assets x WACC),. the profitability of the business from the frame of reference of the debt and equity holders,. profitability of the business from the frame of reference of the equity holders,Opportunity cost of the (blended) debt and equity capital,Opportunity cost of the equity capital,Profitability is measured as income earned less the opportunity cost of total capital invested,Profitability is measured as income earned less the opportunity cost of equity capital invested,Stakeholder:,EP definition:,Perspective:,. . . given that, what is the frame of reference?,Accordingly:,Performance Measurement Linkages: - Ratio: - EP:,Total Capital Spread = ROA - WACC EP = Total Capital * (ROC-WACC),Equity Capital Spread = ROC - Ke EP = Equity Capital * (ROC-Ke),Return on Assets (ROA)*,Return on Equity (ROE),Key Ratio:,Discount Rates - Two Different Definitions of EP,Economic Profit,60,CorporatePerformanceMeasurement,Discount Rates,Note: * Since invested capital is calculated based on book value of debt + equity, WACC can be calculated for EVA purposes with book value weighting,*Bu = Unlevered Beta = BL 1 + (1 tax rate) (market value of debt market value of equity),Economic Profit,61,CorporatePerformanceMeasurement,EVA and MVA measures differ from other more standard Economic Profit and Market/Book measures primarily due to adjustments to book capital and earnings advocated by Stern/Stewart .,Source: The Quest for Value,Stern Stewarts Stated Objective,Key Adjustments,Make NOPAT a more realistic measure of the actual cash yield from recurring business activities Turn capital into a more accurate measure of the base upon which investors expect returns,Convert from accrual accounting to cash accounting Reserves, deferred taxes Convert from successful efforts to full-cost accounting Cumulative unusual items Do not discriminate between tangible and intangible assets Capitalize R the period-to-period change flows through the income statement,Note: NOPAT is net of depreciation; depreciation is considered a true conomic expense because assets need to be replenished Source: The Quest for Value,Additions to Book Capital: Equity equivalents,Additions to NOPAT: Change in Equity Equivalents,Deferred Tax Reserve LIFO Reserve Other Reserves Cumulative Goodwill Amortisation Unrecorded Goodwill (Net) Capitalised Intangibles Full-Cost Reserve Cumulative Unusual Loss (Gain) after Tax,Increase (decrease) in Reserves,Eliminate Goodwill Amortisation,Increase in (net) capitalised intangibles,Increase in full-cost reserve,Unusual loss (gain) after tax,Non-capitalised leases are capitalised and form debt equivalents; the interest expense is added back to NOPAT,Accounting Adjustments - Stern Stewarts Mechanics,Economic Profit,64,CorporatePerformanceMeasurement,Source: INSEAD,Is it likely to have a material impact on EP? Can managers influence the outcome? Can operating managers understand it? Is the required information relatively easy to track or derive? If the adjustment is made, will manager behaviour improve ?,The following five criteria should be used to determine whether an adjustment should be made,Basic Principle: Eliminate distortions to the extent that it is practical to do so,Economic Profit,Accounting Adjustments - Selection Criteria,65,CorporatePerformanceMeasurement,The following short-cut approach provides a quick means of calculating EP, but does not include the appropriate adjustments,Operating Income (EBIT) +Interest Income +Equity Income (or - equity loss) +Other Investment Income -Cash operating taxes -Tax shield on interest* =Net Operating Profit After Tax (NOPAT) Total Assets -Short-Term Non-Interest Bearing Liabilities (ST NIBL)* =Invested Capital (IC) Average IC = (IC Beginning + IC End) 2 Note: Sometimes IC Beginning, not IC Average used NOPAT -Capital Charges (Average I