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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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PERFORMANCE MEASUREMENT PITFALLS

Given that what gets measured gets managed, managers and executives should exercise caution. Though business schools have been teaching valuation concepts for decades, earnings per share and other traditional accounting-based metrics continue to dominate corporate decision making. However, these metrics have many risks and can mask rampant value destruction if the costs of capital and capacity are inadequately addressed. Chronic problems result from using the popular potpourri of performance metrics—top line growth, market share, gross margin, operating income and standard cost—as an implicit proxy for value creation.

Overproduction

Standard cost typically ignores or understates the cost of capital, such as the opportunity cost of capital employed in capacity, inventory, and receivables. Standard cost converts period costs into unit costs: the fixed production costs and the costs of capacity. Excess (unsold) throughput is often capitalized into inventory, reducing perceived unit cost. Because inventory has no income statement cost and a false “absorption” benefit, profit increases with production even if no demand exists for the goods produced.

Plant managers are often directed to minimize unit costs, irrespective of actual demand and will, thus, produce to and expand capacity. Producing as many units as possible, irrespective of demand, maximizes profit per unit. Gross margins and profits will increase with production and capital investment, but ...

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