Using EVA and MVA at OUTSOURCE, INc.
"I've been hearing a lot lately about something called MVA, which stands for Market Value Added, and I was curious whether it is something we can use at OSI." This was Keith Martin's comment as he finished eating bis lunch. Keith is president and CEO of OutSource, lnc. His guest for lunch that day was a computer-industry analyst from a local brokerage firm. Keith invited him to lunch to get more information on MVA and its uses.
"Yes," replied the analyst, "I've heard a great deal about MVA. lt's based on Economic Value Added, or EVA, which is a residual income approach where a firm's net operating profit after taxes-called NOPAT- is compared with a minimum level of return a firm must earn on the total amount of capital placed at its disposal."
"Have you seen the most recent issue of Fortune?" he continued, as he handed a copy of the publication to Keith. ''It has an article[1] in it updating Stem Stewart's list of the top 1,000 firms ranked by MVA. You will also be interested in an earlier Fortune article[2] on EVA; however, don't be misled by the simplicity of the EVA calculations in that article. The after-tax operating profit-NOPAT-and the amount used for capital don't come directly off the financial statements. You have to analyze the footnotes to determine the adjustments that have to be made to come up with those amounts; Bennett Stewart calls them equity equivalents."
"Those articles sound like very interesting reading for me at the point I'm at on this topic," said Keith. "Can you send me a copy of the earlier article too?"
"Yes, 1 will," said the analyst. "But tell me, what is it about MVA and EVA that piqued your interest in trying them at OSI?"
"In tracking our industry," Keith replied, "I see the stock prices of some of our key competitors, like Equifax, increasing. Yet, when I compare OSI's recent growth in sales and earnings, our return on equity and earnings per share compare well, but our stock price doesn't achieve nearly the same rate of increase, and I don't understand why.”
The analyst offered that "some of those firms might be benefiting from using EVA already, and the market value of their stock probably reflects the results of their efforts. lt's been shown that a higher level of correlation exists between EVA and a stock's market value than has been found with the traditional accounting performance measures, like ROE or EPS."
"But the MVA 1,000 ranking probably includes only large firms," Keith observed after looking over the article the analyst had given him. "Will EVA work in a small service firm like OSI?"
"Most of the largest U.S. firms are in the Stem Stewart MVA ranking," said the analyst, "but I've read about EVA being used at smaller firms. And some firms in the ranking are service firms, such as AT&T, McDonald's, Marriott International, and Dun & Bradstreet I'm not an expert on MVA or EVA, but I don't see any reason why it wouldn't work at OSI."
"I'd like to find out more in detail about MVA and EVA and how we can use it at OSI. For example, we've talked about a new incentive plan; will it work in that area? And, if so, will it help us in deciding how we should organize and manage our operations as we expand and grow in the future? What can you do to get more information on these things to me fairly soon?"
"An application EVA is touted for is its use in incentive plans," replied the analyst. "I have a team of MBA students from Wake Forest assigned to me this fall to do an industry-related project and I was looking for something 'meaty' for them to do. This looks like just the ticket. I'II brief them on it and have them come over to get the necessary information and interview you."
"Great! I look forward to meeting them," said Keith. "And, in that case, lunch is on me," as he reached for the check.
Company lnformation
OutSource, Inc. (OSI) is a computer service bureau that provides basic data processing and general business support services to a number of business firms, including several large firms in their immediate local area. lts offices are in a large city in the mid-Atlantic region, and it serves client firms in several mid-Atlantic states. OSI's revenues have grown fairly rapidly in recent years as businesses have downsized and outsourced many of their basic support services.
The Corplnfo Data Service (CIDS) classifies OSI as an information services firm (SIC 7374). This group is composed, in large part, of smaller, independent entrepreneurs that provide a variety of often disparate services to both corporate and government clients. Market analysts feel a continuously healthy economy translates into strong potential for higher earnings by members of this group. A factor sustaining an extended period of growth is the increased attention of firms to control costs and to outsource their noncore functions, such as personnel placement, payroll, human resources, insurance, and data processing. This trend is expected to continue, probably at an increasing rate, through to the end of the decade. Several firms in this industry have capitalized on their growth and geographic expansion to win lucrative contracts with large clients that previously had been awarded on a market-by-market basis.
Although OSI operates out of its own facilities, which include some computing equipment and furniture, the bulk of its computer processing power is obtained from excess computer capacity in the local area, primarily rented time during third-shift operations at a large local bank. However, to be successful in the long-term, OSI management knows it must expand its business considerably, and, to ensure it has full control over its operations, it must set up its own large-scale computing facility in-house. These items are included in OSI's long-range strategic plan.
As OSI's reputation for accurate, reliable, quick response service has spread, the firm has found new business coming its way in a variety of data processing and support services. The issue has been deciding which services to take on or to stay out of in light of the current limitations on OSI's computing resources and to ensure that they can continue to provide high-quality service to customers. Things are definitely looking up for OSI, and industry market analysts have recently begun to look more favorably on their stock.
In 1993, OSI's board decided to pursue additional opportunities in payroll processing and tax filing services, and OSI purchased a medium-sized firm that had an established market providing payroll calculating, processing, and reporting services for several Fortune 500 firms on the East Coast. OSI is now in the midst of developing a new payroll processing system, called PayNet, to replace the outmoded system that was originally created by the firm it acquired.
Once PayNet is developed, it will give users an integrated payroll solution with a simple, familiar graphical user interface. From an administrative perspective, it will allow OSI to reduce its manual data entry personnel, speed data compilation and analysis, and simplify administrative tasks and the updating of customer files for adds, moves, and changes. PayNet will serve as the backbone for OSI's service bureau payroll processing operations in the future; however, developmental and programming costs are proving to be higher than expected and will delay the roll-out of the final version of the new payroll engine. Beta testing of the production version of PayNet is being delayed from the second to the third quarter.
Additional Accounting lnformation
OSI's financial statements for 1995 appear in Exhibit 1. The following is a list of information pertinent to calculating a firm's EVA extracted from the footnotes to OSI's financial statements for 1995.
A. Inventories are stated principally at cost (last-in, first-out), which is not in excess of market Replacement cost would be $2,796 greater than in 1994 and $3,613 greater than in 1995.
B. Deferred tax expense results from timing differences in recognizing revenue and expense for tax and reporting purposes.
C. On July 1, 1993, the Company acquired CompuPay, a payroll processing and reporting service firm. The acquisition was accounted for as a purchase, and the excess of cost over the fair value of net assets acquired was $109,200, which is being amortized on a straight-line basis over 12 years. One-half year of goodwill amortization was recorded in 1993.
D. Research and development costs related to software development are expensed as incurred. Software development costs are capitalized from the point in time when the technological feasibility of a piece of software has been determined until it is ready to be put on line to process customer data. The cost of purchased software, which is ready for service, is capitalized on acquisition. Software development costs and purchased software costs are amortized using the straight-line method over periods ranging from three to seven years. A history of the accounting treatment of software development costs and purchased software costs follows:
EXPENSED
|
CAPITALIZED
|
AMORTIZED
| |
1993
|
$166,430
|
$9,585
|
0
|
1994
|
$211,852
|
$5,362
|
$4,511
|
1995
|
89,089
|
18,813
|
5,111
|
$467,371
|
$33,760
|
$9,622
|
| EXHIBIT 1 OSI 1995 Financial Statements | ||
| OUTSOURCE,INC. BALANCE SHEET (DECEMBER 31) | ||
| ASSETS | 1995 | 1994 |
| Current Assets | $144,724 | $169,838 |
| Cash | 217,085 | 192,645 |
| Trade and other receivables (net) | 15,829 | 23,750 |
| Inventaries | 61,047 | 49,239 |
| Other | $438,685 | $435,472 |
| Total current assets | ||
| Noncurrent Assets | $123,135 | $109,600 |
| Property, plant, and equipment | 33,760 | 14,947 |
| Software and development costs | 151,357 | 141,892 |
| Data processing equipment and furniture | 3,650 | 8,844 |
| Other noncurrent assets | $311,902 | $275,283 |
| Less: Accumulated depreciation | 85,018 | 57,929 |
| Total noncurrent assets | $226,884 | $217,354 |
| Goodwill | 88,200 | 96,600 |
| Total assets | $753,769 | $749,426 |
| Liabilities and Shareholders' Equity | ||
| Current Liabilities | ||
| Short-term debt + current portian oflong-term note | $27,300 | $31,438 |
| Accounts payable | 67,085 | 57,483 |
| Deferred income | 45,050 | 32,250 |
| lncome taxes payable | 19,936 | 12,100 |
| Employee compensation and benefits payable | 30,155 | 28,950 |
| Other accrued expenses | 28,458 | 27,553 |
| Other current liabilities | 17,192 | 29,769 |
| Total current liabilities | $235,176 | $219,543 |
| Long-term debt less current portian | 98,744 | 117,155 |
| Deferred income taxes | 6,784 | 4,850 |
| Shareholders' Equity | ||
| Cumulative nonconvertible preferred stock, $100 par value, | ||
| authorized 5,000 shares, issued and outstanding 1,000 shares | 100,000 | 100,000 |
| Common stock, $1 par value; 300,000 shares authorized; | ||
| 219,884 shares issued and outstanding | 219,884 | 219,884 |
| Additional paid-in capital | 32,056 | 32,056 |
| Retained earnings | 61,125 | 55,938 |
| Total shareholders' equity | 413,065 | $407,878 |
| Totalliabilities and shareholders equity | $753,769 | $749,426 |
| 1995 | |
| Statement of lncome for Year Ended December 31, 1995 | |
| Operating revenue | $2,604,530 |
| Less: Costs of services | 1,466,350 |
| Gross profit | $1,138,180 |
| Less: Operating expenses | |
| Selling, general and administrative | 902,388 |
| Research and development | 89,089 |
| Other expense (income) | 59,288 |
| Write-off of goodwill and other intangibles | 13,511 |
| Earnings (loss) before interest and taxes | $73,904 |
| lnterest income | 1,009 |
| lnterest expense | 12,427 |
| Earnings (loss) before income taxes | $62,486 |
| lncome tax provision | 21,870 |
| Earnings (loss) | $40,616 |
| Statement of Cash Flows for Year Ended December 31, 1995 | |
| 1995 | |
| Cash Flows from Operating Activities | |
| Net Earnings (Loss) | $40,616 |
| Depreciation | 21,978 |
| Amortization of software & development costs | 5,111 |
| Decrease (lncrease) in accounts receivables | -24,440 |
| Decrease (lncrease) in inventaries | 7,921 |
| Decrease (lncrease) in other current assets | -11,808 |
| lncrease (Decrease) in deferred income | 9,602 |
| lncrease (Decrease) in accounts payable | 12,800 |
| lncrease (Decrease) in income taxes payable | 7,836 |
| lncrease (Decrease) in employee compensation | 1,205 |
| lncrease (Decrease) in other accrued expenses | 905 |
| lncrease (Decrease) in other current liabilities | -12,577 |
| lncrease (Decrease) in deferred income taxes | 1,934 |
| Net cash provided by operating activities | $61,083 |
| Cash Flows from lnvesting Activities | |
| Expended for capital assets | $-36,619 |
| Goodwill amortized | 8,400 |
| Net cash used for investing activities | $-28,219 |
| Cash Flows from Financing Activities | |
| Payment of long-term note | $-4,138 |
| Payment of short-term note | $-18,411 |
| Preferred dividends | $-11,000 |
| Common stock dividends | $-24,429 |
| Net cash used for financing activities | $-57,978 |
| Net cash flows used ($25, 114) | |
| Cash at beginning of year | $169,838 |
| Cash at end of year | $144,724 |
Additional Financial lnformation
OSI's common stock is currently trading at $2.00 per share. A preferred dividend of $11 per share was paid in 1995, and the current price of the preferred stock is approximately at its par value. Other information pertaining to OSI's debt and stock follows:
RATE
| ||
Short-terrn debt:
|
$8,889
|
8.00%
|
Long-terrn debt:
| ||
Current portion
|
$18,411
|
10.00%
|
Long-terrn portion
|
$98,744
|
10.00%
|
Totallong-terrn debt
|
$117,155
| |
Stock market risk-free rate
|
5.00%
| |
(90-day T-bills)
| ||
Expected return on the
|
12.50%
| |
market
| ||
Beta value of OSI's
|
1.2
| |
common stock
| ||
Growth rate of dividends
|
8.00%
| |
Incometax
|
35.00%
|
Requirements
The management of OutSource, Inc., has asked you to prepare a report explaining EVA (economic value added) and MVA (market value added), how they are calculated, and how they compare with traditional measures of a firm's financial performance. OSI's management would also like to know the advantages and disadvantages of using EVA to evaluate the firm's performance on an ongoing basis as well as in assessing the performance of individual managers throughout its organization. As part of your report, calculate EVA and MVA from OutSource, Inc.'s, financial statements for 1995. Finally, OSI's management would like to know if EVA can be used as part of an incentive system for its employees and how they should proceed to implement such an incentive system at OutSource, Inc.
[1] 'Who Are the Real Wealth Creators?" R. B. Lieber, Fortune (Decemher9, 1996), pp. 107-08,110,112,114.
[2] The Real Key to Creating Wealth," S. Tully, Fortune (September 20, 1993), pp. 38-40, 44-48, 50.
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