Guide: Prof Abhilash S Nair

Vyaderm Pharmaceuticals

Submitted by:
Student Name
Mohammed Anzy S Arvind Gupta Gautam Sethi

Student Name
Raymond Amalraj Siva Kumar NV

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) NOPAT: Net Income Before Tax $ Research & Development Expense 1. R&D Adjustment Advertising Expense 2. Advertising Adjustment 3. Goodwill Amortization Net Current Operating Profits Before Taxes Current Year's Income Tax Paymentsb Net Operating Proft After Taxes (NOPAT) $ CAPITAL: Net Operating Assets 1. Capitalized R&D 2. Capitalized Advertising 3. Accumulated Goodwill Amortization Capital Capital Charge (11%) Economic Value Added (EVA)
a

1999a 20,000 $ 20,000 (14,973) 45 (41) 2,500 27,531 (7,875) 19,656 $

2000 51,000 $ 39,000 (20,638) 50 (46) 2,500 71,866 (18,725) 53,141 $

2001Ec 27,848 $ 27,378 (23,616) 55 60 2,500 34,114 (10,622) 23,493 $

2002Ec 32,861 32,032 (27,101) 61 (55) 2,500 40,297 12376 27,921

110,000 34,598 44 7,500 152,142 (16,736)

135,000 52,960 48 10,000 198,008 (21,781)

153,164 56,721 53 12,500 222,439 (24,468)

180,734 61,653 59 15,000 257,445 (28,319) (398)

2,920

31,360

(975) $

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. Taxes = 35% of (Net Incom e Before Tax + Goodw ill Am ortization) 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%.

b c

The above value indicates that the EVA value reduced drastically in year 2001 and 2002.

Calculation of Bonus:
($000 except bonus) Economic Value Added (EVA) EVA Improvement Goal EVA Target Interval Actual EVA Improvement EVA Performance North American Manager's Bonus Base Salary Target EVA Bonus (60% Base Salary) Starting Bank Balance 1. Calculated Bonus New Bank Balance Pay Out 100% of Available Target Plus 50% Remaining Bank Balance 2. Total Bonus Payout Ending Bank Balance 1999 2000 2001E 2002E Old Model EVA Year 1 EVA Year 2 EVA Year 3 $ 2,920 $ 31,360 $ (976) $ (398) 2,150 2,510 2,510 5,070 33,510 1,174 12,000 12,000 12,000 $ 28,440 $ 319% (32,336) -187% 578 87%

200,000 120,000

200,000 120,000

200,000 120,000 (93,410) 104,279 10,869 10,869

382,897 382,897 120,000 131,449 251,449 131,449

131,449 (224,858) $ (93,410) $

$ $

(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