Planning and the Shareholder

Before we can calculate a target return on capital employed we must first estimate the returns which shareholders are likely to expect over the planning period. The following factors will affect these returns:

(1) The rate of return which shareholders have had in recent years.

(2) The rate of return which they could earn elsewhere. If a better rate of return is obtainable from similar companies, there will be pressure from management to increase the profit target.

(3) The impact of inflation on the rate of return. The rate of return may have to be increased to compensate shareholders for the falling value of money.

(4) The effects of changes in government policy with regard to taxation. For example, the introduction of capital gains tax, and the restrictions which governments have imposed on dividends in recent years have had serious repercussions on shareholders.

(5) The effects of changes in gearing. It may be possible to increase the return on shareholders' funds by altering the capital structure.

(6) The character of the firm's dividend policy. There are two methods by which the risk borne by ordinary shareholders may be rewarded. The first method emphasizes a high annual rate of dividend, and the second stresses the capital gain which accrues as a result of the increased value of the shares where a company retains and re-invests a high proportion of its profit. There are some who argue that the interests of investors and of the community would best be served by the total distribution of profit as dividends, and that individual companies should go to the market for any capital which is needed for expansion. In practice many companies attempt to strike a balance, distributing approximately half their profits as dividends and retaining and re-investing the balance in their capital expansion plans. As a result, most ordinary shareholders receive a return which is a mixture of annual dividend and capital gain.

Setting profit targets

Once having agreed the returns to shareholders, the next step is to incorporate the results of these calculations in a return on capital employed. This takes into account the amount to be retained in the business and the tax liability.

Consider the position of a firm for which it is calculated that a necessary return to shareholders of £30,000 has been calculated; whilst it is estimated that £20,000 should be retained in the business.

Divisional profit targets

Once the company's overall long-range profit target has been agreed, the next task is to apportion it across the separate parts of the enterprise, whether these be divisions or subsidiary companies. It is not necessary, nor indeed desirable that the overall profit target be evenly spread across the enterprise, for different growth rates and different profit targets are perfectly compatible with sound strategic planning. Thus, it is possible to select a distribution showing an expected rate of return on investments of 30 per cent in respect of one division as against a 10 per cent rate for another division. The reasons for a diversity among planned divisional profit targets may lie in the type of market in which the divisions operate: fast growing markets may offer higher return prospects than mature and established markets. Equally, varying rates of return may reflect the different degrees of risks attached to the different types of activities in which the several divisions may be engaged.

In the discussions leading to the formulation of the overall profit target, the various divisions will have submitted their estimates of the possible profit targets. If there should have existed a gap between the aggregated divisional profit recommendations and the overall target which top management sought to attain, it may have been necessary to revise the corporate strategy and re-examine both the company and divisional profit targets.

Next - Decision Making

Read on: The Importance of the Long-range Profit Goal

The importance of the long-range profit goal

We stated at the beginning of this webpage that the firm's success depends on its ability to generate a sufficiency of cash flows, symbolized by profit. The selection of a profit target for long-range planning purposes is not just a matter of fixing an arbitrary figure such as £5 million. A profit target of itself has little meaning: its significance appears when it is related to some other measurement, such as total assets employed, when it becomes a meaningful measure of performance. Thus, the return on capital employed (ROCE) which relates... see: The Importance of the Long-range Profit Goal