Influence of Accounting Balance Indicators on Investment Evaluation

Transcription

1 Applied Fiace ad Accoutig Vol. 2, No. 1, February 2016 ISSN E-ISSN Published by Redfame Publishig URL: Ifluece of Accoutig Balace Idicators o Ivestmet Evaluatio Leva Sabauri 1 1 Faculty of Ecoomics ad Busiess, Iv. Javakhishvili Tbilisi State Uiversity, Tbiilsi, Georgia Correspodece: Leva Sabauri, Faculty of Ecoomics ad Busiess, Iv. Javakhishvili Tbilisi State Uiversity, Tbiilsi, Georgia. Received: October 21, 2015 Accepted: November 4, 2015 Available olie: November 17, 2015 doi: /afa.v2i URL: Abstract The work cosiders essetial matters of cash flow retur o ivestmets. The basic of CFROI methodology is the idea of a compay as the itegrity of projects. Those projects have differet momets ad terms of developmet ad effect as well as the various rates of payback. Subject to the goals of the aalysis, they are represeted as a sigle cosolidated project, which geerates cash flows withi the term of useful life of those assets to which the ivestmets are aimed. The CFROI is based o the mai idea to determie the iflatio-adjusted cash flows i favor of every capital ower ad to compare them with the iflatio-adjusted historical ivestmets which have bee put i the busiess i cosideratio of the depreciated cost of o-depreciable assets accordig to the iteral rate. The work focuses o the detailed aalysis of the CFROI compoets. All compoets are cosidered separately ad i coectio with each other that makes the sigle chai determiig the cash rate of retur o ivestmets. Withi the aalysis of cash rate of retur o ivestmets it is importat to determie the duratio of life cycle of strategic ivestmets that is directly related to the establishmet of the average age of the fixed depreciated tagible assets. Whe determiig the average asset age oteworthy is by what formula it will be calculated. Based o the practical examples the work presets the cases of artificial rejuveatio of depreciated assets ad artificial agig of assets. The work also determies the values of total ivestmets ad total cash flows, their effect o calculatio of the cash rate of retur o ivestmets. Parallel with ivestmets ad cash flows there is also cosidered the role of IRR ad MIRR for calculatio of CFROI. Together with the ivestmet model of calculatio there has bee applied calculatio with CFROI coefficiet which is based o the use of data of the ecoomical depreciatio of total ivestmets. Therefore, the operatig cash flows are recurret ad reiterated ad they create the ecessary idea of the profit to be received from a busiess i future. CFROI value is measured o the aual basis. It may be subject to modificatio. Noteworthy is to determie the iteral rate of retur (IRR) of a busiess i the curret coditios. CFROI is of aalytical predictable ature. However, it shall be applied with a particular cautio. I the fial aalysis, the purport of the compay existece is to retur all ivestmets deposited i it ad to receive the adequate reveue which will compesate alterative expeses ad brig profit to the compay. Keywords: CFROI, et preset Value, iteral rate of retur, weighted average cost of capital, depreciable assets, assets life 1. Firm Portfolio Project Basis of CFROI 1 methodology is the cocept of a firm as the collectio of projects. These projects have differet istats ad life of operatio as well as differet levels of profitability. For the purposes of aalysis, they are represeted as oe cumulative project providig geeratio of cash flows durig the useful life of assets, towards which the ivestmet are directed. If we discuss the firm i terms of ivestmet projects, the regular assessmet of their effectiveess shall be coducted by usig such idices as NPV 2 ad IRR 3. Oly such accoutig features as profitability ad ecoomic efficiecy 1 CFROI - Cash Flow Retur o Ivestmet 2 NPV- Net Preset Value 3 IRR - Iteral Rate of Retur 57

2 caot express complete success achieved i implemetatio of such aggregated projects. The oly problem is that we do t have ay iformatio o the ivestmets made ad cash flows but this problem ca be solved through relatively mild trasformatio of fiacial statemet highlights. Based o profit ad loss statemet, the data o cash flows geerated from ivestmet projects portfolio ca be obtaied, ad the balace sheet may provide more or less precise values of ivestmets made i this portfolio. I geeral, this is all what is ecessary for ivestmet aalysis. Thereafter, NPV, IRR, MIRR 4 ad etc. ca be calculated. The oly problem is to defie the discout ad reivestmet rates. Usually, WACC 5 - weighted average cost of capital [1; 3] assumes the role thereof. CFROI CFROI idicator is based o fiacial theory hypothesis that mostly the capital market estimates the compay s ability to provide cash flow geeratio ad represets a peculiar iteral orm of profitability, which is adapted to evaluate the ivestmets made i the compay. It was worked out by HOLT Value Associates. CFROI is based o the basic idea to idetify the cash flows adjusted for iflatio i favor of all capital owers ad compare them to those historical ivestmets adjusted for iflatio, which were made i busiess through iteral orm of profitability, cosiderig the residual value of o-depreciable assets. CFROI model cosists of four compoets: 1) GI Gross ivestmet 2) GCF Gross Cash Flow 3) No Depreciable Assets 4) Assets Life There are two mai methods of CFROI calculatio (they will be discussed below) ad both methods apply the above-metioed compoets. CFROI calculatio stages: 1) Accoutig data through adjustmet will be trasformed ito ecoomic cocepts. The above-metioed four compoets will be determied. They will embody the ivestmet cash flows. 2) Based o the values obtaied, the iteral rate of retur (IRR or adjusted IRR) will be determied. Now, let s discuss the calculatio details of the above-metioed model compoets. 2. Gross Ivestmet Gross ivestmet is the compay s cotributio to assets i the very ivestmet projects portfolio, which we have just discussed above. The gross ivestmet value shall be determied by the sum of et asset value ad accumulated depreciatio. I additio, the obtaied adjusted ecoomic value shall icrease by the iflatio rate applicable upo the momet of asset formatio. So, this is the way to defie the value of capital ivested for the etire existece of the compay. The assets value show o the balace sheet shall be deducted o-debt liabilities. The debt ad liabilities cocepts are uambiguous. Debt is the fuds borrowed, ad liabilities are defied as future "sacrifices" of ecoomic beefits that the etity is presetly obliged to make to other etities. Liabilities arise due to the operatios ad evets occurred i the past. No-debt cotiget liabilities are the liabilities arise due to the reasos other tha the loas, for istace, liabilities imposed by court actios, warraty liabilities, liabilities for evirometal damage. No-debt curret liabilities usually are represeted by accouts payable ad accruals. From a ecoomic poit of view, ivestmets cosist of tagible ad itagible assets. Itagible assets, first of all, iclude goodwill. Sice goodwill udergoes aual impairmet testig i accordace with US GAAP 6 ad IFRS 7, the balace sheet value thereof may be less tha its historical value. I order to obtai the ivestmet value of goodwill, the goodwill impairmet shall be restored for a defiite period i the past. Aual impairmet test is required to establish the fair value of capital ivested i busiess; however, restoratio of impairmet shall apply to log-term physical assets as well. 4 MIRR - Modified Iteral Rate of Retur 5 WACC - Weighted Average Cost of Capital 6 US GAAP Geerally Accepted Accoutig Priciples of the Uited States 7 IFRS - Iteratioal Fiacial Reportig Stadards 58

3 Furthermore, it is required to capitalize the amout of scietific research ad pilot desig works (hereiafter the R&D) o dyamics or withi at least five years sice depreciatio of such works usually occurs durig this time period, however, this is the matter of maagerial accoutig policy adopted withi the orgaizatio. Other expeses, which are realized ot oly durig the curret period but also for a log period of time, may be also capitalized (expeses related to advertisemet, studies ad etc.). Listed above is oly a small part of adjustmets that may be applied to the accoutig provisios. Ay adjustmet applied at EVA 8 calculatio shall be appropriate, amely, adjustmet of deferred taxes, pesio obligatios ad ivetory accoutig methods (if LIFO 9 is applied), elimiatio of profit ad loss through assets owership, removal of distortig revaluatio effects, capitalizatio of reorgaizatio expeses. Oly after elimiatio of curret accoutig errors we ca be sure that the cash flow values of ivested capital ad operatig icome are foud, which allows formatio of profitable compay or determiatio of actual state of the same compay s failure. I additio, the adjustmet must ot be misused. Each adjustmet must be imbued with commo sese ad applied systematically. Otherwise, doubts may appear o purposeful maipulatio of idicators. 2.1 Adjustmet for Iflatio Gross ivestmet value must be brought ito lie with curret-period prices. Book value of assets icreases i cosideratio of the iflatio rate occurred upo the momet of purchase of such assets. It should be take ito accout that adjustmet for iflatio is ecessary ot oly to idetify the exact value of assets by the momet of assets evaluatio but to determie the value of the capital that the ivestors failed to come up with at the momet of capitalizatio [6]. Therefore, it is ecessary to kow the curret purchasig power thereof. If we evaluate ivestmet based o the prices applicable te years ago ad express the operatig cash flow i curret prices, the idicators will be icosistet ad this will promptly affect the results of aalysis. All value idices must be evaluated based o curret prices. 3. Fixed Assets (Gross Plat) Gross plat is the cetral part of gross ivestmet. Property Plat & Equipmet (PP&E) 10 are the fixed assets to be adjusted to curret prices i the first place. Furthermore, the adjusted gross plat may be also icluded i calculatio. No-depreciable log-term assets (lad areas) shall be excluded from gross plat. They shall be icluded i liquidatio value of busiess. Gross plat does t etail itagible assets, goodwill, capitalized leasig ad capitalized costs of R&D. The cocept of gross plat applies agaist o-depreciable assets, deotes the total value of depreciable assets itegratig buildigs ad idustrial equipmet. I order to calculate gross plat, the lad areas, lad improvemet costs (such calculatio may lead to icrease ad capitalizatio of lad value) ad costructio i progress 11 must be excluded from the accoutig article Property Plat & Equipmet (PP&E). 3.1 Asset Life Adjusted Gross Plat = Gross Property Plat & Equipmet (PP&E) Lad & Improvemets Costructio i Progress. (1) Fixed assets are purchased at differet times, ad the operatio life thereof differs. Therefore, the asset life, usually as the average value, shall be determied i a simplified maer. Adjusted Gross Plat shall be divided by Aual Depreciatio, Depletio ad Amortizatio (DDA) Expese [9]: Asset Life = Adjusted Gross Plat / DDA Expese. (2) Of course, the result of such operatio creates oly geeral impressio of busiess lifecycle. Presumably, it may differ from reality as the used assets are replaced with ew oes at the expese of depreciatio fud. But the use of depreciatio fuds withi CFROI cash flow methodology is cosidered for replacemet of assets as a ew ivestmet, i other words, the asset life implies the period durig which they will geerate cash flow util full depreciatio thereof. Asset life ca be calculated by addig the asset age available at the momet ad the period of the remaiig life of assets: Asset Life = Asset Age + Remaiig Life of Assets (3) I additio, the asset age shall be calculated by correlatio of the accumulated depreciatio with the value of aual 8 EVA Ecoomic Value Added 9 LIFO Last I First Out 10 Property Plat & Equipmet (PP&E) the America or Europea balace sheet article; this accoutig article (PP&E) implies Lad, Buildig ad Machiery ad Equipmet. 11 Objects uder costructio do ot participate i the operatig activity ad thus, the value thereof must be excluded from gross ivestmet. I additio, they caot ear profit yet ad thus, o depreciatio must be charged, therefore, they belog to o-depreciable assets. 59

4 depreciatio expese, ad the remaied operatio life shall be calculated by correlatio of the book value of depreciable assets with the value of aual depreciatio expese. Both alteratives must give approximately oe ad the same result as the adjusted value of depreciable assets iclude the book value thereof ad accumulated depreciatio, i other words, these are two alteratives of oe formula. Differece may arise oly due to asymmetric use of adjustmet. The asset maiteace service life shall be determied upo makig ivestmet util full amortizatio thereof. 4. Strategic Ivestmet Lifecycle The life (duratio) of strategic ivestmet maiteace shall be established by differet methods, which depeds o peculiarity of a particular busiess ad applied strategic guidelies. It should ot be hastily determied. This is the subject of detailed ad thorough aalysis. I miig eterprises the ivestmet lifecycle starts upo commecemet of mie works ad eds after depletio of atural resource reserves. Duratio of deposit exploitatio depeds o resource reserves studied ad extractio rates. Util ow these values have t bee fully determied. Duratio of the eterprise performace i most cases may be coected with the estimated period of strategic gross plat operatio, full depreciatio of which will make it impossible to further cotiue busiess. I capital-capacious idustries the restoratio of gross plat oly through depreciatio charges may become problematic due to high cost of equipmet. I order to solve the problems caused by tear-ad-wear, ew ivestmets are to be made, which by the scale ad sigificace may be compared to primary strategic fuds. They may be directed at complete replacemet of equipmet, techical ad techological rearmamet, costructio of ew plats, lauch of ew capacities ad etc. Comig i a ew market, foudig of ew braches, lauch of ew productio lies are typical examples of strategic solutios. Accoutig criteria do t allow givig clear classificatio of the compay s assets ito strategic ad supportig ivestmet. Strategic ivestmet shall be evaluated idepedetly as the geeratig assets. We thik that such approach is ot a particular difficulty; however, it ca be applied oly if a clear uderstadig is developed of the profit eared from the assets capable of geeratio. Curret assets, as metioed above several times, are ot themselves ivestmets. Oly the circulatig capital ca be deemed ivestmet as it is used durig oe year ad makes almost o ifluece o the ivestmet maiteace service life. As already oted, the assets maiteace service life is ofte determied i a simplified maer: Adjusted Gross Plat is divided by Aual Depreciatio, Depletio & Amortizatio (DDA) Expese: Assets Life = Adjusted Gross Plat / Aual DDA Expeses (4) I the first place, differet busiess fields mostly are based o tagible or itagible assets, or eve o ecoomic life of R&D. For example, i computer ad software busiess tagible assets tell us othig about how a compay may maitai viability i a competitive eviromet. All i all, a compay s success ad capability depeds o the expected life of patets ad competitive advatages uder R&D, ew ivetios ad techologies. As soo as the computer geeratio is chaged, the hardware must be chaged as well. I such cases, it is logical to calculate the hardware service life based o the service life of itagible assets ad/or depreciatio thereof, ad the service life of their competitive advatages. Calculatio shall be as reasoable ad correct as possible ad shall cosider all possible disturbig cases. I the secod place, the basic assets shall be take ito cosideratio after they are added with accumulatio depreciatio; however, this shall be effected before adjustmet for iflatio as the depreciatio expeses are accrued o historical value of the give assets. Applicatio of the formula after adjustmet for iflatio may strogly icrease the useful life of assets. I the third place, all o-depreciable articles shall be excluded from the basic assets as they affect ujustified icrease of service life of equipmet ad facilities. 5. Average Age of Assets I order to provide gross capital adjustmet for iflatio, we should kow the age of gross basic assets. It is ot easy to determie the precise age of fixed depreciable tagible assets as o registratio is held i this term; however, approximate evaluatios ca be obtaied. Sice the curret assets are purchased ad used durig oe year, they may be igored. We should oly kow the age of fixed (o-circulatig) assets. The easiest ad maybe the oly simple rule to establish the same is as follows the accumulated depreciatio divided by the curret depreciatio expese [6]: Asset Age = AccumulatedDepreciatio CurretDepreciatioExpese. (5) 60

5 It is clear that the obtaied value may be approximate. If there are o special problems with regard to accumulated depreciatio (depreciatio accumulated as per past ad fully depreciated assets reduces at the write-off), the curret depreciatio expeses require more cautio. This may be the reaso of excessive rejuveatio or excessive agig of assets. Effects thereof are directed ot oly at deomiator but at umerator as well. Accumulated depreciatio is othig else but the sum of past depreciatio expeses as per basic assets still to be writte-off. Here the differeces i approximate service lives of old ad ew equipmet, premises ad facilities play crucial role. The thig is that depreciatio expeses may be the result of high-cost ad small-service-life fixed assets purchased ot so log ago. Mergig of log operatio life of ew equipmet with short operatio life of old equipmet, if compared to real value, will lead us to the icrease of calculated asset age, which will cause artificial agig of assets. Merger of log operatio life of old equipmet with short operatio life of ew equipmet, o the cotrary, will lead us to the reductio of calculated asset age, which will cause artificial rejuveatio of assets. Attetio shall be also devoted to the share of youg assets. The youger is the asset the less service life it has, but such ifluece may have cosiderably less effect o operatio life. Exactly the youg assets affect the value of depreciatio expeses. Table N1 provides the age structure of assets ad real value of average age, also the calculated asset age obtaied o the basis of the above discussed accoutig formula. Fially, assets may tur out youger as the operatio life of youg assets is cosiderably short, subject to which the depreciatio value is icreased. Table 1. Artificial rejuveatio of assets Age Total Iitial value (oe thousad Lari) Useful service life (year) Accumulated depreciatio (oe thousad Lari) Depreciatio expeses, liear method (oe thousad Lari) Residual value (oe thousad Lari) Share of assets as per the iitial value (%) Share of assets as per book value (%) Average asset age (year) 4,9 1,8 0,2 0,1 7 Table 2. Artificial agig of assets Calculated service life Age Total Calculated service life Iitial value (oe thousad Lari) Useful service life (year) Accumulated depreciatio (oe thousad Lari) Depreciatio expeses, liear method (oe thousad Lari) Residual value (oe thousad Lari) ,15 Share of assets as per the iitial value (%) Share of assets as per book value(%) Average asset age (year) 1,8 1,6 0,8 0,2 4,4 Table 2. Provides the iverted situatio. Assets are twice older tha the obsolete assets beig i operatio for smaller period. As a result of such errors, adjustmet for iflatio may have disastrous impact o the compay efficiecy assessmet. Example: if we use the data of the above formula ad "UCNOBI" LTD statemets, by the ed of 2010 the average age of "UCNOBI" assets would make approximately 11,8 years ( / Lari). Book value of the limited liability compay s fixed assets would make Lari by the ed of I such a case, is adjustmet for iflatio eeded? Sice the assets are expressed i real value o the balace sheet, there s o eed to provide adjustmet for iflatio. The problem is that assets devaluatio is permaetly tested. I this coectio it is virtually impossible to determie the iitial values of ivested fuds. However, devaluatios, as a rule, are isigificat (iessetial). Gross calculated asset value alog with the accumulated depreciatio makes Lari. This amout of fixed assets fully icludes the depreciated but operatig fixed assets, total value of which as of 31 December 2010 made ,31 61

6 Lari. Accordig to the above formula, (through depreciatio) oly the age of depreciable assets ca be calculated. The age of o-depreciable fixed assets ca be determied oly accordig to iteral iformatio. If the share of o-depreciable fixed assets is ot large, their age may be igored. But what if o-depreciable assets are the basis of compay s property? I such case, it is ot advisable to determie their age by the above methods. Adjustmet of book value of log-term o-depreciable assets for iflatio is better to be provided separately ad by the use of data o the purchase dates. Fial average age of gross assets shall be determied i cosideratio of depreciable ad o-depreciable asset structure ad age: Asset Age= 6. No-Depreciable Assets o deprfa FA GrossPlat x o-deprfaage+ x GrossPlatAge. (6) This is the part of gross ivestmet, which wears out over the time. At the ed of ivestmet operatio life, o-depreciable assets may be sold. Therefore, at the aalysis of ivestmet activity the residual value of such assets must ot be igored. The residual value may be quite high. No-depreciable assets iclude the lad parcels owed by compay. Accordig to the accoutig rules, depreciatio o such assets shall ot be charged. Furthermore, i CFROI model o-depreciable assets iclude also the cash assets, accouts receivable (other tha the bad requiremets) ad ivetory: 6.1 Residual Asset Value FA No - Depreciatig Assets = Curret Assets - Curret Liabilities + Gross Lad + Other Log Term Assets (7) Salvage asset value equals o-depreciable asset value as theoretically they are maitaied uchaged at the ed of asset operatio life ad may be sold. This of course is a very simple uderstadig. I the first place, the o-depreciable asset prices may be chaged. I ay case, it would be advisable to cosider established treds i the dyamics of price chages o immovable property ad lad parcels. I the secod place, we face certai problems with regard to storage of cash facilities ad tagible assets. Cash facilities, of course, caot be depreciated but they may be spet at ay time. Ad the tagible asset prices are more variable tha the lad parcel prices. Withi the scope of CFROI methodology, such assumptio is applicable that at the ed of depreciable asset service life all o-depreciable assets shall be sold as per their curret value ad shall make the last (liquidatio) cash flow. We have to make aother specificatio: at the ed of asset lifecycle, the busiess salvage value may be positive or egative. Part of the property may be sold ad real moetary compesatio may be received as per the residual value. However, liquidatio of some eterprises may be accompaied with serious expediture related to asset liquidatio, which are dictated by both evirometal ad social cosideratios. Such expediture may be ievitable as executio thereof is prescribed by laws. Therefore, calculatios shall cosider the circumstaces that may occur at closig of busiess. It s very difficult to forecast what the eterprise assets will cost after several decades. Usually, the data of salvage value of fixed assets may be applied, which are determied by accoutats whe recordig them o the balace sheet. 7. Calculatio of Gross Ivestmet Let s summarize everythig related to calculatio of gross ivestmet. Gross ivestmet shall be defied as the sum of capitalized values of o-depreciable assets, accumulated depreciatio, total value of all eterprise depreciable assets, ad all expediture icurred i the past ad curret periods for capitalized operatig leasig ad R&D durig the etire alleged period of utilizatio of assets leased as per applicable iterest rate, mius curret o-debt liabilities: Gross Ivestmet (GI) = Net Asset Value + Accumulated Depreciatio o Asset + Accumulated Goodwill Impairmets + Capitalized R&D + Capitalized Operatig Leasig + Curret Dollar Adjustmet. (8) More complicated alterative is as follows: Gross ivested Capital 62

7 Book Assets + Accumulated Depreciatio + LIFO ivetory Reserve + Capitalized Operatig Leases + Capitalized R&D - Equity Method Ivestmet - Pesio Assets - Goodwill - Deferred Taxes - No-Debt Moetary Liabilities = Gross ivested Capital + Iflatio Adjustmet to Gross Plat = Iflatio Adjusted Gross ivested Capital After all these calculatios, the gross ivestmet value shall be brought ito lie with applicable prices (adjustmet for iflatio). Adjustmet for iflatio ad a umber of other calculatios are arbitrary assessmets, which reduces the level of cofidece i the results. Example: Calculatio of gross ivestmet. Let s discuss the compay, the average asset age of which makes seve years. Its et asset value makes Lari. Asset operatio life icludes 15 years. Assets of Lari are o-depreciable. Accumulated depreciatio durig seve years upo icorporatio of the compay made Lari. I additio, the assets used for operatig leasig are recorded off the balace sheet. Duratio of leasig agreemets makes five years. Lease paymets value equals Lari. Iflatio for the past period is represeted i Table N3. Iflatio factor is calculated by multiplicatio of temporary values of those idicators that have bee formed durig the period from asset formatio util coductio of assessmets. Table 3. Years Iflatio idicator agaist the previous year (for idustrial goods maufacturers) 1,319 1,083 1,177 1,125 1,288 1,134 1,104 Total iflatio idicator durig 7 years , Gross ivestmet may be determied accordig to the followig scheme: GI = ( ) x 3, = Lari Ivestmet start date i the compay may have take place i the distat past. Determiatio of adjustmet for iflatio is ot a difficulty for a youg compay but how to behave whe busiess is 20, 50 or 100 years old? I such case, the adjustmet for iflatio may take us far away. I additio, it s ratioal to cosider oly essetial ad curret ivestmets i busiess developmet, where amog the oldest ivestmet shall be determied by the age of those assets through which the system was set up. However, may ivestmets from the old oes may have lost effectiveess ad have expired useful life. I such case, the age of techological equipmet, facilities ad premises shall be studied ad their value shall be determied by the sale price. 8. Gross Cash Flow Gross cash flow icludes the aual cash assets flow from the mai activity. Such cash flow ca be obtaied permaetly for the period of operatio of assets ad evaluatio of gross cash flow. Gross cash flow shall be determied as the et cash flow from operatig activities after deductio. Cash flow from fiacial activities must t be icluded. Gross cash flow shall be calculated o the basis of et or operatig profit, which shall iclude the depreciatio expese for the give period, other o-moetary costs, operatig lease expese. It is also admitted to deduct o-operatig icome (excludig profits tax). At calculatio o the basis of compay s et profit, where the pesio schemes with fixed payables are used (i other words, whe the compay is resposible for the pesios grated to its former 63

8 employees), the profit shall be also added with the pesio costs ad deducted the pesio service costs. At calculatio the effective iterest rate shall be applied: Or: Gross Cash Flow = Net Icome + DDA + Iterest Expese = Retal Expese + Pesio Costs Pesio Service 9. Calculatio of CFROI Cost + Miority Iterest Gai o Special Items (after tax), (9) Net Icome + Extraordiary Items - Special Items After Tax + Iterest Expese + R&D Expese + Retal Expese Gross Cash Flow + Miority Iterest Expese + Net Pesio Cash Flow Adjustmet + LIFO charge to FIFO Ivetory + Moetary Holdig Gai/Loss - Equity Method Ivestmet Icome = Gross Cash Flow CFROI shall be calculated as the iteral rate of retur (IRR) o the cash flow scheme, where gross ivestmet is made at the iitial stage, ad gross cash flow is added with salvage value of assets (Table N4) [3;5;8]. As is kow, there is o formula for calculatio of IRR. Calculatio shall be usually provided i Excel by BSD support. Table 4. Fial table for CFROI calculatio (Ivestmet Model) Time Period Gross Ivestmet Gross Cash Flow Busiess Salvage Value 0 GI GI Cash Flow Scheme 1 GCF GCF 2 GCF GCF... GCF GCF GCF SV GCF + SV CFROI IRR problem IRR ( io CF i ) Lately, the distrust of IRR has icreased. We may thik that the defects of IRR may be also peculiar to CFROI but this is ot true. CFROI model is characterized by costat cash flow allowace, ad the mai defects of IRR are caused by the set of profitability values arise i case of o-permaet cash flows with variable features. Thus, the give problems do t cocer the CFROI model. The matter of cash flow reivestmet shall be cosidered more carefully. The thig is that IRR implicitly icludes that iterim cash flows are reivested agai i the project ad cause to collect reveue equal to IRR. Actually, the rate accordig to which the project cash flows are reivested may differ from the project iteral rate of retur, especially whe this latter is too high or too low. But it still does ot give us the basis to lose hope. The IRR followers may breathe freely as the problem of gross cash flow reivestmet is subject to solvig. CFROI may be also calculated as MIRR (Modified Iteral Rate of Retur). Usually, the capital value shall be obtaied from the project as the rate of positive iterim cash flow reivestmet. Negative iterim cash flows (outflows) are discouted by the fiacig rate ( safe rate) ad shall be discussed as the part of iitial ivestmet. Accordigly, MIRR will elimiate all the kow defects of IRR. I additio, separatio of 64

9 fiacig ad reivestmet rates is the achievemet itself. Fiacig rate is the value of the firm s capital. It is uderstood that all egative cash outflows shall be compesated i cosideratio of this rate. Reivestmet rate, i fact, may be higher or lower tha fiacig rate. Average or margial rate of corporate ivestmet profitability may be applied, for istace, as the reivestmet rate. Uless cash outflows are ivested, we may pla reivestmet equal to zero. I this sese, MIRR allows to take all the essetial uaces ito accout ad cosiderably expad the possibilities of aalysis. Calculatio of MIRR ca be by the followig formula: MIRR t CashIft.(1 r) t 1 t 0 CashOutt t (1 f ) 1 (10) I theory, it is more accurate determiatio of profitability as i reality cash flows are reivested o the basis of ordiary busiess profitability or at the level of capital value ad ot accordig to iteral rate of retur. CFROI Calculatio of Coefficiet The CFROI value shall be also easily calculated by use of the data o ecoomic depreciatio of gross ivestmet. Moreover, ecoomic depreciatio implies costat cash flow, which allows compesatig the value of assets applied at the expiratio of the project lifecycle (strategic ivestmets made i busiess). The above curret value of cash flow shall equal the curret value of gross depreciated ivestmet by the ed of strategic ivestmet lifecycle [2], i other words, equality must be performed: PV of the Replacemet Cost of the Assets = PV of Ecoomic Depreciatio (11) GrossPlat (1 r) EcoomicDepriciatio r 1 x 1 (1 r). (12) Wherefrom, GrossPlatxr Ecoomic Depreciatio =. ( 1 r) 1 (13) Such liear form of ecoomic depreciatio is obtaied because the costacy of gross cash flow is allowed. The formula shall apply the value of fixed depreciated assets (Gross Plat) adjusted for iflatio i order to ivolve depreciatio i curret prices. Suppose that the gross ivestmet makes 470 millio USD, the residual value of assets equals 120 millio USD, gross depreciated assets total 210 millio USD. Remaied useful service life of assets makes 15 years. The age of assets is 7 years, ad the capital value 7%. Accordigly, the ecoomic depreciatio makes: CFROI shall be calculated by the formula: 2100,07 1,07 1 ED = 4, 3 22 GrossCashFlow EcoomicDepreciatio CFROI = GrosIvestmet. Furthermore, the formula results i the MIRR variety as the cash flow reivestmet is discussed accordig to the 65

10 discout rate used for calculatio of ecoomic depreciatio (usually, this is the average weighted value of capital). CFROI ratio versio is remarkable that it allows the possibility to calculate egative results. IRR caot be determied i case of egative operatig cash flows. I additio, the profitability ratio always shall operate both i positive ad egative diapasos of values. Negative CFROI is a typical evet at the iitial stage of busiess developmet or at developmet of ew market segmets, reorgaizatio ad replacemet of techologies. Furthermore, the ecoomic efficiecy has the capacity to be egative agaist fiacial difficulties, egative tedecy developmet ad solvecy. Calculatio ratio versio is also coveiet as it reflects the expeses icurred o capital ad better provides the cash flow reivestmet possibilities. Example: operatig cash flow makes USD, ad gross ivested capital USD. Service life of gross fixed assets totals 15 years, residual value of assets USD, ad capital expediture ratio makes 10%. Ecoomic depreciatio amouts to 2769, 7 USD x 1 0, ,1. CFROI equals _ 22,8% , For the give case, IRR ad MIRR give errors. Now, we ca move to more serious problem. For the begiig, let s try to clear up the ratio calculatio. Example: the compay s gross assets make 500 millio USD, wherefrom the fixed assets total 250 millio USD, ad o-depreciable fixed assets (lad parcels) equal 45 millio USD. Furthermore, the compay ows cash assets i the amout of 10 millio USD ad easily realizable securities. Stock of materials is evaluated at 25 millio USD. Accordigly, gross o-depreciable assets make 80 millio USD, ad short-term curret liabilities equal 35 millio USD. Net profit made 52 millio USD, aual depreciatio expese 26 millio USD, accumulated depreciatio 185 millio USD, the tax rate prescribed by the Tax Code 24%, ad iterest paymets 7 millio USD. Accordig to the data available o R&D expediture for the past 4 years, the gross value of such expediture made 17 millio USD, capitalized operatig lease 23 millio USD, ad average weighted value of capital 7%. Calculatio of depreciable asset service life (accordig to accumulated depreciatio expese): Fixed assets shall be calculated by the historical value. Gross Plat Age = 185/26 = 7, 11 7 years Suppose that average iflatio rate withi this period made 1,097, i.e. prices icreased by 1,91. Age of lad parcels is te years. After the last revaluatio coducted 5 years ago, prices icreased by 2,2. Thus, the value of depreciated assets adjusted by iflatio ratio makes 744,9 millio USD (( ) x 1,91), ad the value of lad parcels - 99 millio USD (45 x 2,2). Curret assets are ot required to be adjusted by iflatio ratio. Average age of fixed assets: Asset Age = (205/250) x 7,11 + (45/250) x 10 = 7,63 8 years. Gross ivestmet: GI = 744, = 883,9 millio USD Gross cash flow: GCF = x (1 0,24) = 78,76 millio USD Salvage value: SV = =131 millio USD 66

11 Useful service life of depreciable assets (assessmet made based o the age of fixed assets): Alterative 1. Asset Life = ( ) / 26 = 15 years. Determiatio of CFROI Time Period Gross Ivestmet Gross Cash Flow Salvage Value of Busiess Cash Flow Scheme 0 883,9-883,9 1 78,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, ,76 78, , ,76 CFROI (IRR) 4,95% CFROI (MIRR, r=7%, f=7%) 5,97% Alterative 2. Ecoomic depreciatio: ED = GrossPlatxWACC 744,9x0,07 = ( 1WACC ) 1 1,07 15 = 29,6 millio USD. 1 CFROI : CFROI = GrossIvestmet SalvageValue GI = 78,76 29,6 883,9 =5,56 %. All types of CFROI settlemet lead us to differet results. I the give case, the advatage shall be give to the settlemet uder IRR, which equals 4,95%. Whereas, this is i whole the result of profitability for the compay, assumptio about reivestmet as per the rate, which equals the capital value, wo t work. Note: chages caused by iflatio ratio shall be charged oly o the objects of Gross Plat, which is related to the fact that the asset age is calculated based o depreciatio. Ad depreciatio shall be charged oly o log-term assets. Calculatio of age shall ot iclude the capitalized operatig expese ad goodwill, though it was possible to do so. Evaluatio of curret assets shall be provided by FIFO method. Accordigly, the ivetory value shall be evaluated as per the last batch purchase price. 10. CFROI Iterpretatio Thus, the operatig cash flows are repeated ad reiterated, ad therefore, it creates a ecessary impressio of the profit to be obtaied from busiess i future. CFROI value shall be measured per aum. It may be modified or chaged. Uder curret coditios, it s importat to evaluate what kid of iteral rate of retur (IRR) applies to busiess. 67

12 CFROI has a aalytical forecastig ature. This idicator requires special cautio. If the asset operatio life is 50 years, ad accordig to calculatios CFROI makes 18%, this does ot mea that at the closure of busiess its profitability wo t be + 30% or -10%. As practice shows, the operatig cash flow is a ustable value. Busiess coditios may strogly chage ad the forecastig based o the cash flow efficiecy will remai i the past. However, the oly ratioal thig is that withi each period of time it s useful to be aware of your compay s, as the large ivestmet project s profitability. Perhaps, you have plas with regard to busiess developmet ad you ca make a progosis about how the cash flow efficiecy will chage i the earest years, what will be the retur rate (it mostly depeds o realized ivestmet projects). CFROI shows stability of ivestmet reserves. If the stability is low, we have to thik about ivestmet projects with a high NPV. If the profitability margi is high, we have to take all measures to maitai it at the same level. Mostly, it relates to the cocept of total retur of ivestmet formed by the retur of ivestmet itself ad the retur o ivestmets. Fially, the essece of the compay existece is to fully refud the fuds ivested therei ad gai icome i the amout that will cover alterative expese ad brig profit to the compay. Refereces Brad, B., Joier, M., Olse, E. E., Stelter, D., & Xhoeeux, P. (2002). Value Greators Report 2002: A Global Study of How Today's Top Corporatios Ca Geerate Value Tomorrow-Succeed i Ucertai Times. Bosto: Bosto Cosultig Group Report, Damodara, A. (2002). Ivestmet Valuatio (2 d ed.). N.Y: Joh Wiley & Sos. Madde, B. J. (1999). CFROI Valuatio, A Total System Approach to Valuig the Firm. Oxford: Butterworth-Heiema. Madde, B. J. (2000). CFROI Valuatio, Efficiet Markets ad Behavioral Fiace. Oxford: Butterworth-Heiema. www. LeariWhatWorks.com. Madde, B. J. Maximizig Shareholder Value ad The Greater Good (1 st ed.). www. LeariWhatWorks.com. Obrycki, D. J., & Resedes, R. (2001). Ecoomic Margi: The Lik Betwee EVA ad CFROI. The Applied Fiace Group, Ltd. http// Olse E. E., Plaschke, F., & Stelter, D. (2005). Balacig Act: Implemetig a Itegrated Strategy for Value Creatio: The 2005 Value Creators Reports. Bosto Cosultig Group Report. http// ov05.pdf. Rawley, T. (2003). Value Maagemet Past, Preset ad Future. Life Cycle Returs, Ic. Subramaia S., & Berstei, R. (2003). A Aalysis of CFROI//Quatitive Viewpoit, #27. This work is licesed uder a Creative Commos Attributio 3.0 Licese. 68