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Guide: Prof Abhilash S Nair

Vyaderm Pharmaceuticals

Submitted by:
Student Name Student Name
Mohammed Anzy S Raymond Amalraj

Arvind Gupta Siva Kumar NV

Gautam Sethi
Company Background:
Company founded in 1945.

Multinational, multi-product

Has focused on Earnings per share

Bonus system for managers: based on various operating results and on a


subjective evaluation

1997: New CEO- decides to change bonus system

What is EVA (Economic Value Added):


Used to be called as Residual Income

Stern Stewart & Co. re-named it Economic Value Added

Needs to define as EVA


Advantage of EVA:
You get a number (dollars, euros, etc.)

You are calculating the shareholder value-added by operations (not just


increase in sales,for example)

You are correcting GAAP numbers for various problem areas of traditional
accounting numbers

Disadvantage of EVA:
Expensive to make adjustments to GAAP income

The accounting adjustments seem a little strange. (Is the GAAP income really
true and fair?)

Employees may lose confidence in the accounting system

Problem Defination:
The Dermatology (skin care) division has a lucky opportunity when their main
competitor gets into trouble with the US Food and Drug Administration (FDA)

As a result, in year 2000, the Dermatology division has a really profitable,


unusual year, In years 2001 and forward, this temporary advantage is
expected to be lost
The above statement is proved after calculation the EVA for year 2001 and 2002:

EVA Calculation: Dermatology:


($000) 1999a 2000 2001Ec 2002Ec
NOPAT:
Net Income Before Tax $ 20,000 $ 51,000 $ 27,848 $ 32,861
Research & Development Expense 20,000 39,000 27,378 32,032
1. R&D Adjustment (14,973) (20,638) (23,616) (27,101)
Advertising Expense 45 50 55 61
2. Advertising Adjustment (41) (46) 60 (55)
3. Goodwill Amortization 2,500 2,500 2,500 2,500
Net Current Operating Profits Before Taxes 27,531 71,866 34,114 40,297
Current Year's Income Tax Paymentsb (7,875) (18,725) (10,622) 12376
Net Operating Proft After Taxes (NOPAT) $ 19,656 $ 53,141 $ 23,493 $ 27,921

CAPITAL:
Net Operating Assets $ 110,000 $ 135,000 $ 153,164 $ 180,734
1. Capitalized R&D 34,598 52,960 56,721 61,653
2. Capitalized Advertising 44 48 53 59
3. Accumulated Goodwill Amortization 7,500 10,000 12,500 15,000
Capital $ 152,142 $ 198,008 $ 222,439 $ 257,445

Capital Charge (11%) (16,736) (21,781) (24,468) (28,319)

Economic Value Added (EVA) $ 2,920 $ 31,360 $ (975) $ (398)

a
EVA w as introduced in the Derm atology Division in 2000. The 1999 EVA figures w as calculated retroactively
solely to set 2000 EVA targets. The 1999 EVA calculation includes am ortizations of 1995 R&D expense of $10,673.
b
Taxes = 35% of (Net Incom e Before Tax + Goodw ill Am ortization)
c
2001 and 2002 estim ated results obtained by forecasting four financial statem ent item s at historical grow th rates
from 1999 base: net incom e before tax at 18%, R&D at 17%, consum er advertising at 10% and net operating assets
at 18%.

The above value indicates that the EVA value reduced drastically in year 2001 and
2002.
Calculation of Bonus:
($000 except bonus) 1999 2000 2001E 2002E
Old Model EVA Year 1 EVA Year 2 EVA Year 3
Economic Value Added (EVA) $ 2,920 $ 31,360 $ (976) $ (398)
EVA Improvement Goal 2,150 2,510 2,510
EVA Target 5,070 33,510 1,174
Interval 12,000 12,000 12,000

Actual EVA Improvement $ 28,440 $ (32,336) 578


EVA Performance 319% -187% 87%

North American Manager's Bonus


Base Salary $ 200,000 $ 200,000 $ 200,000
Target EVA Bonus (60% Base Salary) 120,000 120,000 120,000

Starting Bank Balance 131,449 (93,410)


1. Calculated Bonus 382,897 (224,858) 104,279
New Bank Balance $ 382,897 $ (93,410) $ 10,869

Pay Out 100% of Available Target 120,000 10,869


Plus 50% Remaining Bank Balance 131,449
2. Total Bonus Payout $ 251,449

Ending Bank Balance $ 131,449 $ (93,410)

Bonus payout in 2000 was very good, but as bank balance had been reduced in
2001, bonus payout had been reduced, so EVA system does not prove to be
right.

What company must do to solve the problem?


1. Company must reduce the Bonus and set the precedent, so that does not
create higher expectations

2. Try to change the plan calculations, so that EVA for other years can also be
positive
We need to make sure that goal of financial management are following to achieve
to avoid any dissatisfaction in stakeholders:

Maximize shareholders wealth

Harmonize managers of many units of firm

Connect managers decision to overall corporate goals in lower divisions

Managers must perceive relation between their decisions, corporate goals,


and compensation