Page 78 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 4: Responsibility Centers

Strategy 3: Withdrawal of Unproductive Capital Notes
1000 of working capital can be liquidated with only a marginal decline of net operating profit
after tax. Net operating profit after tax will fall by just 50. Withdrawing this working capital
would increase the rate of return to 21.67% (2,000 – 50)/(10,000 – 1000) and EVA to 600

EVA = 9000  (0.2167 – 0.150) = 600
Strategy 4: Reduction in the cost of capital
The capital structure of the firm is altered and this change lowers the cost of capital to 13%,
without affecting anything else. As a result, EVA rises from 500 to 700.
EVA = Capital employed  (return on capital – cost of capital) = 10,000 (0.20 – 0.13) = 700
Measuring Net Operating Income after tax (NOPAT) and Capital Employed (CE): Adjustment
for the variation in GAAP
As we have seen, EVA is a function of net operating profit after tax (NOPAT) and capital employed
and weighted cost of capital. The measurement of NOPAT and CE calls for adjusting for the
variation in GAAP.

The accounting profession has worked hard since the early 1970s to make balance sheet and the
income statement reflect the financial position and performance of the firm more accurately. In
spite of such hard work, the General Accepted Accounting Principles (GAAP) have failed to
generate accounting reports that reflect the economic reality. In reality, the association between
accounting data and capital market values suggests that the usefulness of financial reports is
rather limited. The gap between GAAP based accounting information and economic reality
arises from the extreme conservatism followed in accounting practice. Accountants charge all
outlays on intangibles on research and development, market development and employee training
since they follow the principle "provide for all possible losses but anticipate no gains."
The basic reason for the accountants adopting conservatism approach is because early days they
were preparing these statements primarily for the lenders whose perspective is different from
the owners’ and managers’. Security laws have contributed to conservatism. Accountants can be
sued if they overstate earnings or asserts, not if they understate them. Further, regulators have
mandated several conservative rules because of the fear that managers may swindle investors
by exaggerating earnings and assets.
To calculate EVA that is reliable guide to value creation, several adjustments are required to
accounting earnings and accounting book value. The purpose of these adjustments is required to
derive NOPAT figure that reflects economic performance and a capital figure that reflects the
capital contributed by shareholders and lenders.

Stern Stewart has identified more than 160 potential adjustments: These relate to things like:
1. Research and Development: Outlays on R&D are truly investments in future products and
processes. Yet GAAP requires companies to expense out (deduct from earnings) these
outlays, as if they have no valuable payoff in future. For EVA purposes, the R&D outlays
are capitalized and amortized over a period of time that represents the useful life on R&D.
Stern & Stewart normally use an amortization period of 5 years.
2. Strategic investments: Normally, under the EVA system, the capital charge on an
investment is deducted from the time the outlay is made-this injects the required discipline
into investment decision making. Hence, managers may be reluctant to prose a strategic
investment that has a gestation period of few years. During this period, the investment
does not produce any returns but has to bear a capital charge, thereby adversely affecting

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