STRATEGIC FINANCIAL STRUCTURE AND = 3/5 * 0.04 + 2/5 * 0.06 * 0.65 = 0.0396 = 3.96%.

PERFORMANCE EVALUATION Company B

FINANCIAL STRUCTURE - refers to sources of capital = 5/6 * 0.05 + 1/6 * 0.07 * 0.65 = 0.049 = 4.9%.
and the proportion of financing coming from short-term The above calculations, Company A has a lesser cost of
liabilities, short-term debt, long-term debt, and equity capital (WACC) (3.96%) than Company B (4.9%).
to fund the company’s long-term and short-term Depending on the return both of these companies make
working capital requirements. at the end of the period, we would be able to
DEBT - includes a loan or other borrowed money that understand whether, as investors, we should invest into
has an interest component associated with it which is these companies or not.
periodically paid till the borrowed amount is fully FACTORS AFFECTING FINANCIAL STRUCTURE
repaid. 1. Cost of capital - debt and preference share is a
EQUITY - refers to diluting the owner’s stake in the cheaper source of capital than equity, and a
company and selling it to investors. Equity investor does company focuses on reducing its cost of capital
not need to be paid interest like debt. Rather, the profit 2. Control- Equity as a source of capital has its
earned by a company is attributed to them as they own limitations. The excessive dilution or selling of
a share in the company and are part owners. Profit is stake may lead to loss of power in decision
distributed through dividends paid by the company to making and controlling stake in a company.
its investors 3. Leverage - Debt can be both positive and
OPTIMAL FINANCIAL STRUCTURE negative. On the positive side, it helps keep the
While every company or firm, private or public, is free low cost of capital as it is a cheaper source than
to use any structure, any random mix of debt and equity equity and a small increase in profit magnifies
is neither preferable nor good for a going concern certain return ratios. On the other hand,
company. Furthermore, the kind of structure a company however, it may negatively create solvency
employs affects its WACC (Weighted Average Cost of issues and increase its financial risk.
Capital), which directly affects the valuation of a 4. Flexibility - The financial structure should be
company. Therefore, an optimal design is necessary to arranged to change the environment. Too much
maximize the value of a company. rigidity may make it difficult for a company to
WACC (Weighted Average Cost of Capital) - is the survive.
average rate of return a company is expected to pay to 5. Credibility and Size of a Company - Small-sized
all its shareholders, including debt holders, equity companies, new companies, or companies with
shareholders, and preferred equity shareholders. a bad credit history may not have unrestricted
FORMULA: access to the debt due to insignificant cash
WACC= (market value of equity/total market value of flows, lack of assets, and a missing guarantor for
equity and debt) x Cost of Equity + (Market value of the security of a loan. Therefore, it may be
debt/Total market value of Equity and debt) x Cost of forced to dilute its equity to raise capital.
Debt x (1- Corporate Tax Rate) STRATEGY
Example: a. What sources of short term or long-term funds
In US $ Company A Company B should be tapped and in what proportion?
Market Value 300,000 500,000 b. To what extent should long-term debt be resorted?
of Equity(E) c. How much does it cost?
Market Value 200,000 100,000 d. Lease financing?
of Debt (D) e. Leverage decisions?
Cost of equity 4% 5% f. Trading on equity?
(Re) CAPITAL STRUCTURE VS. FINANCIAL STRUCTURE
Cost of Debt 6% 7% CAPITAL FINANCIAL
(Rd) STRUCTURE STRUCTURE
Tax rate 35% 35% DEFINITION A combination A combination
of different of different
WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax) types of long types of long
Company A
 terms sources term as well as • Potential conflict
of funds. short term • More costly than debt financing
sources of Performance Evaluation - A complete evaluation of a
funds. company's overall standing in categories such as assets,
BALANCE SHEET is part of the includes all the liabilities, equity, expenses, revenue, and overall
liabilities items in the profitability.
section liabilities We use measures to evaluate performance valuation.
of balance section of the
These measures determine the company’s ability to
sheet balance sheet
withstand competition and adverse rising costs, falling
SCOPE has a narrower has a broader
prices or declining sales in the future and capitalization.
scope scope
compared compared to Debt leverage - shows the degree to which a business is
to Financial Capital utilizing borrowed money.
Structure Structure Liquidity- shows the ability to convert an asset to cash
FINANCIAL equity shares, equity shares, quickly and reflects the ability of the firm to manage
INSTRUMENTS preference preference working capital when kept at normal levels.
shares, shares, Net Investment- is the total spending on new fixed
debentures, debentures, investment minus replacement investment, which
long term long term simply replaces depreciated capital goods
borrowings, borrowings, CONCLUSION
retained retained Financial structure gives an insight into a company’s
earnings earnings,
leverage and cost of capital. For example, an asset to
accounts
equity, debt-to-equity, etc., are some ratios that give an
payable, short-
idea about financial structure. In the initial years, many
term
borrowings companies may deviate from their target or optimal
TWO TYPES OF FINANCING: capital structure due to the need for funds and,
1. DEBT FINANCING - The act of raising capital by therefore, may not think about the sources of funds.
borrowing money from a lender or a bank, to be But in the long term, every company moves towards its
repaid at a future date. In return for a loan, target or optimal capital structure whereby the cost of
creditors are then owed interest on the money capital is minimized, and the firm’s value is maximized.
borrowed.
ADVANTAGES OF DEBT FINANCING MANAGEMENT CONTROL AND STRATEGIC
 Maintain control PERFORMANCE MEASUREMENT; STRATEGIC
 Get tax deduction INVESTMENT UNITS AND TRANSFER PRICING
 Build and improve business credit
Performance evaluation - The process of assessing the
 Aids business growth
performance of tasks at all levels within the firm and
DISADVANTAGES OF DEBT FINANCING
evaluate them using a preestablished criteria as set out
 Loan repayment
in budgets, strategy and objectives
 Qualifying can be difficult
 All levels mean that the top management,
 High rates
middle management and operating level
 Collateral
personnel are evaluated of their performance
2. EQUITY FINANCING - Involves selling a portion
Management Control - The evaluation of the
of a company's equity in return for capital
performance of mid-level managers done by the upper
ADVANTAGES OF EQUITY FINANCING
level managers
• Less burden
Operational Control - The evaluation of the
• Possibility of raising more capital
performance of operating level employees done by the
• Learn and gain from partners
mid-level managers.
DISADVANTAGES OF EQUITY FINANCING
• Share profit
• Loss of control
 MANAGEMENT OPERATIONAL CONTROL Strategic Investment Unit A K A Responsibility Center is
CONTROL a specific unit of an organization assigned to a manager
Evaluation of mid level Evaluation of operational who is held accountable for its operations and
managers’ performance level employees done by resources.
done by upper level mid level managers Strategic performance measurement is also known as
managers Responsibility Accounting. It is a system used by top
management to evaluate SIU managers.
Long term strategic Short term performance
DECENTRALIZATION – the authority to make decisions
issues
is spread throughout the organization.
Management by Management by
BENEFITS
objectives approach exception approach
MANAGEMENT CONTROL OBJECTIVES: • Uses local knowledge
 MOTIVATE MANAGERS - induce them to use • Allows timely and effective response to customers
their full potential and effort in achieving the • Train managers
goals set by the top management • Motivate managers
 PROVIDE THE RIGHT INCENTIVE FOR • Offers objective method of performance evaluation
MANAGERS - enables them to make the right LIMITATIONS
decisions which must be in line with the •Can hinder coordination among SIUs
corporate objectives • Can cause potential conflict among SIUs
 DETERMINE FAIRLY THE REWARDS EARNED BY
MANAGERS - as compensation for their efforts, For an effective strategic performance measurement,
skills, and expertise and the effectiveness of the following basic conditions are necessary:
their decision making 1. A well-defined organization structure
DESIGNING MANAGEMENT CONTROL SYSTEMS 2. Well defined and established standards of
FOUR QUESTIONS that management must ask when performance in revenues, costs and investments
developing a management control system: 3. A system of accounting that identifies any revenues,
expenses, and assets to specific units in the
 WHO is interested in evaluating the
organization.
organization’s performance?
4. A system that provides for the preparation of regular
 WHAT is being evaluated?
performance reports
 WHEN is the performance evaluation to be
TYPES OF SBUs:
conducted, and should it be based on the
1. COST SBUs responsible for providing the best
master budget or the flexible budget?
quality product or service at the lowest cost
 SHOULD the system be formal or informal?
 Minimize cost
INFORMAL FORMAL SYSTEMS
 Budget of cost based on expected level of
SYSTEMS
operation
INDIVIDU  Aspiration  Hiring
AL level practices  Performance report or variance analysis reports
 Personal  Promotion 2. REVENUE SBUs focus on the selling function
drives procedure and/or defined either by product line or by
 Strategic geographic area
performan  This is a unit or segment within an organization
ce where the manager is responsible for selling
measurem budgeted quantities of various products or
ent services at budgeted price
TEAMS  Peer norms  Keiretsu 3. PROFIT SBUs both generates revenues and
 Organizatio  Shared incurs the major portion of the cost for
nal cultural responsibil producing these revenues
ity
 Generation of revenues and control of costs
STRATEGIC PERFORMANCE MEASUREMENT:
 Budget for guidelines and authority
BASIC CONCEPTS
  Income statements using the contribution - This variance measures the difference
margin between actual unit sales and budgeted unit
4. INVESTMENT SBUs includes assets employed by sales.
the SBU as well as profit in the performance 3. Sales Mix Variance = (Flexible budget ave. Contri
evaluation margin per unit* - master budget ave. contri margin
per unit) x Actual Unit Sales
Objectives: *Flexible budget ave contri margin per unit = flexible
 Motivate managers to exert high level of effort budget total contri margin/Actual unit sales
to achieve the goals of the firm.
 Provide the right incentive for managers to Transfer pricing - A problem common to most
make decisions that are consistent with the companies operating with decentralized segments is
goals of top management that of placing a fair value of exchange of goods and
 Determine fairly the rewards earned by the services between segments within the company
managers for their effort and skill  The transfer price of interdivisional sales will
FORMULAS: affect the selling division sales and the buying
ROI = Net operating income/ average operating assets decision cost but will not have any direct effect
OR on the company’s profit
 A particular transfer pricing basis may also be
ROI= Net operating income/ Sales X Sales/ Ave. an excellent management tool
Operating Asset  For motivating division manager
OR  For establishing and maintaining cost control
ROI= Operating Profit Margin x Asset Turnover (Return systems and for measuring internal
on Sales) performance
Return on Investment Alternative Transfer Pricing Strategies:
ADVANTAGES LIMITATIONS In practice, four general approaches are used on setting
It is easily understood Subject to Criticisms transfer price.
and has gained wide • It results to disincentive 1.MINIMUM TRANSFER PRICE – a general rule for
usage for high ROI units to making transfers to maximize a company’s profits in
• It is comparable to invest in projects either perfect or imperfect market uses formula:
interest rates of returns with ROI greater than the Transfer Price= Differential costs per unit +
of alternative minimum rate of return Lost Contribution margin per unit on outside
investments. but less than unit’s
sales(or opportunity coosts per unit)
Formulas: 𝑅𝑂𝐼= current ROI.
2. MARKET BASED TRANSFER PRICE – Under this
𝑁𝑒𝑡𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔
approach, the transfer price is the price at which the
3 TYPES OF VARIANCES: goods are sold on the open market.
1. Sales Price Variance = (actual Sales Price – The market price approach is designed for situations in
Master Budget Sales Price) x Actual Unit Sales where there is an outside market for transferred
- This variance shows how much of the product or services the product or services is sold in its
difference between actual and budgeted present form to outside costumers
contribution margin is caused by the 3. COST BASED TRANSFER PRICE – Under this approach,
difference between actual and budgeted the transfer price is based only on variable or
sales prices. differential costs.
2. Sales Volume Variance = (Actual Unit Sales- Advantage:
Master Budget Unit Sales) x Master Budget It ensures in the short run the best use of total
Ave. Contribution Margin per Unit* corporate facilities because it focuses attention on the
*Master budget average contri margin per unit contribution margin a transfer generates and on how it
= Master budget total contri margin/ Master increases short run profitability
budget sales Disadvantages:
• A company must cover all costs before earning profit MULTINATIONAL TRANSFER PRICING – A company will
If fixed costs are ignored, a variable cost transfer price usually concentrate on satisfying a single objective,
may be profitable in the short run, but not in the long namely “minimize income taxation”
run TRANSFER PRICING IN THE SERVICE INDUSTRY- Service
• It allows one segment manager to make a profit at the industry firms and nonprofit organizations use transfer
expense of another segment manager because the pricing when services are transferred between
receiving segment receives all the profit responsibility centers
A.VARIABLE COST - Variable cost based pricing DUAL PRICES – Under dual prices of transfer pricing,
approach is useful when the selling division is operating selling division sells the transferred goods at a (i)
below capacity. These costs are direct materials, direct market or negotiated market price or (ii) cost plus some
labour and variable factory overhead. profit margin
B. ACTUAL FULL COST - It is based on the total product
cost per unit which will include direct materials, direct FINANCIAL AND NON-FINANCIAL PERFORMANCE
labour and factory overhead. MEASURES
C. FULL COST PLUS PROFIT MARGIN - Include the PERFRORMANCE EVALUATION- “What gets measured
allowed cost of the item plus a mark up or gets done”.
other profit allowance - The process by which managers at all levels
D. STANDARD COST - In actual cost approaches, there is gain information about the performance of
a problem of measuring cost Actual cost does not tasks within the firm and judge the
provide any incentive to the selling division to control performance against pre-established
cost criteria.
4. NEGOTIATED TRANSFER PRICES - The measures that quantify financial and
- Negotiated prices are generally preferred as a middle non-financial performance
solution between market prices and cost based prices Importance of Performance Evaluation
- Avoids mistrusts, bad feelings and undesirable  Motivate managers to provide a high level
bargaining interests among divisional managers of effort
Advantages:  Provide a basis for determining fair
• Some Form of Outside Market for the Intermediate compensation for the mangers
Product  Guide them to make decisions congruent
• Sharing of all Market Information Among the with the goals of the management
Negotiators Goal of Performance Evaluation
• Freedom to Buy or Sell Outside Enable managers and employees at all levels of the
• Support and Occasional Involvement of Top organization to understand, implement and refine the
Management organization's mission, goals and strategies
Disadvantages: Financial Performance Measure - Defined as lagging or
• A great deal of management effort, time and historical measures because it summarizes results of
resources can be consumed in the negotiating process past events that are important to a firm's owners,
• The final emerging negotiated price may depend more creditors, suppliers and employees
on the divisional manager’s ability and skill to negotiate Non-financial Performance Measures - Defined as
than on the other factors leading in that they relate to future profitability created
• One divisional manager having some private by current activities that drive future financial
information may take advantage of another divisional performance
manager
• It is time consuming for the managers involved Effective management requires a balanced perspective
• It leads to conflicts between divisions on performance measurement, this viewpoint is called
the balanced scorecard perspective
DISTRESS PRICE – It is when a firm chooses to mark Balanced Scorecard balances the use of financial and
down the price of an item or service instead of non-financial performance measures to evaluate short
discontinuing the product or service altogether run and long run performance in a single report. It
consists of a system of performance measures that are Reduce unfairness of Adjustments necessary in
derived from and support the company's strategies. historical cost setting the target levels
of performance(step 5)
DESIGNING ACCOUNTING-BASED PERFORMANCE DRAWBACK: difficult to estimate.
MEASURES
STEP 1: Choose performance measures that align with GROSS BOOK VALUE NET BOOK VALUE
top management’s financial goal. Adv: eliminates the Adv: maintains
ROI= Income/ Investment OR Investment Turnover x disadvantage of net book consistency with the SFP
Return on Sales value and Income
Residual Income = Income – (Required rate of return x Dis: Not consistent with Dis: increases ROI,
SFP and Income and susceptible to
investment)
reduces the error(depreciation), and
Economic Value Added = After Tax operating income – [
comparability misleading
weighted ave cost of capital x (total assets – current
*FOR LONG-TERM ASSETS MEASUREMENTS
liab)]
Return on sales = Operating income / Sales
STEP 5: Decide on a target level of performance.
 Carefully select benchmarks/targets that can
STEP 2: Determine the time horizon of each
help offset shortcomings.
performance measure.
 Appropriately set target to avoid: (1)wrong
Reasons to evaluate subunits on the basis of ROI,RI, EVA
impression;(2) wrong interpretation
and ROS over multiple years:
 Another popular way to establish targets is to
✓ To avoid short-run changes in performance measures
continuous improvement targets.
that could contradict with the long-run goals of the firm
✓ The benefits of action taken on the current period STEP 6: Choose the timing of feedback.
may not show up in the short-run performance  Setting of standard of when you need to receive
measures feedback.
✓ If managers use the net present value method to o Determine to whom it is sent to
make investment decisions, using multi-year RI to o How often and when it is sent to
evaluate manager's performance achieve goal o Determining transporting system of
congruence feedback
 If it does not produces expected results:
STEP 3: Define the components of each performance - Implementation problems
measure. - Invalid strategy
Total Assets Available = includes all assets PERFORMANCE MEASUREMENT IN MULTINATIONAL
Total Assets Employed = TA - (Idle Assets + Assetsfor COMPANIES
future expansion) Multinationals - companies that operates in several
Total Assets Employed minus CL = excludesassets countries
financed by short-term creditors Multinational companies may be either:
(i) a large decentralised firm having a corporate head
STEP 4: Choose a measurement alternative for each office and many divisions
performance measure (ii) a parent company and a number of subsidiaries.
CURRENT COST HISTORICAL COST
Better Measures of Tend to give significantly Evaluation of performance of foreign units and their
current economic returns higher ROI
managers can create difficulties for the following
from investment
reasons:
compared to historical-
cost.  Economic, legal, political, social and cultural
Make calculations Unaffected by price environments differ significantly across
relevant and comparable changes and reduced by countries.
depreciation.
  Governments in some countries may impose *If the MCE is less than 1, then non-value-added
controls and limit selling prices of a company’s time is present in the production process
product. *If the MCE is 0.5, then half of the total production
 Availability of materials and skilled labouras as time is consisted of non-valued-added activities.
well as costs of materials, labour and By monitoring the MCE, companies are able to
infrastructure (power, transportation and reduce non-value-added activities and thus get
communication) may also differ significantly products into the hands of customers more quickly
across countries at a lower cost
 Divisions operating in different countries keep
score of their performance in different CUSTOMER SATISFACTION SCORE - CSAT is for
currencies. Issues of inflation and fluctuations in assessing customer support, product and service.
foreign currency exchange rates affect - (No. of SatisfiedResponses/Total No.of
performance measures greatly. responses) x 100
 Performance evaluation of a manager should be CUSTOMER EFFORT SCORE - CES is focused more on
distinguished from the performance evaluation customer convenience; gauges the amount of perceived
of a manager’s subunit such as a division or work a customer has to put into dealing with your
subsidiary of a company. company.
 Division’s performance may be adversely NET PROMOTER SCORE- NPS monitors how often or
affected by economic conditions and other likely your consumers offer your brand to other
constraints which are beyond the control of the potential customers
manager. PASSIVE: Customers who rate 7 or 8 and have average
INTERNAL BUSINESS PPROCESS PERFORMANCE experience with your company. They are satisfied with
1. Delivery cycle time your services but might switch your competitors if given
- The amount of time from when an order is an opportunity. They have a neutral stand - won't
received from a customer to when the spread negative word-of-mouth but won't promote
completed order is shipped. your brand either.
- This time is clearly a key concern to many DETRACTORS: Customers who rate below 6 and are not
customers, who would like the delivery happy with your product or service. They share their
cycle time to be as short as possible. bad experiences with others and damage the company's
2. Throughput (manufacturing cycle) Time reputation. They would not like to repurchase your
- The amount of time required to turn raw product or service and would discourage others too.
materials into completed products. PROMOTERS: Customers who rate 9 or 10 and are
- Throughput time is made up of; happy with your services. They are loyal enthusiasts and
o Process time - is the amount of might prove to be evangelists for your business growth.
time work is actually done on the They are extremely likely to recommend your company
product. to people in their social or professional circles.
o Inspection time- is the amount of
time ensuring that the product is
not defective.
o Move time- is the time required to
move materials or partially
completed products from
workstation to workstation.
o Queue time - is the amount of time
a product spends waiting to be
worked on, to be moved, to be
inspected, or to be shipped
3. MANUFACTURING CYCLE EFFICIENCY (MCE)
MCE = Value added time/Throughput time