Page 77 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes Cost of Capital

Providers of capital i.e., shareholders and lenders want to be suitably compensated for investing
in the capital of the firm. The cost of capital should have the following features:
1. It represents average of the costs of all sources of capital.

2. It is calculated in post-tax terms.
3. It reduces the risk borne by various providers of capital.

Capital Employed

To obtain the capital employed in the business, we have to make adjustments to the ‘accounting’
balance sheet to derive the 'economic book value' balance sheet. These adjustments are meant to
reflect the economic value of assets in place rather than the accounting values as determined by
inherently conservative historical cost-based generally accepted accounting principles.

What Causes EVA to Increase

EVA rises when:

1. The rate of return on existing capital increases because of improvement in operating
performance. This means operating profit increases without infusion of additional capital
in the business.
2. Additional capital is invested in projects that earn a rate of return greater than the cost of
capital.

3. Capital is withdrawn from activities which earn inadequate returns.
4. The cost of capital is lowered by altering the financial strategy.
Numerical illustration of value creating strategies-
Base Case

Capital employed ` 10,000
Net operating profit after tax ` 2000
Cost of capital 15%
Return on capital 20 %
EVA = 10,000 (0.20 – 0.15) = 500
Strategy 1: Improvement in Operating Performance
Net operating profit after tax increase from 2,000 to 2,250, due to greater operating efficiencies.
This rises return to 22.5%. As a result EVA rises to 10,000 (0.225 – 0.15) = 750
Strategy 2: Profitable Investment
A new project requiring 10,000 is expected to earn a return of 18% thereby adding 1800 to Net
Operating profit after tax. This project will increase EVA to 19% (the average of 20% and 18%),
even though the consolidated return will decline.
EVA = Capital employed  (return on capital) =20,000 (0.19 – 0.15) = 800
Note that maximizing EVA is more important, not maximizing return on capital. Hence, the
project should be accepted.

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