Bazeele hires out plant and machinery to small firms working in the construction industry. Bazeele’s senior managers, including the chief executive officer (CEO), have worked in the business since it was established 30 years ago, and they own the majority of the shares. During that time, Bazeele has acquired many smaller plant hire businesses. Of these business units, those which have underperformed after acquisition have either been sold on or restructured, for example, to increase their operating margins. Bazeele has recently diversified by hiring out large items of plant to large construction firms working on major infrastructure projects. These projects can last for up to 10 years. Strong growth in the general economy has increased the number of these large projects and has also led to a predicted large increase in bank interest rates.
The shareholders’ objective is for Bazeele to maintain its historic return on capital employed (ROCE). Managers at business units are given the objective of maintaining net profit margins of their own business units. Similarly, managers at individual branches of business units are given the same objective according to their own areas of responsibility.
Following two years of poor performance, it has been suggested to the CEO that Bazeele would benefit from adopting a value-based management (VBM) approach.
The CEO requires your advice and has said, ‘The shareholders are unsure what VBM is, whether it will benefit Bazeele, and what changes the business would need to make if it were to adopt it. All managers in the business are already clear what their objectives are. For example, one business unit manager recently postponed some expensive staff training on improving customer satisfaction, which I believe was the correct decision. Our recent poor performance has meant we cannot afford this sort of expenditure, especially as we have no information on what levels of customer satisfaction actually are. Personally, I dislike change, but would not object to the adoption of VBM if it was thought to be beneficial for Bazeele. The shareholders have heard that economic value added (EVA™) can be used to measure whether Bazeele has created or destroyed value for its shareholders, but this has not yet been calculated.’
Details of the company’s recent performance are given in Appendix 1.
Appendix 1 – Notes from Bazeele’s management accounts for the most recent year end
1. Net profit after tax for the year: $10m
2. Capital employed at the start of the year: $250m
3. The interest charge for the year was $15m on a variable rate loan with an interest rate of 10%. Bazeele is funded 60% by debt and 40% by equity. The cost of equity is 12%. Bazeele pays tax at a rate of 20%.
4. The depreciation charge for non-current assets for the year was $6·0m; the economic depreciation of which was $14·0m. At the start of the period, the accumulated economic depreciation of non-current assets exceeded its accounting depreciation by $16·0m.
5. Brought forward at the start of the year was a provision of $4·8m which was made in respect of a debt owed by a customer who has since repaid it.
6. Within the current profit or loss account there is an expense for $0·6m for advertising in trade magazines. This led to several enquiries from new customers involved in large infrastructure projects, which has resulted in Bazeele signing at least two large contracts after the end of the accounting period.
Required:
Evaluate whether a value-based management approach is appropriate for Bazeele.
In the context of VBM, value of a business is measured by discounting cash flows at the business’s cost of capital. When investment returns exceed the cost of capital, value will be created for shareholders. When returns are lower than the cost of capital, value will be destroyed.
The VBM approach is to ensure that all activities and decisions in a business are undertaken so as to create value for shareholders. Currently, Bazeele’s overall objective is to maintain ROCE at historic levels, but this does not necessarily create value for shareholders.
This is particularly so now that Bazeele has diversified into hiring large items of plant for use in major infrastructure projects. These projects last up to 10 years, so the time value of money is likely to be significant, as is the initial capital expenditure for the plant. Long-term hire agreements may give an acceptable ROCE, but may have a negative net present value, and hence destroy value for shareholders. The prediction of large increases in bank interest rates will increase Bazeele’s cost of capital, and further reduce the net present value of long-term agreements.
Similarly, business unit and branch managers are given the objective of maintaining net profit margins. Thus, managers may avoid activities which reduce profits in the short term, but which have future long-term benefits and create value for shareholders, such as investment in staff training.
With VBM, decisions are taken to create value for shareholders by considering value drivers, which are any factors which affect the value of the business. Value drivers may be non-financial, such as the customer satisfaction which may have been improved by the postponed staff training. A VBM approach is, therefore, suitable for Bazeele as it will encourage creation of value for shareholders.
Explain to the CEO what changes Bazeele would need to make to its performance measurement and performance management systems if it were to adopt a value-based management approach.
To adopt a VBM approach, Bazeele would need to use a different set of performance indicators, as ROCE and net profit margin do not necessarily create value for shareholders. Economic value added (EVA™) is a performance measure for shareholder value. Though more complex to calculate and more difficult to understand than the existing measures, EVA™ does encourage managers to make decisions, such as undertaking staff training, which have future long-term benefits. By encouraging managers to make investments which give a positive EVA™, value will be created for shareholders.
With VBM, managers would be given targets according to their areas of responsibility. For example, the board may have objectives to maximise value by making acquisitions which create value. Branch managers’ objectives may be focused on non-financial value drivers such as customer satisfaction.
To identify value drivers, Bazeele will need good information which is accurate, reliable and timely, for example. It is unclear whether the current management information system is able to provide good information, but the CEO has said that information on customer satisfaction is not available. Resources, such as financial investment, time and training, may be needed to improve Bazeele’s management information. Managers may resist the change in culture which would be required to adopt VBM; not least the CEO would need to set the ‘tone at top’ for what would be a disruptive and major change to Bazeele. However, the benefits of adopting VBM seem to outweigh the costs of doing so.
Using the information in Appendix 1, advise the CEO whether Bazeele has generated economic value for its shareholders.
As the economic value added (EVA™) is $(13·1m), Bazeele has destroyed value for shareholders.
Calculation of net operating profit after tax (NOPAT)
