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This paper describes a new model designed to support the financial planning process of a large electric utility in Brazil. The model will be primarily used for analysis of strategic and policy issues related to the financial requirements of an electric utility. It computes several financial performance ratios while considering the utility's statutory and legal requirements, as well as the regulatory compact for the electricity supply industry, the characteristics of the financing agencies and the private investor values.
The model contains a large number of feedback relationships. Key relationships involve price and demand, the capital markets and the regulators. The model stresses the relationships between individual projects cash-flow and the utility financial performance. The overall electric power sector financial flows are not included in the model; rather, the interface between the utility and the electric sector is represented as exogenous financial constraints. This approach is adequate for the utility as an independent agent, according to the trends of the ongoing institutional restructuration of the Brazilian electric power sector.
The model is being developed with the support of the Powersim shell. The model may be used stand alone or as part of a larger, integrated utility model under development at the same university. A "flight simulator" version of the model is also being developed as a support for teaching economics and marketing at undergraduate and graduate courses at the electrical engineering course at the university.
The traditional financial ratios - Earnings Per Share (EPS), Return on Assets (ROA) and Return on Equity (ROE) - are based on the total net profit after taxes (NPAT), as shown on Table 1.
A serious limitation of these traditional ratios is that they are very sensitive to changes in the mix of debt and equity that a company employs and to changes in the rate of interest it pays on its debts. This behaviour is due to the numerator NPAT, that makes it difficult to tell whether the ratio rises or falls due to operating or financial reasons. With this kind of performance ratio, management may be tempted to accept truly substandard projects that happen to be financed with debt and pass by very good ones if they must be financed with equity.
| Measures the net income earned on each share of common stock | |
| Measures the rate of return earned on total assets provided by both creditors and owners | |
| Measures the rate of return earned on total assets provided by shareholders |
In place of these ratios, the rate of return on total capital (r) is the return that should be used to assess corporate performance. It is computed by dividing a firm's net operating profits after taxes (NOPAT) by the total capital employed in operations; it is a savings account equivalent, after-tax, cash-on-cash yield earned in the business.
The rate of return on total capital (r), unlike the other ratios, is completely unaffected by a change in the mix of debt and equity a company chooses to employ. This does not mean that leverage is unimportant for assessing performance. Debt does shelter operating profits from being fully taxes. This benefit, however, is incorporated into c* (weighted average cost of capital), that reflects the capital structure employed.
What matters is simply the productivity of capital employed in the business, no matter the financial form in which the capital has been obtained. Because the effect of financial structure is entirely eliminated, this rate of return is a much clearer measure of operating performance than the other ratios.
To win the competition for capital and build a premium-valued company, an attractive rate of return must be earned. The performance measure to account properly for all the ways in which corporate value may be added or lost is Economic Value Added (EVA). EVA is the difference between the profits the company derives from its operations and the charge for capital incurred through the use of this credit line.
The model structure and results are presented in Figure 1. Until
the time 60, the financial expense makes ROE and ROA unstable.
The results reinforce the theory that ROA and ROE ratios are very
sensitive to capital structure employed. On the other hand, the
EVA is the one measure that properly accounts for all the complex
trade-offs involved in creating value.
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The traditional financial ratios are sensitive to changes in the mix of debt and equity that a company employs. This become EPS, ROE and ROA inadequate when used to assess shareholder value. On the other hand, EVA consider the weighted average cost of capital, which supports the financial operations, when it calculate the financial performance. In the traditional financial statements, the cost of capital lent by the banks its qualified as financial expenses. The cost of equity "lent" by the shareholders stays hidden, therefore, it consists an important portion that should be considered when one intends to evaluate the business performance.
Lehn, K., and A. K. Makhija. 1996. EVA & MVA as Performance Measures and Signals for Strategic Change. Strategy and Leadership. 34-38.
Stewart, G. B. 1991. The Quest for Value. Library of Congress Cataloging-in-Publication.
Rappaport, A. 1986. Creating Shareholder Value. The Free Press.
Geraghty, D., and J. Lyneis. 1984. A New Strategic
Model for Electric Utilities. IEEE Transactions on PAS
103 (7): 1576-1582.
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