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    GOTHENBURG STUDIESIN FINANCIAL ECONOMICS

    971214

    VALUE BASED MANAGEMENT:

    Economic Value Added or Cash Value Added?

    byFredrik Weissenrieder

    Department of EconomicsGothenburg University

    andConsultant within Value Based Management

    Anelda ABV. Hamngatan 20

    S-411 17 GteborgSweden

    STUDY NO 1997:3

    VALUE BASED MANAGEMENT:

    Economic Value Added or Cash Value Added?

    byFredrik Weissenrieder

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    Fredrik Weissenrieder, 1998 http://www.anelda.com2

    VALUE BASED MANAGEMENT:

    Economic Value Added or Cash Value Added?

    by

    Fredrik Weissenrieder

    Table of Content: Page:

    1 Introduction 32 Value Based Management 33 CVA and the concept of Strategic Investments 54 EVA 7

    4.1 EVA's corrections - Do they work in practice? 84.1.1 Not enough adjustments are carried out 94.1.2 Irrelevant issues are discussed 105 EVA instead of Cash Flow? 105.1 EVA at H&M/Wal-Mart 115.1.1 EVA at store no 6 125.1.2 EVA at the parent 135.2 CVA at H&M/Wal-Mart 145.2.1 CVA at store no 6 15

    5.2.2 CVA at the parent 165.3 EVA compared to CVA at H&M/Wal-Mart 175.4 The EVA leverage 206 Completing the "Circular Reference" 226.1 CVA vs. EVA using straight line depreciation 236.2 CVA vs. EVA using annuity depreciation 256.3 CVA vs. EVA, 1st adjustment 276.4 CVA vs. EVA, 2nd adjustment 296.5 Further real analysis of the concepts' capital bases 30

    7 Market Value Added - MVA 338 Conclusion 35

    Appendix 1: What is value? 38

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    Fredrik Weissenrieder, 1998 http://www.anelda.com3

    VALUE BASED MANAGEMENT:Economic Value Added or Cash Value Added?

    1 Introduction

    Corporate managers now face a period where a new economic framework that better reflects value

    and profitability must be implemented in their companies. Accounting systems, which has been usedup until today, are insufficient and will not stand the challenge from the increasingly efficient capitalmarkets and owners. The increased efficiency at the capital markets requires that capital allocationwithin companies become more efficient and it is therefore not possible for companies to in the futureallocate capital as inefficient as they do today. A new economic framework, a Value Based Manage-ment framework that better reflects opportunities and pitfalls, is therefore necessary.

    In my opinion, there are four major frameworks within Value Based Management; Economic ValueAdded (EVA1), Cash Value Added (CVA2), Cash Flow Return on Investments (CFROI), and Share-holder Value Analysis (SVA). A company can chose one of these four for their company's economicframework of the future. The choice will have a substantial effect on management resources, strategychoices, and on how investors, analysts, media, etc view the company.

    This paper will deal with EVA and CVA, the two most frequent concepts in Sweden. Many things arebeing said about the two frameworks. I will in this paper present my reflections on a few similaritiesand differences of the two frameworks.

    In section 2 I will briefly discuss Value Based Management in general. Section 3 discusses the partsof the CVA concept that is necessary for the comparison with EVA. Section 4 discusses the parts ofthe EVA concept that is necessary for the comparison with CVA. Section 4 will also discuss whetherEVA functions as a Value Based Management concept (which is its objective) or just another versionof accounting. Section 5 will discuss the alleged necessity, for technical reasons, of basing a ValueBased Management tool on accounting which EVA does, contra the possibility of basing it directly onCash Flow which CVA does. Section 6 further compares EVA to CVA and it discusses the final cor-rections that are necessary to eventually have EVA become a concept that simulates cash flow. Sec-tion 7 will discuss the Market Value Added concept, and then we have the conclusion in section 8. InAppendix 1 I will discuss a company's concept of value from the shareholders' perspective. All figures,graphs and tables in the paper are my own.

    I will leave out some interesting aspects in order to keep this paper a paper and not a book, e.g. theproblems that we find in accounting's consolidation of multinational corporations, i.e. consolidationeffects from inflation and currency effects, which also influence the quality of EVA.

    2 Value Based Management

    What we use today to follow up a company's profitability and value creation is inconsistent with thecapital market's mechanism, and what the market considers determines value (further explained inAppendix 1). That is why we have what is called Value Based Management (VBM). VBM is what weshould use instead of accounting for internal financial management. Accounting will still be used tocalculate tax and to control the company from the legal perspective. Inside companies, to understandand manage our business, we use VBM. Management, controllers, engineers, and other people in acompany that are in touch with economic issues should never use accounting simply because it doesnot improve the quality of their work3.

    I have in figure 2.1 illustrated a company in what I call the "Company Golf Course". I try to illustratethe company with its two most important frontiers, the one towards its owners (Stock market) and theone towards the company's customers. To the left on the golf course we have the Business Reality,i.e. the activities that actually takes place in reality. We need to manage those activities so that ourowners' value is maximized. We must then be able to bridge the activities at the left, the BusinessReality, to how the market wants us to view it. I believe it is only possible to do that if we simulate("Financial Simulation of Business Reality") the Business Reality using the capital market's mecha-

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    Fredrik Weissenrieder, 1998 http://www.anelda.com4

    nism. We will then obtain relevant knowledge from our financial illustration of Business Reality. Thatwill give us the relevant feedback we need to improve the activities in the company's Business Real-ity.

    The Business Reality's border line towards the capital markets' mechanism (the gray vertical line) caneasily be abused, as accounting abuses it today with the usage of P&L and balance sheets. We thenhave little or no chance of achieving the knowledge that is necessary to manage our company the

    way we should manage it. We will become greatly misinformed if we stand on the border, looking atthe Business Reality using "improper glasses". Our company will be managed by using somethingelse than Value Based Management as the large arrow down to the right, pointing to the left, tries toillustrate (we lose our connection to the stock market). The company's so-called Strategic FeedbackLoop will not function. The Strategic Feedback loop is the continuous evaluation of strategies wherethey are evaluated using information from the strategies to make necessary adjustments in the strat-egy. There seems to be an infinite amount of examples in companies where the Business Reality'sfrontier does not work the way it should and can do, but rare are the examples where the frontierfunctions the way it should and can. The Financial Simulation of the Business Reality must of coursebe based on Discounted Cash Flow as concluded in the appendix

    Figure 2.1; the "Company Golf Course"

    A true VBM framework is consistent with the market's mechanism and our four factors that, accordingto the market, determine value (Appendix 1). It must be simple but correct. In order to further increaseour knowledge about how to increase shareholder value we must be able to simulate, view, and ana-

    lyze our business from this perspective - the Financial Markets' Reality. Our Investor Relation functionshould be used to make sure that the company is priced correctly from the new perspectives VBMgives us. All this can be accomplished by structuring the business reality by e.g. using the BalancedScorecard concept and link this to the relevant VBM framework of our choice.

    CU

    STOMERS

    IntellectualCapitalMarketing

    CustomerLoyalty

    CustomerSatisfaction

    PricingStrategy

    ProductMix

    FlexibilityImprovement

    ProductivityIm rovement

    OperatingEfficiency

    R&D

    OperatingCash Flow

    EconomicLife

    CVA

    Value Drivers

    CapitalCost

    StrategicInvestments

    Pre-strategyValueSimulations

    InvestmentBehavior

    Capital

    Structure

    StrategyValueSimulations

    Value Creation

    CapitalAllocation

    Accounting:Profit/shareP/E-ratios,Re, ROCE,?

    Real O tions

    STOCKMARKET

    Logistics

    SIL

    Business RealityFinancial Simulation of

    Business Reality

    Financial Markets'Reality

    TQM InvestorRelations

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    Fredrik Weissenrieder, 1998 http://www.anelda.com5

    The consulting market contributes four basic frameworks for VBM4: EVA5, CVA6, CFROI7 and SVA8.As I mentioned earlier I will only focus on EVA and CVA in this paper.

    3 CVA and the concept of Strategic Investments

    CVA (Cash Value Added) is a Net Present Value model that periodizes the Net Present Valuecalcu-lation and classifies investments into two categories, Strategic and Non-strategic Investments9. Stra-tegic Investments are those which objective is to create new value for the shareholders, such as ex-pansion, while Non-strategic Investments are the ones