Reference no: EM132768393

Question - GAK Ltd is a high quality clothing retailer who has been trading since 1960. In response to a fall in profits over the past few years, the board of directors produced a new company mission statement. High on the list of core aims is the desire to increase shareholder value. To help achieve this in late 2014 they appointed Leah Porter as the new CEO. Leah negotiated the following remuneration package:

Salary = £400,000

Bonus = £50,000 for every 1% increase in ROI above a target of 6% p.a. (the company use profit before tax to calculate ROI)

The management accountant is concerned that the scheme is flawed and has collated the following data relating to last year's performance to help her calculate EVA, which she thinks is a better measure of performance.

Income Statement 2015 £m

Revenue 45.2

Profit before tax 7.9

Tax 1.6

Profit for the period 6.3

Other Information

1. Book value of non-current assets is £28.5m but replacement value is estimated at £38.6m.

2. The net capital employed at the year-end was £90m.

3. Prior to Leah's appointment the company started a rebranding exercise. £4m relating to this project was written off as an expense in 2015. The board believe that the rebranding will increase profits for the next 3 years (2015 to 2017).

4. The profit before tax includes interest expenses which amounted to £3 million.

5. The effective tax rate was 20%.

6. Included in the profit before tax in 2015 is £6.5 million depreciation charge. The economic depreciation charge is estimated at £7.7 million. One of Leah's first changes was to ask the Financial Director to change the depreciation policy in line with what she called 'industry standards'

7. Revenue for the year ending 2014 was £40.2 million and ROI was 4.1%

8. Leah has cancelled plans to refurbish a number of the outlets

9. Leah has decided to personally approve all discretionary spending. Including staff training, staff travel, product design and marketing

Required -

A) Using a weighted average cost of capital of 10%, calculate the EVA for 2015.

B) Critically evaluate the current incentive scheme and referring to the calculations you performed in part A, explain why EVA may encourage managers to make decisions which improve shareholder value.