Residual income and measuring value creation Michelin, the French tyre manufacturer, provides in its annual report to shareholders an assessment of its economic performance in the year. Management compare the group’s actual return on capital employed with the target return to determine whether it has created or destroyed value in the period.

The target return on capital is similar in concept to the weighted average cost of capital: Michelin’s was estimated by management to be 10.7% in 2001.

Exhibit 19.20 contains summary income statement and balance sheet information for 2001 for the Michelin Group.

Required

(a) Calculate Michelin’s residual income for 2001. According to your figures, did the group create or destroy value that year? Assume Michelin’s marginal tax rate is 40% in 2001.

(b) In calculating actual and target returns on capital, Michelin include ‘commitments under noncancellable operating leases’ as part of capital employed. Average operating lease commitments in present value terms were A602 million in 2001. Michelin also adjust the profit figure but do not disclose precisely how they do it. Indicate, in general terms, how Michelin’s NOPAT (net operating profit after tax) should be adjusted for the effect of capitalising non-cancellable operating leases when calculating residual income. (There is insufficient information in the exhibit to compute the adjustment.).AppenedixLO1

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Exhibit 19.20 Michelin Group: summary financial statements, 2001 in bn Condensed income statement for 2001 in mn Net sales Operating income Net interest expense Income tax expense Net income of fully consolidated companies Share of losses of equity-method investments Amortisation of goodwill Net income before minority interests Minority interests Net income 15,775 1,011 -321 -329 361 -13 -34 314 -18 296 Fixed assets Goodwill Intangible assets Property, plant and equipment Investments Current assets Inventories Condensed balance sheets at 31 December 2001 2000 Trade receivables Other receivables and prepayments Cash and cash equivalents Total assets 2001 2000 Shareholders' equity 319 283 Share capital and premium 1,879 1,879 115 122 Retained earnings 2,117 1,964 6,410 5,943 3,996 3,843 493 532 Minority interests 330 311 7,337 6,880 Group equity 4,326 4,154 Liabilities 3,302 3,564 Debt 5,820 5,856 3,390 3,340 Provisions for risks and charges 3,959 3,711 2,414 939 2,427 931 10,045 10,262 Trade payables 1,451 1,590 Other payables and accrued expenses 1,826 1,831 13,056 12,988 Total liabilities 17,382 17,142 and shareholders' equity 17,382 17,142