Chapter 16: Financial Performance

Measures and Their Effects – Detailed

Notes
Introduction
 • Organizations must fulfill responsibilities such as product safety, fair employee
treatment, community engagement, and environmental care.
 • They must also cover costs and, if shareholder-owned, maximize shareholder value by
increasing firm value.
 • Investors value companies based on the discounted future net cash flows, where the
discount rate depends on perceived risk.
 • Higher risk → higher discount rate → lower value.
 • Company value increases by boosting expected cash flows or reducing perceived risks
(thus lowering the discount rate).
 • A distinction exists between economic income (based on returns to shareholders) and
accounting income (based on accounting rules), affecting management control.

Market Measures of Performance

 • Market measures are based on stock price changes and dividends paid, capturing
return to shareholders over time.
 • They are the closest proxy for firm value in publicly traded companies.
 • Advantages include timeliness, objectivity, cost-effectiveness, and alignment with
shareholder interests.
 • They are not easily manipulated and offer direct indication of firm value changes.
 • Limitations:
 • - Controllability: Only top executives can influence stock prices, making these
measures inappropriate for evaluating lower-level managers.
 • - External Influences: Stock prices are affected by macroeconomic factors, market
sentiment, politics, and competitor actions.
 • - Expectation vs. Reality: Market prices reflect investor expectations, which may not
materialize. This misalignment can be misleading.
 • - Possibility of manipulation: Executives may try to time disclosures to influence stock
price for stock options.
 • - Market ignorance: Markets can’t value information not publicly disclosed due to
confidentiality (e.g., R&D or layoffs).
 • - Inapplicability to private firms or non-profits: Market values are unavailable for
firms not publicly traded.
Accounting Measures of Performance
 • These are traditionally used to evaluate and reward managerial performance.
 • Two main forms:
 • 1. Residual Measures (Net Income, Operating Profit, EBITDA, Residual Income)
 • 2. Ratio Measures (ROI, ROE, RONA, RAROC)
 • Advantages:
 • - Can be measured timely and precisely based on defined accounting standards (IASB,
FASB).
 • - Auditable and objective.
 • - Align with the profit-maximization goal.
 • - Managers can control them within their authority.
 • - Inexpensive and easy to understand, as they are already required for financial
reporting.
 • Limitations:
 • - Backward-looking, focusing on past performance rather than future value.
 • - Transaction-based: Does not account for value creation unless a transaction occurs.
 • - Sensitive to accounting choices (e.g., depreciation method).
 • - Conservative: Ignores future potential from R&D or brand equity.
 • - Does not include cost of equity, overstating profit.
 • - Ignores risk and future-oriented strategies, discouraging long-term investment.

ROI, ROCE, and ROE – Specific Problems

 • These metrics can discourage investment because adding assets may reduce the ratio
even if the investment is beneficial.
 • They delay recognition of returns (e.g., capital gains) while recognizing investments
immediately.
 • Suboptimization: Managers may reject value-adding projects if it lowers their
divisional ROI.
 • Example:
 • - Division P and Q consider the same project.
 • - Net assets and net income affected differently, causing one division to accept and the
other to reject the investment despite overall benefit to the company.

Residual Income (RI)

 • RI = Net Income – (Cost of Capital × Net Assets)
 • Addresses ROI's limitation by encouraging investment if the return exceeds cost of
capital.
 • Reduces suboptimization, motivating managers to accept all projects that yield returns
above the corporate cost of capital.
 • Also accounts for financing structure by including cost of equity and debt (WACC).
 • Limitations:
 • - Like ROI, RI increases as assets depreciate, not necessarily reflecting improved
performance.
 • - Not comparable across divisions due to scale differences – larger divisions naturally
show higher RI.

Economic Value Added (EVA™)

 • EVA = Adjusted Net Income – (Capital × Cost of Capital)
 • Developed by Stern Stewart to correct distortions from accounting rules.
 • Adjusts net income by capitalizing long-term investments (e.g., R&D, training,
marketing).
 • Encourages forward-looking decisions by spreading expense impact over future
periods.
 • Advantages:
 • - Builds on RI with strategic adjustments.
 • - Reduces investment myopia by rewarding future-oriented spending.
 • Limitations:
 • - Subjective: Requires judgment on what to adjust and how long to capitalize costs.
 • - Complex: Managers may find EVA hard to understand and apply.
 • - Still doesn't fully capture economic income.

📈 Market Measures (e.g., Share Price)

Advantages:

 Aligns manager incentives with overall company/shareholder interests.

 Encourages long-term thinking and strategic decision-making.
 Publicly available and objective — hard to manipulate.
 Promotes cooperation between divisions.

Disadvantages:

 Not controllable at the division level — influenced by external factors (e.g.,

economy, investor sentiment).
 Can feel unfair if a well-performing division isn’t reflected in the company’s share
price.
 Risk of short-term behaviour to influence share price quickly.
 Demotivating for managers who can't see a direct link between their performance
and the reward.

📊 Accounting Measures (e.g., ROI, RI, EVA)

Advantages:
  More directly tied to divisional performance — better controllability.
 Easier to hold managers accountable for what they can influence.
 Encourages efficient use of resources and internal cost control.
 Motivating for managers as they see a clear link between actions and results.

Disadvantages:

 May encourage short-term focus (e.g., cutting investment to boost ROI).

 Can lead to dysfunctional behaviour (e.g., rejecting profitable projects if they lower
ROI).
 May not align fully with overall company goals or shareholder value.
 Susceptible to manipulation through accounting policies.

✅ In Exams – Remember to Mention:

 Controllability
 Goal congruence
 Time horizon (short vs. long-term)
 Motivation
 Risk of manipulation

When rewarding divisional managers, both market and accounting measures

have advantages and disadvantages. Market measures, such as share price,
promote goal congruence by aligning manager incentives with shareholder
interests and encouraging long-term thinking. However, they can be unfair at
the divisional level, since managers often have limited control over the overall
company share price. On the other hand, accounting measures like ROI or
Residual Income are more controllable and better reflect individual division
performance, which can be more motivating. Still, they can lead to short-
termism and may not always align with overall company strategy. A balanced
approach, combining both types of measures, is often the most effective for fair
and strategic performance evaluation.
ROI is a widely used accounting measure to evaluate divisional performance, as
it helps assess how efficiently a division uses its assets to generate profit.
Compared to a market measure like share price, ROI is more controllable,
making it easier to hold managers accountable. However, ROI can sometimes
lead to short-term decisions or rejection of profitable projects that may lower
the ROI. In contrast, market measures align better with long-term shareholder
value but can feel unfair or demotivating if division performance doesn’t
impact share price directly. A mix of both can balance controllability and
strategic focus.
Residual Income (RI) addresses some limitations of ROI by focusing on absolute
profit after deducting the cost of capital. It encourages managers to invest in
projects that generate returns above the company’s required rate of return. RI is
more aligned with overall company value creation than ROI and
is controllable at the divisional level. However, like other accounting measures,
it may still promote a short-term focus. In contrast, market-based rewards
linked to share price promote long-term alignment with shareholders, but lack
divisional fairness. Using RI alongside a market measure can balance individual
accountability with strategic goals.
EVA is a refined version of RI that includes more adjustments to better
reflect economic profit. It promotes value creation by encouraging managers
to focus on returns above the true economic cost of capital. Compared to market
measures, EVA is more accurate for internal performance evaluation, with
stronger links to managerial decisions. However, it can be complex to calculate
and may still drive short-term performance management. Market measures,
while encouraging shareholder alignment, are not controllable at the
divisional level. Therefore, combining EVA with market-based incentives can
support both fair evaluation and strategic alignment.