Is market value-based residual income a superior performance measure compared to book value-based residual income?

Transcription

1 JUSUS-LIEBIG- UNIVERSIÄ GIESSEN Andreas Bausch / Barbara E. Weißenberger / Marcus Blome Is marke value-based residual income a suerior erformance measure comared o book value-based residual income? Working Paer / 2003 Arbeisaiere Indusrielles Managemen und Conrolling Herausgeber: Professur für Beriebswirschafslehre mi dem Schwerunk Indusrielles Managemen und Conrolling (Prof. Dr. Barbara E. Weißenberger) Jusus-Liebig-Universiä, Gießen h://wiwi.uni-giessen.de/conrolling/ JEL-Classificaion: M40 Vorrag auf dem Kongress der Euroean Accouning Associaion am , in Sevilla, Sanien

2 - - Is marke value-based residual income a suerior erformance measure comared o book value-based residual income? Absrac Wih he increasing use of residual income-based conces of erformance measuremen, significanly differen formulas are roosed for calculaing boh he firm s oeraing rofi as well as is cos of caial. On he one hand, here is he radiional book value-based aroach (EVA), on he oher hand here are marke value-based aroaches, in which eiher only he cos of caial (REVA) or boh cos of caial and he firm s oeraing rofi before ineres (residual economic income, REI) are deermined by using marke values. In our aer, we comare he advanages and disadvanages of hese differen yes of residual income measuremen. Our resuls are he following. Firs, we show ha REVA comared o EVA migh lead o underinvesmen in rojecs wih a sricly osiive ne resen value as well as o overinvesmen in rojecs wih a sricly negaive ne resen value even if rincial and agen discoun a rojec s income sream a he same rae. Second, we show ha a roosiion o base incenives on sricly osiive EVA arges derived from an observed Marke Value Added (MVA) euals he alicaion of a REVA-ye erformance measure and, herefore, migh be affliced wih he same deficiencies. Keywords: Residual Income Measuremen, Economic Value Added, Refined Economic Value Added, Economic Income, Incenives Acknowledgemens: We would like o hank aricians a he 2003 EAA conference in Sevilla (Sain) for helful commens and discussion. We graefully acknowledge financial suor of KPMG Deusche reuhand Gesellschaf mbh and of he Schmalenbach-Gesellschaf für Beriebswirschaf e.v.

3 - - Inroducion In recen years, differen conces of residual income measuremen have been widely discussed wihin he field of value-based managemen in boh academic research and cororae racice. he objecive has been o define a erformance measure ha sricly moivaes an agen o imlemen all available invesmen rojecs wih a non-negaive ne resen value. yical assumions under which hese yes of erformance measuremen are discussed are he exisence of unresriced financial means a a given cos of caial and informaion asymmery beween he rincial and he agen wih regard o he ne resen value of he invesmen rojecs chosen by he agen. Generally, residual income is measured by deducing a caial charge from he firm s rofi. he exac way on how eiher rofi or cos of caial is measured, is no secified a all. he only crucial assumion made in mos cases is ha he sum of accrued earnings measuring he firm s oeraing rofi euals he sum of cash flows from oeraing and financing aciviies. In ha case, Preinreich (937) and Lücke (955) have shown ha he sum of discouned residual income resuling from a given invesmen rojec is eual o he rojec s ne resen value. Conseuenly, residual income measuremen leads o an euivalen rojec choice comared o decision-making based on a rojec cash flows: he value of he discouned residual income sream euals he rojec s ne resen value. Among he many conces of residual income measuremen ha have been discussed in revious years (Bromwich/Walker, 999), he varying use of book values versus marke values in deermining he firm s rofi and/or he caial charge is a sriking difference: book value-based measuremen of boh rofi and caial charge, e.g. Sern Sewar s Economic Value Added (EVA) (see Sewar, 99; Sewar, 994; Sern/Shiely/Ross, 200), book value-based rofi measuremen, marke value-based measuremen of caial charge, e.g. Refined Economic Value Added (REVA) (see Bacidore e al., 997) marke value-based rofi measuremen of boh rofi and caial charge, i.e. residual economic income (REI). In our aer, we analyze he uesion wheher marke-based residual income eiher as REVA or as REI is suerior o he commonly used book-value based aroach (EVA). Our discussion is srucured as follows. In secion 2, we rovide an overview on EVA, REVA and

4 - 2 - REI as differen yes of residual income-based erformance measuremen. In secion 3, we give a deailed analysis on he informaion rovided by hese erformance measures. In secion 4, we focus more closely on he incenive effecs of REVA vs. EVA. We show ha REVA could resul in eiher underinvesmen in rojecs wih a osiive ne resen value or overinvesmen in rojecs wih a negaive ne resen value, boh comared o EVA. In secion 5 we discuss he ossibiliy of using he MVA o derive EVA arges for invesmen ceners. We rove ha wih an infinie horizon hese arges eual he alicaion of REVA. Secion 6 concludes he aer. 2 Residual income-based erformance measuremen Of all aroaches o residual income-based erformance measuremen, Sern Sewar s Economic Value Added (EVA) has gained he mos aenion in economic racice. Is underlying hilosohy is inuiively eviden. Since invesors reuire a reurn as a comensaion for roviding funds and bearing business risk, he firm s oeraing rofi mus exceed he cos of caial o creae wealh for he shareholders. herefore, Sern Sewar defines EVA as NOPA less a caial charge ha reflecs he cos of caial: BV BV ( ) EVA NOPA r I NOPA BV is he ne oeraing rofi afer adjused axes in eriod, r is he cos of caial, usually calculaed as weighed average cos of caial (WACC), and I BV - reresens he firm s gross invesmen (asses) a he beginning of eriod. Boh ne oeraing rofi and he firm s gross invesmen are accouned for based on book values, i.e. I reresens he cash ouflows from a firm s invesmen afer dereciaion and imairmen and NOPA reresens he changes in a firm s euiy including (eniy aroach) he firm s ineres aymens. A srong link can be esablished beween fuure EVAs and he value of he firm by defining he resen value of all fuure EVAs as Marke Value Added (MVA): he sum of book value based invesmen I BV and MVA formally euals he overall marke value of he firm calculaed on an esimaed sream of cash flows. o eliminae various accouning disorions (Sern/Shiely/Ross, 200,. 20) under an EVA regime, in many cases income saemen and balance shee are subjec o various adjusmens in deriving NOPA and Caial, convering he underlying measuremen from a firm s accouning model o he more aroriae economic model. he objecives of hese adjus-

5 - 3 - mens are e.g. o caure all sources of financing (e.g. leases) or o eliminae accouning conservaism (e.g. caializaion of R&D exenses). Alhough fair values are inroduced in some cases boh in rofi measuremen as well as in deermining he level of invesmen, even afer Sern Sewar s accouning adjusmens a subsanial ar of he firm s original goodwill accouning for he difference in book value of he firm s asses and is marke value is usually no included in he invesmen I BV. Criics of Sern Sewar s EVA argue ha he book value-based EVA measuremen framework does no caure he invesors ooruniy coss as EVA does no ake ino accoun ha invesors exec a reurn on he marke value of he firm. If invesors sell he firm for is marke value and inves heir roceeds in asses idenical in risk, hey could exec o earn a reurn eual o he firm s WACC on he firm s overall marke value and no only on he book values of he firm s invesmen shown in he balance shee. Conseuenly, he caial charge has o reflec his ooruniy cos of invesors (Richer/Honold, 2000). Mainly o overcome his shorcoming of EVA, Bacidore e al. (997) have suggesed o relace i by a measure hey named REVA (Refined Economic Value Added). hey define REVA as BV MV ( 2) REVA NOPA r I In comarison o EVA he basis for he caial charge is he marke value of he firm I MV - raher han (adjused) book values I BV - of is asses. Comared o EVA, REVA resuls in a higher caial charge, if he firm s marke value exceeds he adjused book values of is asses, and vice versa. Unil now he REVA aroach has no gained he oulariy of EVA, bu we have knowledge of some comanies alying i successfully. In order o avoid recalculaion of he marke value every year hey freeze he MVA for several years and aler book values according o he invesmens ne of dereciaion underaken during his eriod. Comaring REVA o EVA, REVA has a severe ifall as any changes in marke value I MV - are included ino he caial charge, bu no in a corresonding measure ino he ne oeraing rofi NOPA BV. Only if hese changes are realized in he accouning accruals, e.g. by an imairmen of asses, boh rofi measuremen and caial charge do mach under an REVA regime. his ifall is avoided by residual economic income (REI) as a hird ye of residual income-based erformance measuremen. REI is in conras o EVA and REVA enirely

6 - 4 - based on marke values. Is heoreical foundaion is he conce of economic income (EI) which has been discussed in economic heory for a long ime (Fisher, 906; Hicks, 946). he economic income of a given eriod is defined as he change in euiy value of he firm lus ne cash flows disribued o is shareholders during his eriod. his definiion ensures ha he any changes in a firm s cash flow rofile deermining is overall marke value are caured in a comrehensive way. Deducion a caial charge from economic income hen leads o residual economic income (REI). As in he REVA aroach, he caial charge reflecs invesor s full ooruniy cos, because he caial charge is calculaed on he basis of he marke value of euiy. Summarized, REI is defined as follows: MV MV MV MV ( 3) REI NOPA r I wih NOPA V V + and I V wih V reresening he sum of discouned (free) cash flows a he end of eriod. From a heoreical ex ane ersecive, REI is he bes erformance measure, since i caures all resen and fuure cash flows resuling from managerial aciviies during a given eriod (Hax, 989). Wha makes REI inaroriae for incenive urose is he subjeciviy in calculaion of he firm s marke value in case of non-lised firms. Neverheless, REI consiues he benchmark for our following discussion of residual income conces. 3 Informaion conen of REI, REVA, and EVA In his secion, we discuss he informaion conen of he hree conces of residual income measuremen oulined in he revious secion. In oher words, we formalize in how far a firm s economic eriodic erformance is refleced by hese erformance measures. As indicaed in secion 2, he benchmark soluion is REI, as i is based on economic income and herefore caures all resen and fuure cash flows induced by managerial decisions. Saring wih he analysis of he firm s economic income, i can be exhausively decomosed ino hree effecs: ime effec, invesmen effec, and informaion effec (Laux, 999, ; Neus, 998, ). hese effecs can be illusraed, if he cash flows of any eriod ha is included ino he measuremen of economic income a a given ime is sli ino hree comonens: ( 4) + inv + reresens he cash flows ha have been lanned for in -. inv reresens he cash flows ha resul from new invesmen rojecs ha have been undergone during he eriod,

7 - 5 - and - R is difference beween he lanned cash flows and he realized R cash flows ( 5) EI I MV I MV V + V + ) + )) Euaion (4) ogeher wih (5) can be resaed as (6) EI inv ) ) invesmen effec ) informaion effec ime effec + inv + + )) + Noe ha any change in a firm s marke value can be aribued o one of he hree effecs which are have o be exlored in furher deail. () he ime effec exlains he comonen of economic income, ha simly resuls from he ime elased from he beginning o he end of he eriod. he following examle may illusrae his oin: A firm has a WACC of 0% and consiss of one asse only from which a one ime cash flow of 00 is execed in eriod 3. A he beginning of he eriod he resen value of he firm is 75.3, a he end i is Conseuenly, he economic income is 7.5 in his eriod. I euals exacly he ineres gained on he firm s marke value a he beginning of he eriod, if execaions of fuure cash flows and ineres raes remain unchanged as assumed in our examle. Proosiion: Proof: V + V r V he euaion s lef hand side can easily be resaed so ha he following holds + + ) + ) + + )) ))

8 ) ) V + ( V + ) ( )( V + ) r ( V + ) r V.e.d. + )) ) he conce of ime value of money gives an exlanaion for he ime effec. Since eole normally refer earlier cash flows o laer ones, he siuaion a he end of he eriod is an imrovemen comared o he beginning of his eriod. his imrovemen is idenical o he ineres ha invesors would have gained, if hey had sold he firm for is marke value a he beginning of he eriod and had invesed he roceeds a he caial marke (rovided ha he discoun rae euals he rae of reurn on he caial marke). As he ime effec herefore simly resuls from he marke valuaion rocess, i is no siulaed by he firm s economic aciviies during ha eriod. (2) o define he invesmen effec, we assume ha all managemen decisions have conseuences on resen and fuure cash flows. yically, invesmen decisions resul in an immediae cash ouflow and addiional cash inflows in he same and/or fuure eriods. Economic income increases or decreases by he ne effec of hese cash flows he ne resen value. herefore, we define he comonen of economic income ha is causally relaed o a firm s managerial decision making as he invesmen effec. I may be inerreed as an indicaor for he ualiy of he decisions underaken by he managemen wihin a cerain eriod of ime. (3) In addiion o ure ime elase and managemen decisions, changes of execaions on cash flows. his is called he informaion effec, because i reresens he comonen of economic income ha can be aribued o new or revised informaion abou he firm s rosecs. On closer insecion he informaion effec comrises wo asecs: Firs, economic income resuls from he difference beween execed cash flows for he curren eriod and hose acually realized. Secondly, i reflecs he change of he firm s marke value wihin he eriod as a con-

9 - 7 - seuence of a revised rojecion of fuure cash flows a eriod end due o addiional informaion. he exen o which hese effecs are incororaed in he aroaches o residual income measuremen discussed in he revious secion deends on heir reliance on he marke value of he firm insead of book values of is asses. Since REI is enirely based on he firm s marke value, he ime effec is neuralized in he REI aroach by deducing he caial charge calculaed on a marke value-basis so ha he remaining residual economic income (i.e. REI) is confined o invesmen effec and informaion effec (r V - r I MV -). Eliminaing he ime effec may be inerreed as seing a hurdle ha reflecs he ooruniy coss of invesors: in he absence of any oher effecs, REI is zero if and only if his hurdle is me and hus he invesors ooruniy coss have been realized. If managers underake new invesmen rojecs hey increase or decrease he REI by he NPV of hese new invesmen rojecs, because REI as an enirely marke value-based measure does reflec any change in execaions of fuure cash flows immediaely and fully. Wih resec o eliminaing he ime effec comonen from eriodic income REVA akes invesor s ooruniy coss ino accoun o he same exen as REI does, because in he REVA aroach he caial charge is calculaed on he basis of he firm s marke value as well. Bu due o is hybrid characer (NOPA based on book values, caial charge based on marke value) REVA differs from REI when i comes o a change in execaions abou fuure cash flows of he firm eiher due o new invesmen rojecs or because of new or revised informaion. In boh cases he change in he firm s marke value resuls in a higher or lower caial charge from he following eriod on. In addiion o he imac on he caial charge, REVA is affeced by new invesmen rojecs insofar, as hey have an imac on he curren eriod s NOPA. he imac on NOPA consiss of addiional ne cash flows less dereciaion induced by he new invesmen rojecs. he same holds for new informaion: he imac on he NOPA is confined o he imac his informaion has on cash flows of he curren eriod. hus, informaion ha influences fuure cash flows has imac on curren NOPA only wih regards o imairmens. Boh invesmen effec and informaion effec are herefore incororaed in REVA in a very rudimenary way due o he book value basis in calculaing NOPA. his re-

10 - 8 - suls in a mismach of he hree effecs in REVA: While he ime effec is eliminaed comleely (as an exression of invesor s ooruniy coss), he oher effecs are included in eriodic income only arially. Since NOPA is no only a comonen of REVA bu of EVA as well, he argumen concerning he imac new informaion and addiional invesmens have on NOPA holds for EVA in exac he same manner: informaion effec and invesmen effec influence NOPA only insofar, as he NOPA (cash flows ne of dereciaion) of he curren eriod changes. Bu EVA differs from REVA in calculaing he caial charge by using book values as a calculaion basis insead of marke values, which means ha caial charge in EVA is an incomlee comensaion of he ime effec of economic income. hus, EVA does no incororae he enire ooruniy coss invesor s face when invesing in a firm. 4 Incenive effecs of residual income-based erformance measuremen In secion 3, REI has been characerized as he erformance measure ha caures he conseuences of a firm s eriodic economic erformance regarding managerial rojec imlemenaion in a comrehensive way. Unforunaely, residual income measuremen does no rovide a clear signal on managerial decision-making. More secifically, a osiive (negaive) residual economic income does no indicae wheher rojecs wih osiive (negaive) ne resen value have been imlemened, as he invesmen effec e.g. of a rojec wih osiive ne resen value migh be wholly or a leas arially se of (or reinforced) by a modificaion of execaions on he cash flow rofile of rojecs imlemened in earlier eriods. As he signals of boh invesmen effec and informaion effec can be observed only in a combined way, REI is clearly no suied for managemen incenive uroses under asymmeric informaion wih regards o managerial rojec imlemenaion. his shorcoming is even reinforced if he manager whose economic erformance is o be measured may even influence he execaions on fuure cash flows eiher by giving discreionary signals o he caial markes or by being direcly asked o rovide esimaions on he firm s cash flow rofile. For his reason, in cororae racice managemen comensaion schemes rely usually on book value-based residual income, such as Sern Sewar s EVA. I can easily be shown (see Reichelsein, 997, ha basically EVA leads o a firs bes level of invesmen if unresriced

11 - 9 - financial means are available, i.e. every rojec wih non-negaive NPV is o be imlemened, if rincial and agen use he same discoun rae r o evaluae fuure sreams of income, and if here is no oher source of disuiliy, e.g. some cos of effor, which he agen is subjec o. Proosiion: If he agen can be rovided wih unresriced financial means a a rae r, if rincial and agen use he same discoun rae r o evaluae fuure sreams of income, and if here is no oher source of disuiliy, e.g. some cos of effor, which he agen is subjec o, hen an EVA-based linear incenive scheme leads o he firs-bes level of invesmen. Proof: If he rincial ses he level of invesmen I* in 0 we have max wih ( + r) and wih wih x I x ( I ) and ( I ) > 0, x' ( I ) and x" ( I ) x '( I*) < 0 If he agen ses he level of invesmen I* in 0 based on EVA wih EVA x ( ) I ab I r wih ab being he dereciaion rae and wih ab I ab we have max EVA ( ) max x I ab I r x ' x ' EVA ( I ) ab r EVA ( I ) ab + r ab! 0 ab As Preinreich (937) and Lücke (955) have shown ha ab I

12 - 0 - ab + r if ab ab his can be resaed as x ' EVA ( I ) x '( I *).e.d. Even hough EVA leads o he firs-bes invesmen level, several auhors (Baciodore e al., 997, Richer/Honold, 2000) criicize ha he book value-based caial charge deduced from NOPA under an EVA regime does no reflec he invesors ooruniy coss which have o be calculaed on a marke value basis. he reasoning behind his argumen is he following: Invesors could sell he firm a any oin of ime and inves heir roceeds in he caial marke. In his case hey could exec a reurn on he marke value of he firm and no on he book values only as he EVA aroach assumes imlicily when calculaing he caial charge on he book value of he firm s asses. herefore, EVA does no reflec he full ooruniy coss invesors face when invesing heir funds in he firm. In addiion o his argumen o be found in economic lieraure, mainly racicioners argue ha EVA does lack comarabiliy in case of idenical businesses wih differen book values of heir resecive invesmens. For examle, a firm consiss of wo divisions idenical wih resec o fuure cash flows: one owns a new lan and machinery while he oher has an old lan and machinery. Due o differences in he asses book value he EVA of hese divisions varies significanly. his would cause roblems in measuring and judging he erformance of hese wo divisions and heir managemen for comarison urose. Anoher examle would be a difference beween divisions wih resec o he inernal vs. exernal growh sraegies in he as. As a conseuence of exernal growh in he as acuired goodwill is ar of he caial in hese division while oher divisions alhough yielding he same fuure cash flows have a small asse base. hus, he EVAs of he division wihou acuired goodwill exceeds he EVA of oher divisions due o a lower caial charge. he REVA aroach of residual income seems o rovide an elegan soluion for boh asecs menioned: Calculaing he caial charge on a marke value-basis caures invesor s ooruniy coss correcly and i uncoules he caial charge from he age of a division s asses and from he exen o which acuired goodwill is ar of he division s asses.

13 - - As a conseuence of using REVA as a measure for eriodic erformance and as a basis for managemen comensaion, managers are romed o judge new rojecs by he effec hese rojecs have on REVA. I will be illusraed below, ha using REVA as a erformance measure insead of EVA does no lead o a firs bes level of invesmen: REVA could induce managers o arove value desrucing invesmen rojecs on he one hand, and i could reven hem from invesing in value creaing rojecs on he oher hand. Conseuenly, REVA lacks suerioriy in comarison o EVA when i comes o moivaing managers o imlemen all available invesmen rojecs wih osiive ne resen value only. he dysfuncional effecs of a REVA regime can easily be seen if he condiion for he oimal invesmen level I REVA is derived which is (7) wih (8) max REVA max x ( I ) ab I r REVA ( I ) REVA ( x '( I ) r x ' ab + r x '( I ab x '( I REVA ) r REVA )) ab + r ) x '( I )) REVA x '( I ) )) REVA r ) )) ab x ( I)! + r )) 0 ab ab Condiion (8) shows ha he oimal level of invesmen under REVA / EVA differs deending on he caial charge ha is calculaed. here may be rojecs wih a negaive ne resen value in which he reduced caial charge offses he lower cash flow rofile so ha he sum of discouned REVA is osiive whereas he rojec s ne resen value is negaive. On he oher hand, rojecs wih a osiive ne resen value may be allocaed an overraed caial charge under a REVA regime which offses he high cash flow rofile so ha he sum of discouned REVA is negaive. hese effecs will be illusraed by he following examles. he examle shows wo invesmen rojecs (A, see Exhibi, and B, see Exhibi 2) wih a necessary cash oulay of in eriod 0 for each rojec.

14 Invesmen -236,25 Book Value 236,25 89,00 4,75 94,50 47,25 0,00 O 6,74 6,74 6,74 67,44 67,44 Dereciaion -47,25-47,25-47,25-47,25-47,25 NOPA -30,5-30,5-30,5 20,9 20,9 Caial Charge (BV) 23,63 8,90 4,8 9,45 4,73 EVA 0,00-54,3-49,4-44,68 0,74 5,47 Discouned EVA (MVA) 23,72 80,22 37,65 96,0 04,97 0,00 Economic Income 23,72 26,00 26,92 27,94 29,06 5,22 Economic Caial Charge 0,00 26,00 26,92 27,94 29,06 5,22 REI 23,72 0,00 0,00 0,00 0,00 0,00 REVA -56,50-57,43-58,45 9,3 04,97 Discouned REVA -5,32 39,65 0,05 69,60 95,43 0,00 Exhibi (Projec A) While rojec A has a slighly osiive MVA, i.e. ne resen value of 23.75, B has a negaive MVA, i.e. ne resen value of Obviously, from a shareholder s oin of view, managers should arove rojec A and rejec rojec B Invesmen -236,25 Book Value 236,25 89,00 4,75 94,50 47,25 0,00 O 7,2 7,2 6,74 6,74,67 Dereciaion -47,25-47,25-47,25-47,25-47,25 NOPA 69,96 69,96-30,5-30,5-45,58 Caial Charge (BV) 23,63 8,90 4,8 9,45 4,73 EVA 0,00 46,33 5,06-44,68-39,96-50,30 Discouned EVA (MVA) -7,77-54,89 -,43-77,89-45,73 0,00 Economic Income -7,77 22,85 3,4 3,03,66 0,5 Economic Caial Charge 0,00 22,85 3,4 3,03,66 0,5 REI -7,77 0,00 0,00 0,00 0,00 0,00 REVA 47, 56,55-33,54-32,7-45,73 Discouned REVA 4,00-3,7-9,43-67,03-4,57 0,00 Exhibi 2 (Projec B) If REVA is used for managemen comensaion, exacly he oosie would haen: Due o a discouned REVA of 5.32 regarding A and of 4,00 regarding B managers would rejec he value-creaing rojec A and underake rojec B resuling in a shareholder wealh desrucion oalling his means ha a REVA-based comensaion scheme does no ensure ha managers imlemen all value creaing invesmen rojecs and rejec invesmens. 5 EVA arges: Reconciling EVA wih REVA In is basic inerreaion, erformance measuremen under an EVA regime decoules he budgeing rocess from comensaion when he incenive sysem ays managers o generae

15 - 3 - an indefinie bu osiive EVA. However, EVA-based incenive rograms of mos comanies ay managers no only o generae a osiive EVA bu also for imrovemens in EVA. In he firs case, an incenive aymen is earned only if a eriod s observed EVA is osiive. his migh reven manager-agens o imlemen rojecs wih an overall osiive ne resen value if he firs eriods EVA are negaive, e.g. because of high invesmens inducing a high caial charge and low income, and if he agen discouns he sream of EVAs wih a higher discoun rae han he rincial, i.e. if he agen akes a myoic ersecive comared o he rincial I has been formally shown (Baldenius/Fuhrmann/Reichelsein, 999), ha ( 9) + EVA r + EVA herefore, he sum of discouned changes in EVA ( EVA) is roorionae wih he sricly osiive facor r - o he sum of discouned EVA reresening a rojec s ne resen value. his alleviaes he roblem of he myoic agens bu does no lead o a firs bes-level of invesmen. For comanies ha imlemen such kind of comensaion scheme, i is necessary o define execed EVA imrovemens in erms of EVA arges. I has urned ou ha a roer seing of hose execed EVA imrovemens is vial for a successful imlemenaion of EVAbased comensaion lans aricularly in muli-business enerrises. he division erformance in creaing value conribuions (on one side) and he incenive which is finally rewarded according o he achievemens (on he oher side) have o be linked deending on he aricular condiions of he resecive line of business. Esecially because of differing curren EVA levels and/or indusry feaures, an aroriae assessmen of erformance is also always a maer of comaring several oucomes in consideraion of he underlying business characerisics. As a case in oin, i is obvious ha he lower he curren EVA level of a aricular business uni is, he higher are oenial EVA imrovemens, ceeris aribus. In oher words, divisional managemen could enhance heir rosecs for imrovemens jus by reducing he curren EVA as comensaion reference for EVA imrovemens (known as big-bah-accouning ). Furhermore, a comany-wide definiion of EVA arges in a muli-indusry enerrise has o be aware of ossibly varying marke growh ooruniies in differen indusries, since hey deermine EVA growh rosecs fundamenally.

16 - 4 - In he alicaion of he described comensaion aroach, he issue for any comany is how o deermine a fair EVA imrovemen rae used as comensaion base in a given conex. Privaely owned comanies given, one aroach is o conduc benchmarking sudies o idenify he oenial of imrovemens by comaring is resuls on a series of measures wih hose of eers. In conras, he way erformance sandards are esablished in ublicly raded comanies is influenced by he fac ha sock rices are driven by execaions. he euiy value of a given sock can be seen as he resen value of all fuure cash flows o euiy as hey are execed by he marke. Conceually, he relaion beween euiy value and cash flows o euiy exiss also in he EVA aroach. I can be shown ha he resen value of all fuure EVAs euals he MVA ha rovides a resen value measure of wealh creaed for invesors and reresens he difference beween he marke value of a firm and is book value. Conseuenly, shareholders execed EVA imrovemens are imounded in he comany s share rice. Which level of EVAs and, hus, which magniude of imrovemen would be necessary o ulimaely jusify he curren marke value of a firm? Le us assume ha MVA can be comued as (0) MVA EVA + ) > 0 In a ereuiy model MVA reresens he marke execaions of a consan sream of fuure EVAs* wih EVA* ( ) MVA r Exhibi 3 rovides an examle in which he conjuncion beween MVA and EVA* is shown, assuming a sock-lised division. he examle shows in he firs column, ha here is a consan sream of EVAs reuired (EVA* 00) o ursue oday s imlici execaions of he sock marke. Since he curren EVA is assumed o be 0, he necessary EVA imrovemen is 00 in order o maerialize he given execaions. A marke value oriened comensaion lan would arge a corresonding EVA imrovemen. Now suose he division managemen could re-deloy he 000 in caial and an execed fuure growh oenial of he invesmen would cause he marke value o go o 3000.

17 - 5 - oday Immediaely afer Invesmen Book Value of Euiy Marke Value of Euiy MVA Curren EVA 0 0 EVA* (WACC 0%) Exhibi 3: EVA/MVA Pereuiy Model In Exhibi 3, he second column shows he imac on MVA and EVA*. If EVA* were used as a basis for comensaion uroses, he invesmen would no be aken because i would rise he EVA arge o 200. In fac, he conrary effec would exis ha he more valuable he business idea, he higher he marke value would rise and he higher he EVA arges would become. In oher words, managers would avoid sysemaically an engagemen in highly valued rojecs. hus, if EVA* is used as arge rofi in invesmen ceners, i could resul in a relicaion of REVA wih all is unforunae conseuences. I can be shown in general ha an EVA-oriened comensaion which is focused on share rice-based execaions is euivalen o a REVA-oriened comensaion lan, verified below. Proosiion: Deriving EVA arges from a firm s observed marke value is euivalen o a REVA erformance measuremen regime. Proof: Deriving EVA arges imlies according o condiions (0) and () NOPA r I NOPA r I! EVA EVA* BV BV r MVA r MVA 0 NOPA r ( I NOPA r I! REVA 0.e.d. BV MV + MVA 0 ) 0

18 - 6 - his imlies ha he dysfuncional effecs shown in secion 4 wih regards o REVA can be exended also o a regime of sricly osiive EVA-arges. 6 Conclusion In our aer we comare differen yes of book value-based vs. marke value-based residual income measuremen (EA, REVA, REI). We rovide a deailed analysis on he informaion rovided by hese erformance measure. Wih regards o he incenive effecs, we focus more closely on comarison of REVA vs. EVA. We show ha REVA could resul in eiher underinvesmen in rojecs wih a osiive ne resen value or over-invesmen in rojecs wih a negaive ne resen value, boh comared o EVA. Finally, we discuss he ossibiliy of using he MVA o derive EVA arges for invesmen ceners. We rove ha wih an infinie horizon hese arges eual he alicaion of REVA. Bibliograhy Bacidore, Jeffrey M./Beuis, John A./Milbourn, odd./hakor, Anjan V. (997): he Search for he Bes Financial Performance Measure. In: Financial Analyss Journal, Vol. 53, Baldenius, im/fuhrmann, Gregor/Reichelsein, Sefan (999): Zurück zu EVA. In: Beriebswirschafliche Forschung und Praxis, Vol. 5, Bromwich, Michael/Walker, M. (998): Residual income as and fuure. In: Managemen Accouning Research, Vol. 9, Fisher, Irving (906): he Naure of Caial and Income, New York: Macmillan. Hax, Herber (989): Invesiionsrechnung und Periodenerfolgsmessung. In: Delfmann, Werner e al. (Eds.): Der Inegraionsgedanke in der Beriebswirschafslehre. Helmu Koch zum 70. Gebursag, Wiesbaden: Gabler, Hicks, John R. (946): Value and Caial: An Inuiry ino some Fundamenal Princiles of Economic heory, 2 nd ed., Oxford: Clarendon Press. Laux, Helmu (999): Unernehmensrechnung, Anreiz und Konrolle: Die Messung, Zurechnung und Seuerung des Erfolges als Grundrobleme der Beriebswirschafslehre, 2 nd ed., Berlin e al.: Sringer.

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