Chapter 12

12A-1

Economic Value Added and the Measurement of Financial Performance
Chapter 12 shows how to calculate the appropriate discount rate for capital budgeting and other valuation problems. We now consider the measurement of fi nancial performance.
We introduce the concept of economic value added, which uses the same discount rate developed for capital budgeting. We begin with a simple example.
Many years ago, Henry Bodenheimer started Bodie’s Blimps, one of the largest highspeed blimp manufacturers. Because growth was so rapid, Henry put most of his effort into capital budgeting. His approach to capital budgeting paralleled that of Chapter 12. He forecast cash flows for various projects and discounted them at the cost of capital appropriate to the beta of the blimp business. However, these projects have grown rapidly, in some cases becoming whole divisions. He now needs to evaluate the performance of these divisions to reward his division managers. How does he perform the appropriate analysis?
Henry is aware that capital budgeting and performance measurement are essentially mirror images of each other. Capital budgeting is forward-looking because we must estimate future cash flows to value a project. By contrast, performance measurement is backward-looking. As Henry stated to a group of his executives, “Capital budgeting is like looking through the windshield while driving a car. You need to know what lies farther down the road to calculate a net present value. Performance measurement is like looking into the rearview mirror. You find out where you have been.”
Henry first measured the performance of his various divisions by return on assets
(ROA), an approach that we treated in the appendix to Chapter 2. For example, if a division had earnings after tax of $1,000 and had assets of $10,000, the ROA would be:1
$1,000
_______ ϭ 10%