sa: measuring and controlling va

GROUP 3

ID no
18006
18014
18017
18048

Name
Eashan Bhuiyan
Md. Riaz Rahaman
Ishrat Rejwana
Rubina Akter

Questions for part A

1. Refer to Endesas current business strategy. In what primary economic activity is
Endesa engaged? Why is it necessary to understand the strategy and primary
economic activity in order to manage Endesas financial activities?
Solution:
Current Business Strategy:
Endesa has developed a new financial management strategy, that is to measure economic value
created (EVC) rather than ROI and ROE.
From this point of view, Endesas current business strategy is
Acquiring business units
Using its expertise to develop as much value in the unit as possible
Either hold or sell the unit, depending on its EVC potential.

Primary Economic Activity:

The primary economic activities refer to sourcing or extracting natural resources from the land
and bodies of water.
From this point of view Endesas primary economic activity is mining.

Necessity for Financial Activities:

As the strategy depends on the EVC potential, the primary activities must create economic value.
If mining assets cannot have potential value, there is no point in expanding.
So, financial activities, strategies, and primary economic activities are interrelated.

2. Why does EVC as computed by Endesa reflect an economic rather than an

accounting perspective?
Solution:
An economic perspective reflects on resources where as accounting perspective reflects on many
non cash activities. EVC can be identified down to business unit level that is basically the source
of value creation. So these business unit levels can be focused as value centre by EVA
perspective rather than mare cost and revenue centers like accounting perspective would have
focused on.
That is why EVA reflects on economic perspective rather than accounting perspective.

Cash-flow Perspective VS Accounting Perspective As a Financial

Management Tool:
Cash Flow Perspective:
Cash flow perspective focuses on how money coming in and exiting a company's operating
vaults. So it is basically related with the cash generation.
Accounting Perspective:
Accounting Perspective focuses on a wide variety of items of profit. Like revenues and expenses.
It also includes non cash items like inventory, accruals, depreciation etc.
Financial Management Tool:
Financial management deals with cash generation and resource allocation and investment. It also
includes development of strategies and plans for the long-term financial goals of the
organization. Earnings is important information for investor because earnings number
shows firms financial performance.

Advantage of Cash-flow Perspective:

Where Accounting perspective reflects on the overall profit of the organization, cash flow
reflects on the available resources for further use. So, finance managers can understand how
much cash is coming and leaving to the organization.
Disadvantage:
There cannot be any long term forecasting, based on cash flow, for this we will need the
accounting data to measure the companys overall performance.

Advantage of Accounting Perspective:

The accounting data gives us the clear view of the profit and performance of the company so it
becomes easy for the finance manager to forecast long term goal.
Disadvantage:
Accounting profit does not give a clear sign of the cash resources available for the investment or
allocation. For this cash flow is needed.
So we can say that both perspective is needed as a tool for financial management depending on
long term and short term goals.

3. From a financial management perspective, the depreciation charge is sometimes

viewed as source of cash and maintaining capital. Evaluate these claimed purposes
in general, and specifically with respect to Endesa. Evaluate Endesas comment that
cash flow is superior tool to accounting measures of profit because it includes the
depreciation tax shield effect but not the depreciation expense.
Solution:
Depreciation as a source of cash:
In general depreciation is NOT a source of cash directly, because simply with more depreciation
charge , it does not generate any profit.
However, if we take a closer look, more depreciation will show less profit that will result in less
tax. So, less tax saves up the cash in the company.

Depreciation as maintaining capital:

With accumulated depreciation we increase our provision which will be further used to buy the
assets we are depreciating helping a capital expenditure. So depreciation is related with
maintaining capital.

With Respect to Endesa:

In the measurement calculation, Endesa determined the EBIDTA but there is no data regarding
the maintenance capital. However, they have a maintenance cost.

Cash Flow as a superior tool:

In the calculation of free cash flow we see that they are deducting income taxes from EBIDTA
but there is no effect of depreciation. But we have clearly seen that any depreciation charge will
lower the cash payable as interest.
So, we can conclude that cash flow is superior tool to accounting measures of profit because it
includes the depreciation tax shield effect but not depreciation expense.

4. Why is the computation of IC different at the business unit level from the corporate
and subsidiary levels?

Solution:
The business unit IC includes Fixed Assets and Working capital whereas Corporate and
Subsidiary IC includes different items than that of Business units.
The reason is very obvious, because business unit mainly deals with production and thus only
need Fixed assets and working capital as Invested capital. Whereas Corporate and Subsidiary
are involved in many more capital related activities like minority interest, shareholders equity,
Provision for pension that is being included in their invested capital calculation. Business unit do
not have any connection with these factors.
Thus, the computation of IC is different at the business-unit level from the corporate and
subsidiary level.

5. Evaluate Endesas policy of assigning risk premium to industry segments and to

specific countries or geographic areas. What types of risks exist for industry
segments and for countries or geographic regions? Which macroeconomic factors
should Endesa include in its model to determine the two types of risk premium?
Evaluate Endesas comment that the focus is on the risk that the factor contributes
to the overall risk of Endesa group, referring to portfolio theory in your evaluation.
Evaluate Endesas approach of assigning different risk premiums to equity capital
and debt capital.
Solution:
Types of Risks:
i. Types of risks exist for industrial segmentation are:
1. Market Risks: market competition, price volatility, uncertainty of services supply eyc.

2. Legal Risks: regulatory change, change in industry law etc

3. Political Risk: political intervention
ii. Types of risks exist for country-wise segmentation are:
1. Economic Risks: change in exchange rate, change in interest rate, inflation etc.
2.

Political Risks: political unrest, political instability etc.

3. Others: local risks, legal risks etc.

Macroeconomic Factors in Risk Premiums:
The macroeconomic factors that Endesa should include in its model to determine industry based
risk premium are: phases of business cycle, capital supply level, price indices consumption, labor
employment rate etc. The macroeconomic factors that should be included in the model of
regional risk premium are: economic growth, exchange rate, interest rate, inflation, international
trade etc.

Evaluation of Focus is on the risk that the factors contribute to the

overall risk of Endesa group:
The overall risk of Endesa includes both the risks. Both types of risks contribute in increasing the
cost of capital. So to determine the actual cost of capital both the risk premiums should be
included considering all the factors associated with the risks.

Evaluation of Approach:
Due to different industry sectors additional risks are associated with the risk of Endesas
business. At the same time, additional risks associated with different countries in which Endesa
operates also influence the business activities of the company. Some of these risks are not
controllable or avoidable. That is why adjustment of these risk premiums in WACC is necessary

to determine the actual cost of capital of Endesa. According to the operation and structure of
Endesas policy of assigning two types of risk premiums is practical and conceptually accurate.

6. Evaluate Endesas policy of measuring EVC both before and after minority
interests. Why would such a distinction be important for Endesas financial
management?
Solution:
In Endesa, EVC is computed by: EVC = FOCF (IC X WACC)
EVC before Minority Interest:
The minority interest is not added for the EVC calculated for Business Unit level. In the
calculation of free operating cash flow (FOCF) only the cash inflows and outflows from the
activities of business unit are taken. The invested capital (IC) is computed by adding fixed assets
and working capital. WACC on the invested capital is determined after adding two types of risk
premiums due to industry wise and country wise segmentation, with both cost of equity (ke) and
cost of debt (kd).
EVC after Minority Interest:
The minority interest is added for the EVC calculated for Corporate and Subsidiary level. In this
calculation, free operating cash flow (FOCF) from the business unit is aggregated with that of
subsidiaries (according to % of holding) after eliminations of inter-company transactions. The
invested capital (IC) is computed by adding long term debt, provisions, shareholders equity and
minority interest. The last element of EVC, WACC on the invested capital is determined based
on inter-bank interest rate (kd), risk free rate and risk premium (ke) without any additional
segment based risk premium.
Here the elements of EVC are calculated differently only to get actual amount of value creation
which is appropriate in case of Endesa. Without the distinction, determination of accurate
economic value created (EVC) is not possible. For this reason, such a distinction is important.

7. Evaluate Endesas position that the effect of interest and dividend payments to debt
and equity suppliers on EVC is captured in the factors used to determine WACC so
that it is inappropriate to deduct these items in determining FOCF.
Solution:
According to general definition of economic value added (EVA), the cost of invested capital is
deducted from net operating profit after tax (NOPAT) which is already interest expense or cost of
debt adjusted. As interest cost is also included in the cost of invested capital of Endesa, EVA will
show a result which deducts interest twice. But in the measurement of retained earnings used by
Endesa, FOCF in concerned instead of NOPAT. As such, dividend and interests are not adjusted
in the calculation of FOCF rather they are deducted in form of cost of capital as the
multiplication of WACC and IC. So no double exclusion occurs and reliable measure of value
creation can be determined. To avoid double deduction of cost of capital, Endesas position in
this regard is appropriate.

8. Evaluate endesas overall financial management approach. What are the strength
ans weaknesses of this approach?
In the Financial Management system of Endesa, they measure the annual value creation by a new
measurement called EVC instead of EVA. Endesa computes EVC in different ways for corporate
and subsidiary level and business level and ultimately takes decision based on the potential EVC
of any business unit.
Strengths:
1. As accounting profit is not used directly, there is less opportunity of profit manipulation,
2. Model and concept of EVC is simpler to understand than that of EVA,

3. As decision is taken based on EVC and strategic fit, it is easy to take decision without
any bias or mistake,
4. The IRR is determined on the basis of WACC so the IRR can be easily determined,
5. There is no double deduction in the measurement which helps in determining a reliable
EVC,
6. As WACC is computed after adjusting all types of risks, it can be easily optimized to
achieve greater EVC.
Weaknesses:
1. A significant amount of cost (depreciation) is not charged in the annual value creation
model,
2. The invested capital and WACC computation for corporate and subsidiary level and
business unit level are totally different, which creates complexity,
3. Two types of risk premiums are computed to determine WACC for business units, each of
which depends on various factors. Any faulty in modeling the risks can give misleading
EVC for the company.
For Endesa, the components of EVC are used as control devices at both the corporate and
subsidiary level and the business unit level. It creates an easy base to prepare budget and
determine variances. Most importantly, EVC is more reliable measurement of residual
income compared to ROI or ROE. That is why Endesas financial management approach is
better than accounting profit based financial management approaches.

Questions for Part B

9. Refer to Endesas current business strargey. In what primary

economic activitiy is Endesa Engaged? Why is it neseccasry to
understand the strategy and primary economic activitiey in
order to evaluate Endesas management control system?
Solution:
Current Business Strategy:
Endesa has developed a new financial management strategy, that is to measure economic value
created (EVC) rather than ROI and ROE.
From this point of view, Endesas current business strategy is
Acquiring business units
Using its expertise to develop as much value in the unit as possible
Either hold or sell the unit, depending on its EVC potential.

Primary Economic Activity:

Primary economic activity involves souring natural resources from the land or body of water.
Primary economic activity Endesa engaged is mining.
Necessity for Management Control System :
Endesa uses EVC for management control systems.
EVC = FOCF (WACC * IC)
One of the important factors of the EVC is the FOCF. Endesa lines of business depend on the
primary economic activity. The probability of the success of resources collection from mining
and the cost and benefit of resources collection depend on the strategy of management. The
more right the management strategy about primary economic activity, the more will be the
FOCF.
Thus the factors help to evaluate Edessas management control systems through EVC.

10. The computation of EVA which is developed and promoted by Stern Stewart & Co.
is based on net income as reported under US GAAP, from which adjustments are
made. Evaluate the suitability of this measurement for Endesa and similar
companies outside the USA that do not use US GAAP.
Solution:
The ultimate result of net income from any standard of US GAAP or IFRS is same. But, there are
some differences in the presentation and format.
1. Under US GAAP, companies must report an item as extraordinary if it is unusual in
nature and infrequent in occurrence.
Extraordinary item reporting is prohibited in IFRS.
2. US GAAP does not require companies to indicate the amount of net income attributed to
non controlling interest.
3. IFRS does not define key measures such as income from operations.
However, US GAAP define many key measures.
4. Under IFRS, companies must classify expenses either by nature or function.
US GAAP does not have that requirement.

11. Evaluate Endesas arguments that accounting based measures of profit are not
suitable for measuring value created for purposes of management control.
Solution:
Management control means how to motivate the management of Endesas wealth maximization
rather the personal gain.
Accounting based measures of profit :
EVA= NOPAT- (WACC* IC)
There are some accrued incomes or expenses in the NOPAT which will increase or decrease the
income without cash flow from the transaction. Endesa already charged the interest in the
calculation of NOPAT then again charged interest of debt portion of the investment capital. The
depreciation expense is deducted to calculate NOPAT but actually there is no cash outflow from
the business.

For these problem the accounting based measures of profit cannot evaluate actual effort of
management.
12. Specific guidelines exist under US GAAP, for the public reporting of cash flow.
Evaluate Endesas cash-flow computation with respect to the requirements of US
GAAP. Evaluate Endesas position that it is inappropriate to deduct interest and
dividends in computing FOCF as would be required by US GAAP. A significant
departure from US GAAP is the inclusion of a portion of the equity in earnings of
subsidiaries that is not paid in cash dividends. Why do you think Endesa has
included this item in FOCF?
Solution:
Evaluation:
In the cash flow computation in Endesa, Endesa is deducting income tax in operating income
which is not according to the US GAAP. Income tax is charged on net income after deducting
interest following the US GAAP. As it is charging income tax directly on operating income and
deducting it from operating cash flow it is showing a cash flow less than actually it should have
been.
Again, it is adding portion of equity in earnings of subsidiary that is not paid in cash dividends
which is also significant departure from US GAAP. It is increasing the FOCF amount of the
company but in reality the cash is not inflowing yet.
Reason behind inclusion:
According to us Endesa has included this item in the FOCF to determine protential EVC instead
of actual EVC. As management is putting more emphasis on EVC in decision making, it is
considering all the possible value additions in the unit in order to make business decision of
selling or expanding of units.

13. Why is depreciation computed and reported on the income statement under US
GAAP and under the accounting policies of most Anglo Saxon countries? Evaluate
Endesas decision to select a measurement of value created that specifically excludes
depreciation charge.
Solution:
Depreciation is a significant cost because asset is useful only for a limited number of years.
Following the matching principal of accounting, cost is allocated against the benefit of using it.
To match the revenue earned using a capital asset against its cost, it is necessary to charge annual
depreciation on it.

Measurement of Value Created:

EVC = FOCF (WACC x IC)
According to standard, we add back depreciation to FOCF. The reason of adding back is that
depreciation does not create physical cash outflow from the business. This treatment decreases
the FOCF along with the reduction of EVC.
This calculation process is not in line with the culture of value creation, so the procedure of
FOCF will affect the management control system negatively with low EVC.

14. Evaluate Endesas policy of computing variances for all component parts of
EVC including WACC and IC. How would you interpret the quantity and mix
variance for IC?

Solution:
Endesas policy of computing variances for EVC involves computing actual and budgeted
amount. Then the variance is calculated by subtracting them from one another which indicates
the situation of the company. So according to the management accounting method the variance
calculation is logical and appropriate for the companys performance evaluation.
In terms of the components of EVC evaluation WACC & IC the same are applicable. Endesa
evaluates the variance for EVC, FOCF, WACC and IC separately. This helps the company to
measure the proper planning and implementation of strategies for every element that influences
the company.

Interpretation of quantity and mix variance for IC:

To evaluate quantity variance different amount of the components of IC and for mix variance
different proportion or mix of the components are applied. The variance here is also calculated in
the same way by subtracting actual amount from the budgeted amount of the IC. IC normally is
the combination of these two elements of IC. For Endesa IC is one of the influencing factor
creating the management control effective, so the IC needs to be different for every subsidiary
and business unit. One uniform IC will not help the company to measure and control the
subsidiaries and the business units where the components of IC has to be customized and
implemented according to their needs. Different quantity and mix presents different IC which
helps the separate units to perform better. And these variances help understanding the proper IC
combinations. After calculating the separate variances for quantity and mix of the elements of IC
for different subsidiaries and units, it helps Endesa to evaluate and understand the usage of the IC
in different perspective and forecast a better future plan.

15. How does the decomposition of EVC into ROIC and WACC allow Endesa to
separate operating and commercial from financial and fiscal management and to
integrate short, medium and long-term objectives? Evaluate this process from a
management control perspective.

Solution:
Decomposition of EVC allows Endesa to separate operating and commercial management from
financial and fiscal management. In EVC calculation, ROIC indicates operating and commercial
management where WACC indicates financial and fiscal management. With the help of ROIC,
Endesas profitability can be measured. When we closely evaluate the amount of ROIC the real
operating performance of the management becomes clear because the IC has an effect on the
management. ROIC gives a result of the operating performance of the management without the
effect of the financing decisions of the company. The measures and strategies taken to improve
the sales in more clear term profit gets a good focus from ROIC evaluation. So higher ROIC
shows the better performance picture of the company. On the other hand, WACC, cost of capital
is all about the financing decisions. WACC indicates how well the financing measures helped the
shareholders to get more comfortable with the investments. In short terms it also helps

understanding the risk of the business units which then helps Endesa to take strategies of
expanding them or selling them.
Also EVC reflects short term, WACC the medium and FOCF the long term, which we can
understand from the value tree. Because EVC is evaluated at the end of a period or analyzing the
value created by each unit while WACC helps get a understating of the risk and investing
opportunities of the units. EVC is done only when the decision about units are necessary or
evaluating the whole companys performance which serves a short term purpose because after
that a decision is directly taken. WACC on the hand helps taking and measuring the capital
investment opportunities and risk which doesnt stay more than a period for the company as well
as the units. After every period of reporting the WACC helps evaluating the firms performance
on financing activities and new strategies are taken. Where FOCF is long term objective based
because of the criteria of this elements being used period after period. When the company
evaluates the FOCF, they can understand the profitability and the operating strength of the
company which normally would be taken for at least five years or more.

16. Traditional Management control approaches have focus almost exclusively on

profitability as a control device, yet Endesa has five value rivers that it attempts to
control. Evaluate Endesas focus on additional value rivers.

Solution:
Endesas additional value drivers are helpful because of the nature and the diversification of the
business. The arguments are:
Strategy: It helps Endesa to control the small business units and take action according to their
performance and possibility of improvement. As Endesa is a huge company with many
subsidiaries and business units, it helps Endesa to ensure proper guidance to the small units as
well as the company whole
Intangibles: Endesa cant reach the customers directly with their primary product line. The value
creation cannot be easy without the customers being loyal to the company. With the addition
services provided by the company, they can create a goodwill and a loyalty from the customers.
Optimizing WACC: By managing the debt from Europe to US the company can improve the
capital structure and utilize the potential of the capital more. As the lower rate will help Endesa
to optimize the financial leverage, it will eventually effect the business performance.

Expansion: Endesa being in the power generation business, eventually have to grow like any
other business. So evaluating different business units performance the expansion helps them to
get better profitability and greater management.
Though all the value drivers are not equally important, the company has to manage them as their
management strategies are different and the companys structural situation. Even operating in
different country has created a different set of value creating activity for them.

17. Based on the information in the introduction and in parts A and B of the case,
develop balance scorecards that you would recommend for Endesa at the corporate,
subsidiary and business-unit levels.

Solution:
Balance Scorecard:

Financial

Greater EVC with optimized WACC

Custom er

Improve customer base through exploiting

intangible assets

Profitability through expansion

Learning &
G row th

Internal
Business

Reduction of leverage

Strategies involving business units

Compensation of the managers
Increase investment opportunity

New finance strategies

Management of business units as value
creation centres

Measurement:
Endesa has created a growth study which involves evaluation of strategic fit and EVC. With this
study the management will be able to take decision on whether they will sell, hold or expand the

business units. Employees will be integrated to the system and more involve with the strategies
by EVC techniques.
The strategies of managing the business unit helps the company to expand or interact with more
investment opportunities. Eventually with the help of the success of the business units the
management will lead the subsidiaries to more profitable positions. To ensure that the
management must involve the managers directly which will be done through managers
compensation policy. This whole evaluation and management is measured by variances of the
elements of EVC.
Intangibles assets will be utilized by introducing several value added services to the customers.
These creates more involvement with the customers and helps the company to utilize its
potentials and expertise. In short the customer base gets more value being directly involved with
the company.
EVC technique the management can maintain a great control over the parts of the company.
WACC optimization helps to reduce the country risk as well as the extra leverage of particular
company which in short reduces the extra cost of capital and increases profitability. Greater
control means greater profitability and more business expansion.

18. Evaluate from a management control perspective Endesas policy of variable

compensation in which up to 25% of a managers compensation can depend on
meeting objectives.

Solution:
Endesas policy of variable compensation for managers upon meeting objectives is a motivating
measure. This will eventually help the company to control the managers in different positions
and situations. As the company is diversified and operating in small units the variable plan is
only helpful for keeping a uniform compensation plan. The managers will be reinforced to meet
the business objectives and ensure a better control all over the company.