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Additional Problems
6A-1. On January 26, 1995, The Wall Street Journal reported that Compaq Computer
Corp. posted record 1994 fourth–quarter results. Despite $20.5 million in losses
from the December, 1993, Mexican currency devaluation, and losses on
currency hedging, earnings grew to $0.90 per share from $0.58 in the same
quarter of 1993, on a revenue growth of 48%. Furthermore, Compaq captured
the No. 1 market share spot, with shipments up 50% from 1993 and with slightly
higher profit margin.
Nevertheless, on the same day, Compaq’s share price fell by $5.00, a decline of
about 12%. The Journal reported that analysts had been expecting earnings of
about $0.95 per share. Also, there were concerns about Compaq’s scheduled
introduction of new products in March 1995, following a warning by Compaq’s
CEO Eckhard Feiffer that first–quarter, 1995 earnings were likely to be “flat.”
Required
a. Use single–person decision theory and efficient securities market theory to
explain why the market price fell.
b. Assume that the $20.5 million in losses from peso devaluation and
currency hedging are a provision (i.e., an accrual), not a realized cash loss, at
the end of the fourth quarter. Use the anomalous securities market results of
Sloan (1996) to explain why the market price fell.
c. The Journal quoted an analyst as stating “the market overreacted.” Use
prospect theory to explain why the market might overreact to less–than–expected
earnings news.
d. Which of the above three explanations for the fall in Compaq’s share price
do you find most reasonable? Explain.
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6A-2. In the MD&A section of its 2000 Annual Report, Royal Bank of Canada reports
“economic profit.” This consists of cash operating earnings less a capital charge
of 13.5%, being the bank’s cost of common equity capital. The amounts for the
last two years are as follows:
2000 1999
Net income after preferred share dividends ($ millions) $2,140 $1,600
Add amortization of goodwill, other intangibles,
and one–time items 87 168
Cash operating earnings 2,227 1,768
Capital charge (1,460) (1,386)
Economic income $767 $382
Required
a. Relate the concept of economic income here to the clean surplus
valuation procedure in Example 6.2. Does Royal Bank have unrecorded
goodwill? (No calculations needed.)
b. Royal Bank also breaks down results for its major business segments. For
example, the personal and commercial financial services segment contributed
$469 million of the $767 total economic income for 2000. If you were the
manager of a Royal Bank segment, would your propensity to incur large capital
expenditures be affected by your knowledge that economic income was a factor
in evaluating your performance? Explain why or why not.
c. What new information, if any, is conveyed to the market by Royal Bank’s
disclosure of cash operating earnings and economic income? Why does Royal
Bank make these disclosures?
6A-3 Reproduced below is the Economic Value Added (EVA) disclosure from the
MD&A section of the 1996 annual report of Domtar, Inc. Some of the uses of
EVA are outlined in Domtar’s discussion in the disclosure. Of interest here is the
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close relationship between the EVA measurement formula and the clean surplus–
based valuation procedure outlined in Example 6.2. Note that the EVA for a
given year is equivalent to abnormal earnings (oxta) for that year in our example.
Recall that goodwill is calculated as the present value of expected future
abnormal earnings.
It is not clear whether Domtar continues to use EVA, since there is no mention of
it in its 2006 annual report. Since 1996 was the last year it gave details of its EVA
calculation, we will continue with its 1996 disclosure, as follows:
Economic Value Added (EVA)
At the end of 1995, the Corporation adopted a new management system known as
Economic Value Added, or EVA®, to ensure that the decision–making process at
Domtar is aligned with the objective of increasing shareholder value.
In 1996, this concept was implemented throughout the Corporation and is being used
for measuring performance, evaluating investment decisions, improving communication
and for incentive compensation. EVA® training courses were developed and are being
provided to a large number of employees in on–going efforts to develop a value creation
culture at Domtar.
The EVA® measurement formula is as follows:
EVA® = NOPAT1 – Capital Charge2
1Net operating profit after tax
2Capital employed × Cost of capital for the Corporation
This simple formula highlights the notion that in order to create value for Domtar
shareholders, every business unit must generate returns at least equal to its cost of
capital, including both debt and shareholders’ equity.
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Following a record year in 1995 when $316 million of EVA® was created, EVA® for
Domtar in 1996 was $120 million negative, due to the decline in selling prices.
EVA® = NOPAT – Capital Charge
1995 316 = 539 – 223
1996 (120) = 88 – 208
Domtar remains committed to creating long–term shareholder value and will intensify its
efforts in 1997, especially in areas under its control, such as productivity, costs,
customer service, and capital management. Domtar will also benefit from an overall
lower cost of capital going forward as a result of its debt management program
completed in 1996.
Source: Economic Value Added disclosure from Domtar, Inc.’s annual report (1996).
Reproduced with permission.
Required
a. Evaluate the usefulness of this approach to communicating information to
investors. Consider both relevance and reliability issues.
b. If you were the top manager of a company using EVA, would its use
encourage or discourage you from initiating major, capital intensive expansion
projects? Explain why or why not.
c. You are an investor in a fast–growing, high–tech company that reports
EVA. The assets of the company are primarily intangible (patents, skilled
workforce) and are unrecorded on the company’s books, hence not included in
the EVA capital charge. How would the unrecorded, intangible nature of the
assets of such a company affect your interpretation of its EVA? Explain.
d. Note that reporting of EVA is voluntary. Domtar reports this information for
1996 even though its EVA is negative. Does Domtar’s willingness to report this
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information add credibility to its claim that it “will intensify its efforts in 1997”?
Explain.
Suggested Solutions to Additional Problems
6A-1. a. According to single person decision theory and efficient securities market
theory, the share price fell for one or more of the following reasons:
• Earnings came in below expectations of $.95 per share. This would cause
investors to revise downwards their expectations of future earnings performance.
b. The provision has a less persistent effect on earnings than a cash loss, since
accruals reverse. If so, the efficient market should react less negatively to the
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All of these effects could explain the strong negative reaction.
d. The chosen explanation is clearly a matter of judgement and preference. Any
of the explanations can be accepted as most reasonable providing that reasonable
justification is given. Points to consider include:
• The efficiency explanation has considerable theory (i.e., single–person decision
theory and the CAPM) behind it. Even the very volatile market response is
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6A-2. a. Royal Bank’s concept of economic income is related to the clean surplus
valuation procedure through the concept of goodwill. Economic income shows
the current instalment of the ability of the bank to earn a return greater than its
b. Yes. I would thoroughly evaluate large capital expenditures. These would
be accepted only if there was a high probability of a return greater than the cost
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Adding back goodwill amortization and other intangible and one–time items to
investors, and the public, that profitability should be measured after a capital
charge. Since this produces a lower number, the bank may feel that concern
about excessive bank profits will be reduced.
6A-3 a. The information is potentially useful to investors since it emphasizes that
earnings do not augment firm value unless they exceed expected earnings, that
is, earnings greater than the cost of capital used to earn them. This is consistent
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use calculations..
b. EVA may discourage the top manager from initiating major capital
expenditures since these would carry with them an automatic capital charge.
Even if the expected value of a project exceeds the capital charge, the manager
may be discouraged if the project is risky. The riskier the project, the higher the
show up in reported earnings over time as their value is realized, not in the
capital base. In clean surplus terms, they are part of abnormal earnings rather
than part of the balance sheet.
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One can then raise the question of whether or not the elimination of amortization
imposes greater discipline on managers of parent companies not to overpay for
acquisitions.
Instructors who wish to consider the accounting, or lack of accounting, for
unrecorded intangible assets and its effects on reported earnings and EVA in
7.11.2), despite the lack of relevance that ensues. The reason
for not recording self–developed intangibles, presumably, is due
to problems of reliability. In effect, the accountant throws up
