NATURALEZA Y CARACTERÍSTICAS DE UN SERVICIO

Young and O’Byrne (2001: 383) warn that although CFROI is calculated in a similar way as an IRR it is important to remember that it cannot be interpreted in exactly the same way. The absolute level of a firm’s CFROI does not indicate whether the firm is creating or destroying shareholder value. In order to determine this, the measure needs to be compared to a benchmark value. Furthermore, it is also important to consider whether a firm is able to maintain or improve its level of CFROI. Failure to achieve this will result in the destruction of shareholder value.

Unlike EVA, where the firm’s WACC is normally used to determine its cost of capital, HOLT Value Associates use a firm-specific discount rate when evaluating CFROI (Martin & Petty, 2000: 117; Madden, 1999: 10). This discount rate is based on the CFROI level, the sustainable asset growth rate, as well as a market derived discount rate (Martin & Petty, 2000: 117).

The market derived discount rate is obtained by considering a large representative sample of firms. Firstly, the total market value of their equity and debt at a certain point in time is calculated. The next step is to estimate the expected future cash flow generated by these firms for the next financial period. These cash flow estimates are obtained by considering earnings expectations published by market analysts. The market derived discount rate is then determined by solving the following equation for a single return period (Young & O’Byrne, 2001: 423):

Aggregate MVequity+debt = market k 1 NCF aggregate Expected + (3.19) where:

MVequity+debt = the total market value of a number of firms’ equity and debt

capital

NCF = the expected net cash flow for the next financial year, based on

market analysts’ earnings forecasts

kmarket = the market derived discount rate

According to Madden (1999: 83) the market derived discount rate has two major benefits over the CAPM. Firstly, it considers the expected future cash flows of the market, while the CAPM is based on historical information. Furthermore, the market derived discount rate is a product of the CFROI valuation model itself.

Firm-specific discount rates are obtained in a similar way. By comparing the firm- specific rate with the market rate a risk differential can be calculated (Madden, 1998). The approach applied by HOLT Value Associates assumes that a firm’s risk is a function of its size and financial leverage, and that this risk cannot be eliminated by means of diversification (Young & O’Byrne, 2001: 425). The risk differential can consequently be applied to evaluate the risk associated with a specific firm.

In those cases where the CFROI value exceeds the firm-specific discount rate, the firm’s NPV is positive (Fabozzi & Grant, 2000: 25). Consequently, shareholder value is created, while it is destroyed by CFROI levels below the discount rate (Young & O’Byrne, 2001: 383). It is also possible to compare CFROI to a real rate calculated for an industry (Martin & Petty, 2000: 117). This enables analysts to identify the greatest shareholder value creators in an industry.

3.5.4.1 BENEFITS OF CFROI

According to Martin and Petty (2000: 116) the primary advantages of CFROI include:

o The conversion of accounting profits into cash flow figures.

o The use of inflation-adjusted total cash flows rather than the

depreciated book values to measure the investment required to support a firm’s operations.

o The recognition of the life time of the assets utilised to generate the

cash flows.

Madden (1999: 9) considers the fact that inflation-adjusted cash flows are used for the CFROI calculation as one of the major benefits of applying this approach. This enables comparisons over time, and also between firms located in different countries. Since it removes some of the accounting distortions, Peterson and Peterson (1996: 29) also regard the use of cash flows instead of accounting figures as a benefit associated with CFROI.

Madden (1999: 108) also suggests that CFROI solves the problem associated with accounting reserves. These reserves are usually easy to manipulate and could distort the financial performance of a firm. According to the CFROI approach these reserves are excluded from the calculations.

Another benefit is that the measure is expressed as a return percentage, rather than a monetary amount (Peterson & Peterson, 1996: 29). This ensures even greater comparability between different firms, since the measure is not influenced by the size of the investment (Fabozzi & Grant, 2000: 165). A return figure is also easily understood by all levels within a firm (Young & O’Byrne, 2001: 417).

Dzamba (2003: 11) also indicates that CFROI represents the future risk exposure of the firm, since it is a risk-adjusted discount rate. Because the CFROI calculation focuses on cash it may also be a more applicable measure for shareholders, who tend to focus on cash dividends.

When calculating CFROI, gross investments are included. Accumulated depreciation amounts are added back to the book values of the assets employed to generate cash flows. As a result of this, the measure removes the problem of heavily depreciated assets (Martin & Petty, 2000: 131) as well as different depreciation policies.

3.5.4.2 DISADVANTAGES OF CFROI

One of the most common complaints regarding CFROI is the complexity of its calculations (Young & O’Byrne, 2001: 407; Ehrbar, 1998: 166). In order to calculate the measure a large number of accounting adjustments need to be completed. Furthermore, all of these adjustments need to be implemented, unlike EVA, where the number of adjustments depends on the firm.

In the case of start-up operations large capital outlays are usually combined with low or negative cash flows. Under these situations, CFROI may not be the ideal performance measure to apply (Madden, 1999: 80). Another example where a CFROI system will add limited value to a firm is where it consists of a large portfolio of different projects with varying levels of CFROI. The firm value for CFROI is an average for the portfolio and it is difficult to identify projects with low or high levels of CFROI (Madden, 1999: 80)

One of the general problems experienced with IRR-type measures is the difficulty to communicate it to all levels of a firm. Translating the figure into actions also presents a challenge (Fabozzi & Grant, 2000: 166). Another criticism is that it is not exactly clear how to tie CFROI to a management compensation system (Young & O’Byrne, 2001: 422).

When evaluating projects with unequal cash flows and a positive NPV, CFROI could provide mixed signals. Even though the project is profitable (the NPV is greater than zero) there may be periods where a CFROI system could indicate the opposite (Martin & Petty, 2000: 149). Stewart (1994: 81) also indicates that the maximisation of a firm’s NPV, and not its IRR, is the correct way to increase value. When applying CFROI this needs to be taken into consideration.

Peterson and Peterson (1996: 29) also indicate that the inflation-adjusted figures used in the calculation of CFROI may expose it to some weaknesses. Since the inflation adjustments are only estimates, the quality of the estimates could greatly influence the measure. Since the cost of capital applied in evaluating the CFROI value also needs to be adjusted for inflation, this adds to the complexity of the estimates.

Fabozzi and Grant (2000: 166) argue that a CFROI system mixes operating and financing decisions. As a result it is not always possible to determine whether changes in CFROI are the result of operating changes, or financing changes. It is, therefore, important to include the level of financial leverage when comparing different firms.