Finance and Accounting elective / SBWL Controlling Wintersemester 2012/ 2013 Exam Value-based Management Feb. 21, 2013 EXAM

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1 TECHNISCHE UNIVERSITÄT MÜNCHEN Fakultät für Wirtschaftswissenschaften Lehrstuhl für Betriebswirtschaftslehre - Controlling Prof. Dr. Gunther Friedl Finance and Accounting elective / SBWL Controlling Wintersemester 2012/ 2013 Exam Value-based Management EXAM The exam consists of 4 questions (5 pages of problems plus cover sheet - printed duplex), all of which must be answered.

2 page 1 1 EVA and free cash flow (30) The following information about a company is available: BALANCE SHEET In million, as of Dec 31 ASSETS Current assets Cash and cash equivalents Accounts receivable (trade) net Inventories Total 1,600 1,800 2,050 Noncurrent assets Intangible assets Property, plant, and equipment 2,900 3,000 2,600 Financial assets Noncurrent securities Total 3,400 3,500 3,050 TOTAL ASSETS 5,000 5,300 5,100 LIABILITIES AND EQUITY Current liabilities Short-term debt Trade accounts payable Accrued expenses Total Long-term liabilities Long-term debt Other noncurrent liabilities Total 1,350 1,370 1,450 Shareholders equity Subscribed capital Capital reserves Retained earnings 2,410 2,720 2,310 Total 3,010 3,370 3,010 TOTAL LIABILITIES AND EQUITY 5,000 5,300 5,100

3 page 2 INCOME STATEMENT In million, Jan 1 to Dec Sales 6, , Cost of Sales 4, , Selling, general and administrative Research and development Operating income Interest expense Income before taxes Provision for income taxes Net income Additional information: Corporate tax rate 35.00% 35.00% WACC 10.00% 10.00% Capital expenditures Depreciation and amortization 1, , Calculate the company s EVA in 2011 and No adjustments are to be made. State the steps of your calculation. (14) 1.2 Calculate the company s free cash flow in 2011 and Do this by starting with operating income. (9) (Hint: working capital requirement needs to be calculated for 2010, 2011 and 2012; for the calculation of WCR, assume that all cash and cash equivalents are operating cash.) 1.3 Why is the EVA a value-based performance measure? In your answer, please refer to the link between EVA and free cash flow. (7)

4 page 3 2 Ratio and DuPont analysis, relative performance measures (30) Use the information given in problem What is the company s EBIT in 2011 and 2012? (Hint: No calculation necessary.). (2) 2.2 Provide the formula for operating margin and profit margin. Calculate the company s operating margin and profit margin for 2011 and What development can you observe? (6) 2.3 Provide the formula for pre-tax ROA and pre-tax ROE. Calculate the company s pretax ROA and pre-tax ROE for 2011 and By what ratio do ROA and ROE differ? (In other words: ROA * [ratio?] = ROE; provide a definition of this ratio, its calculation is not required) (6) 2.4 Decompose the 2011 and 2012 ROA into a profitability and an activity ratio. Provide the formula as well as the values of both ratios for both years. How are these two ratios called? Which one of the two ratios is responsible for the change in ROA? What recommendations can you draw from this analysis? (6) 2.5 When value-creating decisions need to be incentivized, using relative numbers like ROA or ROE as performance measures for top management can cause underinvestment as well as overinvestment. Explain why underinvestment can occur. Use an example to illustrate your argumentation. (10)

5 page 4 3 Management compensation and bonus bank (30) The annual compensation of the manager of one of your company s numerous divisions consists of a fixed salary of 200,000, an EVA-based annual bonus and stock options on the company s stock. The average fixed salary of the peer group is 180,000. The annual value of the stock option grant is competitive. The options can be exercised after a period of 4 years. If the manager leaves the company earlier, the options are forfeited. The bonus is tied to the manager s business unit s EVA performance. Assume the target bonus equals 60% of base salary, which is usual in the market. If the manager achieves exactly the constant annual target EVA performance of 2 mio., he will earn the target bonus. Otherwise, the bonus earned is calculated proportional to the percentage of target achievement. The bonus is supposed to be paid out in three equal tranches over three years. Thus, one third of the bonus earned is paid out in the same year. The rest is to be paid out over the next two years. This holds for a positive as well as for a negative bonus earned. If the total calculated bonus is positive, it is always paid out, regardless of the bonus bank balance after payout. To avoid retention problems and because a negative payout cannot be implemented in reality, a possibly negative bonus is not paid out immediately, but it will be offset against a positive bonus in the next period. The value of the bonus bank can be negative, the bonus bank balance is not capped in any direction. No interest is provided on the bonus bank balance. If the manager leaves the company the bonus bank balance is forfeited. 3.1 Analyze: the structure of this compensation schedule and the design of the implemented bonus bank by using the four main objectives of management compensation as relevant criteria. In your answer, differ clearly between features of the compensation schedule and features of the bonus bank (16). 3.2 Calculate the annual bonus payments the manager will receive in the years as well as the value of the bonus bank after the annual payout has been made. (9) Year Actual EVA in EUR 2,500,000-2,000,000 3,000, Answer the following questions without any calculations: Why is the implemented bonus payout rule from above not consistent with the net present value rule? How could you easily alter the bonus payout rule to make it consistent with the net present value rule? Why is net present value consistency important? (5)

6 page 5 4 Residual income and the option to wait (30) Suppose a risk-neutral firm has the opportunity to invest a fixed budget of b = 484 in an investment project. The project can either be implemented immediately in t = 0 or postponed for one period and undertaken in t = 1. If the firm decides to invest in t = 0, the project will yield a cash flow of c! = at date t = 1 with certainty. If the firm does not invest in t = 0 and waits one period, the firm has the option to invest the same amount in the project at date t = 1, which will yield a cash flow in t = 2. But waiting to invest in the second period is risky because the environmental conditions will change. At t = 0, the firm only knows the probability distribution of the project s cash returns if implemented in t = 1. The cash flows will equal c! = 968 with probability p or c! = 374 with probability (1 p). The firm learns the true realization of c!, before investing at t = Depending on the probability p, in which case would the firm invest right away in t = 0 or find it advantageous to wait one period to postpone the investment decision? The firm discounts future cash flows with an interest rate r = 10%. (10) 4.2 From now on suppose that the owners of the firm delegate the investment decision to a manager. The information about the project s cash flows as described above is only available to the manager. The manager is compensated on the basis of residual income to align his interests with those of the owners. The manager s time preferences are represented by the interest rate r!. Calculate residual income at t = 1 (when the project is undertaken in t = 0) and the expected residual income at t = 2 (when the implementation decision is postponed). Assume that residual income is calculated by only capitalizing and depreciating the investment outlays b and not taking into account the value of the option to wait. Show that goal congruence between the manager and the owners is only achieved, if r! = r. What would be the consequence if the manager s interest rate r! was higher than the owners, i.e. r! > r? (14) 4.3 What kind of modifications would you suggest in order to motivate the manager to make value-maximizing investment decisions even in the case of waiting options? (6)