FM – Nov 2016 – L3 – Q3 – Strategic Performance Measurement

Calculation of EVA for Jack Limited using adjusted financial data and WACC to assess value creation.

Question

Jack Limited is a family-owned business which has grown strongly in the last 50 years. The key objective of the company is to maximize the family’s wealth through their shareholdings. Recently, the directors introduced value-based management, using Economic Value Added (EVA) as the index for measuring performance.

You are provided with the following financial information:

Statement of Profit or Loss and Other Comprehensive Income for the Year Ended December 31, 2015

Item	Amount (₦’million)
Operating profit	340.0
Finance charges	(115.0)
Profit before tax	225.0
Tax at 25%	(56.3)
Profit after tax	168.7

Notes

Description	2015 (₦’m)	2014 (₦’m)
(i) Capital employed – from the Statement of Financial Position	6,285	6,185
(ii) Operating costs: Depreciation	295	285
Provision for doubtful debts	10	2.5
Research and development	60	–
Other non-cash expenses	35	30
Marketing expenses	50	45

Economic depreciation is assessed to be ₦415 in 2015. Economic depreciation includes any appropriate amortization adjustments. In previous years, it can be assumed that economic and accounting depreciation were the same.
Tax: The cash paid in the current year is ₦45 million, with an adjustment of ₦2.5 million for deferred tax provisions. There was no deferred tax balance prior to 2015.
The provision for doubtful debts was ₦22.5 million on the 2015 Statement of Financial Position.
Research and development cost is not capitalized in the accounts. It relates to a new project that will be developed over five years and is expected to be of long-term benefit to the company. The first year of this project is 2015.
The company has been spending heavily on marketing each year to build its brand long-term.
Estimated cost of capital for the company:
- Equity: 16%
- Debt (pre-tax): 5%
Gearing (Debt/Equity) Ratio: 1.5:1

Answer

a)
Calculation of Net Operating Profit After Tax (NOPAT)

Adjusted opening capital employed (AOCE)

 Weighted Average Cost of Capital (WACC)
WACC = (16 × 2/5) + (5 × 3/5× 0.75) = 8.65%
 EVA (Economic Value Added)
EVA = NOPAT – (AOCE × WACC)
= ₦303.75 – (₦6,272.50m × 0.0865) = – ₦238.82 million

Current Position:
- The company is currently destroying value as it is failing to meet the economic cost of its own capital.
- This is an unsustainable position in the long term and will likely lead to shareholder dissatisfaction.
Recommendations to Improve EVA:
- Dispose of Excess Assets: Identify and sell assets that are not critical to operations to reduce capital costs and improve return on invested capital.
- Tighter Expenditure Control: Implement strict cost management strategies to minimize unnecessary expenses.
- Aggressive Sales Drive: Focus on increasing revenue through enhanced sales strategies, improved marketing efforts, and exploring new markets.
- Market Value Added (MVA): Utilize MVA as a supplementary performance measure by calculating the present value of future EVA using WACC.
- Growing Annuity Approach: For the first 10 years with a growth rate of $-2\%$ , employ the growing annuity formula for faster and more accurate analysis.