Performance Measurement and Management for Engineers

Michela Arnaboldi, Giovanni Azzone, Marco Giorgino

• Publisher: Academic Press
• Year: 2014
• Print ISBN: 9780128019023
• eBook ISBN: 9780128019207
• Topic: Business
• Subtopic: Finance
• Index: Business

Performance Measurement and Management for Engineers introduces key concepts in finance, accounting, and management to project managers who have engineering backgrounds. It focuses these basic concepts on issues of measuring and managing enterprise value. Thus, after defining enterprise value, the book begins by explaining the ways and means of measurement. It then takes up financial measurement, describing and analyzing the typologies of financial indicators while illustrating their advantages and disadvantages. After focusing on measuring enterprise value, the second section takes up managing that value. Like the first, it pursues a double view: using indicators for internal control while employing them to analyze other companies. If engineering project managers possess a source of quantitative and qualitative information about business management, Performance Measurement and Management for Engineers will help them increase their contributions to the business. - Explains how main performance indicators are related to the value of the company - Reveals how to assess the financial needs of companies in relation to their financial goals and mechanisms (e.g., equity, debt, and hybrid) - Describes key information and indicators for assessing the ability of enterprises to create value across time - Indicates the profitability sources of different business units

Chapter 1

Introduction

Large infrastructural projects, technology and product development, manufacturing reconfiguration, and cloud computing conversion are just a few examples of activities that are now carried out in enterprises with increasing frequency. These activities are usually managed by engineers from various disciplines, yet they widely impact overall financial performance, exposure, and company value. In this context, it is mandatory to have managers who are capable of measuring weak signals from operations and projects; understanding their wider financial impact considering internal and external stakeholders; and then knowing, as a consequence, the impact on the enterprise value.

Keywords

present value; decision making; internal accountability; disclosure

Large infrastructural projects, technology and product development, manufacturing reconfiguration, and cloud computing conversion are just a few examples of activities that are now carried out in enterprises with increasing frequency. These activities are usually managed by engineers from various disciplines, yet they widely impact overall financial performance, exposure, and company value. In this context, it is mandatory to have managers who are capable of measuring weak signals from operations and projects; understanding their wider financial impact considering internal and external stakeholders; and then knowing, as a consequence, the impact on the enterprise value.

Enterprise value is the backbone of this book and the focus of this introductory chapter. In the first section, we illustrate what enterprise value is, how to measure it and, finally, how value can be managed in a coordinated but delegated manner.

1.1 What is Enterprise Value?

To address the question “What is enterprise value?” it is first useful to understand what an enterprise is.¹ Instead of quoting the formal definition, we can conceptualize companies as input–output systems (Figure 1.1).

Figure 1.1 A company as an input–output system.

Enterprises aim to provide outputs (products and services) to customers and to add value to employed inputs, which include human, financial, and technological resources. To simplify: Enterprises want to maximize their output against their inputs. This simple logical thinking clashes with a fundamental computational problem: There are different types of inputs (people, machines, and patents) and outputs (various products and multiple services), each of them with diverse measurement units; hence, we simply cannot list all of them. To solve this problem and analyze the enterprise capability of creating value, money is used as a reference measurement unit. Inputs and outputs can then be expressed in cash equivalents, measuring inputs in term of the cash outflows needed to get them and outputs in terms of cash inflows deriving from their sale. From an economic point of view, we can further distinguish between:

• • Investments (I): Investments refer to cash outflows related to the purchase of assets that a company is going to use for more than 1 year; examples of assets are machinery, patents, equity investments, and land.
• • Cash flows (CF): Cash flows refer to cash exchanges related to transactions that have an impact on the short-term operating cycle of the company. Some examples include cash inflows originated by the sales of products or services and cash outflows for personnel wages, material purchases, or rent.

Starting from this assertion, considering a single year, the contribution of company activities to the value of a company can be expressed as net cash flow (NCF) originated for Year 0:

$V=\text{NCF}(0)=\text{CF}(0)–I(0)$

However, companies are founded and then are supposed to have an infinite lifecycle; hence, to understand the overall value, the time horizon must be lengthened, considering not only the NCF originated at Year 0 but also all the NCFs that the enterprise is going to generate in future years, with an infinite (∞) horizon of time (Figure 1.2).

Figure 1.2 Time horizon for enterprise value and NCF analysis.

The sum of NCFs originated in different years can appear to be the simpler solution to calculate the overall value, yet this solution overlooks a crucial issue. The value of money changes over time. To test this issue yourself, think about this: Would you agree to give a company 10,000€ this year (Y0) in exchange for 10,000€ next year (Y1)? The answer would be no because you could invest your 10,000€ in other risk-free activities—such as government bonds—to obtain a greater amount of money. For example, if the annual interest rate of government bonds (the so-called risk-free rate) is 3%, by investing 10,000€ now (Year 0), you will get back 10,300€ in 1 year. To explain these calculations:

$\mathit{V}(0)=10,000€\left[\mathrm{Value\; at}Y0\right]$

$\mathit{V}(1)=10,000€*0.03=10,300€[\mathrm{Value}\mathrm{projected}\mathrm{at}\mathit{Y}1\mathrm{with}\mathrm{the}\mathrm{annual}\text{risk}-\text{free}\mathrm{rate}\mathrm{of}3\%]$

This future projection of cash flows is generalized with the compounding formula, where r_f is the risk-free rate, n is a generic year, and FV stands for future value.

$\mathrm{FV}(n)=V(0)\times {(1+r_{\mathrm{f}})}^n\left[\mathrm{compounding}\mathrm{formula}\right]$

Going back to our problem of summing NCFs originated in different future years (Figure 1.2), we have the opposite problem: to calculate the present value (PV) of future cash flows. In this case, we use the discounting formula that can be easily obtained by the previous one:

$\mathrm{PV}(0)=\frac{\mathrm{FV}(n)}{{(1+r_f)}^n}\left[\mathrm{discounting}\mathrm{formula}\right]$

The discounting formula allows us to solve the computational problem of summing expected cash flows over different years. Using the risk-free rate and considering an infinite horizon, the present value of future NCFs can be obtained as follows:

$\text{PV}(0)=\frac{{\mathrm{NCF}}_1}{{(1+r_{\mathrm{f}})}^1}+\frac{{\mathrm{NCF}}_2}{{(1+r_{\mathrm{f}})}^2}+\frac{{\mathrm{NCF}}_3}{{(1+r_{\mathrm{f}})}^3}+\cdots +\frac{{\mathrm{NCF}}_N}{{(1+r_{\mathrm{f}})}^N}$

$\text{PV}(0)=\sum _{t=0}^{+\infty }\frac{{\mathrm{NCF}}_t}{{(1+r_{\mathrm{f}})}^t}[\mathrm{present}\mathrm{value}\mathrm{in}\text{risk}-\text{free}\mathrm{conditions}]$

The calculation of the present value using the risk-free rate does not take into account another element of business activities: Enterprises operate in uncertain conditions; hence, they are not considered by investors as risk-free activities. This uncertainty is compensated by a risk premium for shareholders, who are individuals or entities buying and owning shares of equity² in a corporation. Considering risk from the shareholders’ perspective, the present value formulation changes by including the risk premium at the denominator in the discounting factor, which is called cost of equity capital (k_E). Here, the generic term NCF is substituted by the term free cash flow to equity (FCFE) to clarify that we assume that cash flows pertain to shareholders.³

The value formulated in this perspective is called the equity value (E) and is analytically expressed by

$\mathit{{\rm E}}(0)=\sum _{t=0}^{+\infty }\frac{\mathrm{FCFE}(t)}{{(1+k_{\mathrm{E}})}^t}\left[\mathrm{Equity}\mathrm{present}\mathrm{value}\right]$

Finally, it is important to consider that enterprises are financed not only by equity capital (E) but also by debt capital (D), which may be referred to two main investors: financial institutions and bondholders. In this case, we can still refer to the formulation of equity present value, but another perspective can be adopted wherein the value is calculated with reference to all capital investors (equity and debt). In particular:

• • Cash flows at the numerator pertain to both equity and debtholders and are called free cash flow to firm (FCFF).
• • The discounting rate is the weighted average cost of capital (WACC), including the required rate of return of shareholder capital (k_E) and the average interest rate of debt (k_D) after tax (1−t), where t is the tax rate:
  $\mathrm{WACC}(t)=\frac{D}{D+E}\times k_{\mathrm{D}}\times (1-t)+\frac{E}{D+E}\times k_{\mathrm{E}}$
  

The formulation using the investors’ perspective is called the enterprise value (EV) and is expressed as follows:

$\mathrm{EV}(0)=\sum _{t=0}^{+\infty }\frac{\mathrm{FCFF}(t)}{{(1+\mathrm{WACC})}^t}\left[\mathrm{Enterprise}\mathrm{present}\mathrm{value}\right]$

1.2 How to Manage Enterprise Value: Enlarging the Performance Measurement Toolkit

Having defined present value as a measure of a company’s objective, the next stage is to understand how to use this metric for performance management. Although present value has the advantage of being synthetic and unique, its operational use is not straightforward, as we cannot measure value in an objective way—we can only estimat...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Acknowledgments
• Chapter 1. Introduction
• Chapter 2. Value-Based Management Indicators
• Chapter 3. Accounting-Based Measures
• Chapter 4. Value Drivers
• Chapter 5. Scorecards
• Chapter 6. Target Setting: Budgeting and Risk Management
• Chapter 7. Long- and Short-Term Decision Making
• Chapter 8. Performance Control for Organizational Units
• Chapter 9. Performance Control for Projects
• Chapter 10. Forms and Techniques for Financing
• Annexure 1: Consolidated Financial Statement
• References