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Acca Essay

2467 words - 10 pages

RELEVANT TO ACCA QUALIFICATION PAPER P5

Economic value added versus profit-based measures
of performance
A successful performance measure evaluates how well an organisation performs in
relation to its objectives. Since the primary objective of commercial organisations is
normally assumed to be the maximisation of the wealth of its shareholders, it follows
that performance measures should evaluate this. In practice, many organisations use
profit-based measures as the primary measure of their financial performance. Two
problems relating to profit in this area are:
• Profit ignores the cost of equity capital. Companies only generate wealth when
they generate a return in excess of ...view middle of the document...

The capital
used by the division (equity plus long-term debt) was $70,000. The weighted average
cost of capital of the company is 13%, and this is used when calculating the finance
charge. The residual income of Division A was therefore:
Profit
Finance charge
Residual income

$
10,000
9,100
900

(70,000 x 13%)

The finance charge of $9,100 represents the minimum return required by the
providers of finance on the $70,000 capital they provided. Since the actual profit of
the division exceeds this, the division has recorded residual income of $900.

© 2011 ACCA

2

ECONOMIC VALUE ADDED VERSUS PROFIT-BASED MEASURES OF PERFORMANCE
JULY 2011
EVATM is similar in structure to residual income. It can be stated as:
EVATM = NOPAT – (k x capital)
Where: NOPAT = Net operating profits after tax.
(k x capital) is the finance charge, where k = the firms weighted average cost of capital
and
capital = equity plus long-term debt of the company at the start of the period.
This formula will not necessarily be given in the exam, so you need to learn it.
NOPAT
NOPAT means net operating profit after tax. This profit figure shows profits before
taking out the cost of interest. The cost of interest is included in the finance charge
that is deducted from NOPAT when calculating EVATM. Two approaches to adjusting
for interest are taken. Either:
• start with operating profit. Then deduct the adjusted tax charge. The tax charge
should be adjusted because it includes the tax benefit of interest. Since interest
is a tax-deductible item, having interest in the income statement means that
the tax charge is lower. Since we are taking the cost of interest out of the
income statement, it is also necessary to remove the tax benefit of it from the
tax charge. To do this, multiply the interest by the tax rate, and add this to the
tax charge, or
• start with profit after tax, and add back the net cost of interest. This is the
interest charge multiplied by (1 – rate of corporate tax).
Example 2
An extract from the income statement of Alpha Inc shows the following:
Operating profit
Interest charge
Profit before tax
Tax at 25%
Profit after tax

$
1,000
(100)
900
(225)
675

NOPAT is either:
Profit after tax
Add after tax interest (100 x 75%)
NOPAT

675
75
750

or:
Operating profit
Less tax charge adjusted to exclude tax relief on interest
(225 + (100 x 25%))
NOPAT
© 2011 ACCA

1,000
250
750

3

ECONOMIC VALUE ADDED VERSUS PROFIT-BASED MEASURES OF PERFORMANCE
JULY 2011
Accounting adjustments
The major departure from residual income is the adjustments made to reported
financial profits and capital. Proponents of EVATM argue that profits calculated in
accordance with financial reporting principles do not reflect the economic value
generated by the company. There are three main reasons for these adjustments:
1. To convert from accrual to cash accounting. Investors are interested in cash
flows, so many...

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