SBWL Controlling/ Finance and Accounting elective Wintersemester 2011/2012 Exam Value-based Management

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1 TECHNISCHE UNIVERSITÄT MÜNCHEN Fakultät für Wirtschaftswissenschaften Lehrstuhl für Betriebswirtschaftslehre - Controlling Prof. Dr. Gunther Friedl SBWL Controlling/ Finance and Accounting elective Wintersemester 2011/2012 Exam Value-based Management General remarks concerning the exam: The exam consists of 4 questions (6 pages, including the cover sheet), all of which should be answered. You have a total of 120 minutes to answer the questions. The only aids admitted to the exam are a calculator (non-programmable) and a dictionary (German-English, English-German). Any notes found in the dictionary will be considered an attempt to cheat. If necessary, round off the final results to two digits after the decimal point. Do not round off intermediate results. Leaving the auditorium during the exam requires the permission of the teaching assistants. Mobile phones are not permitted in the auditorium. Anyone caught cheating will fail the exam (grade nicht ausreichend (5.0)). Good luck!

2 page 2 1 Calculating EVA and adjustments for performance measurement (42) The following information about a company is available: Balance Sheet as of December 31, 2010 (in thousands of EUR): ASSETS Current assets Cash and cash equivalents 30,000 60,000 Accounts receivable net 180, ,000 Inventories 150, ,000 Other current assets 100, ,000 Total 460, ,000 Property, plant, and equipment Buildings 500, ,000 Machinery and equipment 800, ,000 Total net 1,300, ,000 TOTAL ASSETS 1,760,000 1,710,000 LIABILITIES Current liabilities Short-term debt 50,000 80,000 Trade accounts payable 250, ,000 Accrued expenses 200, ,000 Other current liabilities 1) 180, ,000 Total 680, ,000 Long-term liabilities Long-term debt 370, ,000 Other long-term liabilities 150, ,000 Total 520, ,000 Shareholders equity Common stock 250, ,000 Retained earnings 310, ,000 Total 560, ,000 TOTAL LIABILITIES 1,760,000 1,710,000 1) The position other current liabilities does not include interest-bearing liabilities. R&D expenses (in thousands of EUR): Year R&D expenses 80, , , ,000

3 page 3 Income Statement 2010 (in thousands of EUR): Sales 4,600,000 Cost of Sales 2,800,000 Selling, general and administrative 900,000 Depreciation 440,000 Research and development 100,000 Operating income 360,000 Interest income 2) 5,000 Interest expense 40,000 Income before taxes 325,000 Provision for income taxes 130,000 Net income 195,000 2) Interest income stems from cash and marketable securities held for operating activities. The following additional information is available: Corporate tax rate: 40%, WACC: 10% 1.1 Calculate the company s EVA in No adjustments are to be made. (10) 1.2 To improve the accuracy of the EVA number for the purpose of performance measurement, R&D expenses have to be capitalized and amortized. Suppose that the company uses an amortization pattern over four years of (40%, 30%, 20%, 10%) in years (1, 2, 3, 4). The first depreciation charge is due in the same year as the R&D expense takes place. Please calculate the company s 2010 EVA after adjusting for R&D expenses. (10) 1.3 What would the effects on the company s 2010 NOPAT be if the company was to use a straight-line depreciation pattern instead of the one in 1.2 for their R&D adjustments? Briefly explain the different effects of such a change in depreciation pattern for this particular example. (4) 1.4 The company is financed partly through operating leases. Describe the effect of capitalizing operating leases on EVA. Would the calculated EVA of the above company be higher, lower or just the same when capitalizing the operating leases? Explain the mechanism behind it. [No calculations necessary.] (6) 1.5 Use the information given about the company to calculate the company s cash cycle in 2010 [Hint: Write down the different parts of the cash cycle first and calculate the necessary ratios after that] (8). 1.6 Briefly explain the link between the ratios calculated in 1.5 and the EVA. (4)

4 page 4 2 Implementing value-based management (28) 2.1 Define and discuss the different paradigms of stakeholder value and shareholder value. What are the strengths and weaknesses of both approaches for value-based decision making? (10) 2.2 Companies often use value-based metrics like Economic Value Added (EVA) to implement the goal of value creation within their companies. What are the advantages of using EVA as performance measure compared to (i) stock price, (ii) return-on-investment (ROI), (iii) net income? (10) 2.3 Suppose a large corporation (e.g., GE or Siemens) consists of many different business units. Furthermore, suppose that one of these business units is operating in a not highly cyclical commodity market and the other unit is a high tech business unit. Assuming that both have the exact same capital structure (i.e. the market value of their equity and debt are the same), what differences in the two business units WACC do you expect? Briefly explain your answer. (4) 2.4 In the same situation as in 2.3, suppose that the two described business units share a building and have an equal amount of the building activated as part of their balance sheet. Furthermore, assume that the managers of the company are in regular contact and have some idea about the other manager s cost structure. For this case, name and explain one possible disadvantage of using EVA as basis for management compensation for the two business units executives. (4)

5 page 5 3 Goal congruent performance measures (22) Consider a company that at date t = 0, has to decide about the acceptance of an investment project to launch a certain product. The project needs an initial investment of b at t = 0 and has cash flows θ x t at time t = 1, 2, 3. The vector X = (x 1, x 2, x 3) represents the intertemporal pattern of the future cash flows. The parameter θ fixes the actual magnitude of the cash flows and reflects the market success of the product. The company s cost of capital is r = 1/9. The amount of the initial investment is given by b = 5,000. The vector X of the project is given by X = (1, 2, 1). The magnitude parameter θ can take two different values: θ {1,500; 1,600}. 3.1 Calculate the NPV function dependent on θ. For what values of θ should the project be accepted/ rejected from the company s shareholders perspective? (7) 3.2 Suppose now that the state of the market, θ, is private information to a divisional manager. Company s headquarters only know the vector X. The divisional manager decides about the realization of the project on the basis of his compensation. The manager s compensation is based on residual income in the periods t = 1, 2, 3. For calculating residual income the concept of the relative benefit cost allocation rule is adopted. The weights z t(x) thereby represent the shares of depreciation and interest payments of the initial investment assigned to period t. For each period calculate the weights z t(x), the charges z t(x)*b and the residual income for both possible values of θ. (9) 3.3 Will the manager decide in the interest of the company s shareholders when applying the relative benefit cost allocation rule? Why? Refer to the manager s time preferences. (6)

6 page 6 4 Residual income and the option to wait (28) Suppose a risk-neutral firm has the opportunity to invest a fixed budget of b = 1,180 into 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 1 = 1,628 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 2 = 2,750 with probability p or c 2 = 880 with probability (1 p). The firm learns the true realization of c 2, 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 M. Calculate the residual income of each period for the three possible decisions of the manager (invest in P1, wait and invest in P2, wait and don t invest at all). Assume that residual income is calculated by capitalizing and depreciating the investment outlays b as well as the value of the option to wait. Show that goal congruence between manager and owner is achieved, independently of r M. (18)