665 : Advice the CEO in PART C

Company background Bazeele hires out plant and machinery to small firms working in the construction industry. Bazeele's senior managers, including the chief executive officer (CEO), have worked in the business since it was established 30 years ago, and they own the majority of the shares. During that time, Bazeele has acquired many smaller plant hire businesses. Of these business units, those which have underperformed after acquisition have either been sold on or restructured, for example, to increase their operating margins. Bazeele has recently diversified by hiring out large items of plant to large construction firms working on major infrastructure projects. These projects can last for up to 10 years. Strong growth in the general economy has increased the number of these large projects and has also led to a predicted large increase in bank interest rates. Objectives The shareholders' objective is for Bazeele to maintain its historic return on capital employed (ROCE). Managers at business units are given the objective of maintaining net profit margins of their own business units. Similarly, managers at individual branches of business units are given the same objective according to their own areas of responsibility. Value-based management approach Following two years of poor performance, it has been suggested to the CEO that Bazeele would benefit from adopting a value-based management (VBM) approach. The CEO requires your advice and has said, 'The shareholders are unsure what VBM is, whether it will benefit Bazeele, and what changes the business would need to make if it were to adopt it. All managers in the business are already clear what their objectives are. For example, one business unit manager recently postponed some expensive staff training on improving customer satisfaction, which I believe was the correct decision. Our recent poor performance has meant we cannot afford this sort of expenditure, especially as we have no information on what levels of customer satisfaction actually are. Personally, I dislike change, but would not object to the adoption of VBM if it was thought to be beneficial for Bazeele. Economic value added The shareholders have heard that economic value added (EVAIM) can be used to measure whether Bazeele has created or destroyed value for its shareholders, but this has not yet been calculated.' Details of the company's recent performance are given in Appendix 1. Required: (a) Evaluate whether a value-based management approach is appropriate for Bazeele. (7 marks) (b) Explain to the CEO what changes Bazeele would need to make to its performance measurement and performance management systems if it were to adopt a valuebased management approach. (7 marks) (c) Using the information in Appendix 1, advise the CLO whether Dazeele has generated cconomic volue for lts shareholders. (11 marks) Appendix 1 - Notes from Bazeele's management accounts for the most recent year end 1 Net profit after tax for the year: $10m 2 Capital employed at the start of the year: \$250m 3 The interest charge for the year was $15m on a variable rate loan with an interest rate of 10%. Bazeele is funded 60% by debt and 40% by equity. The cost of equity is 12%. Bazeele pays tax at a rate of 20%. 4 The depreciation charge for non-current assets for the year was $6.0m; the economic depreciation of which was $14.0m. At the start of the period, the accumulated economic depreciation of non-current assets exceeded its accounting depreciation by $16.0m. 5 Brought forward at the start of the year was a provision of $4.8m which was made in respect of a debt owed by a customer who has since repaid it. 6 Within the current profit or loss account there is an expense for $0.6m for advertising in trade magazines. This led to several enquiries from new customers involved in large infrastructure projects, which has resulted in Bazeele signing at least two large contracts after the end of the accounting period