Useful as a Strategic Decision Tool 

Decisions are implemented in and affect the future. Any decision tool must look forward and must express and compress the future into a single binary "go or no-go" result. AFTF looks forward and reduces the future to a value to which a transparent criterion is applied. This produces a decision. The common language of AFTF among all producers and consumers of financial information makes AFTF very useful in decisions. Decisions will be based on the common interest of all. 

AFTF will not only allow decisions to be freely made, it will encourage decisions to be made. Management will have to articulate its plans for the future in order to produce the company valuation. Management will have to explicitly commit to action or to inaction. 

AFTF is not painless in that implementation may involve substantial work. The degree of gain will be proportional to the pain. Those companies with superior reporting and evaluation systems should find AFTF a natural extension or formalization of what they already do. Those companies, which have weak evaluation and reporting systems, will require the greatest efforts and will receive the greatest benefit. AFTF will help management understand and cope with the future. 

AFTF determines the cost of capital relative to an indisputable capital base, removing two management uncertainties. The cost of capital, expressed as a uniform discount rate, also avoids the very difficult determination of capital usage for subsets of the enterprise. The LOB, project, or product valuation (analogous to the company valuation) could provide a usable capital base for Return On Equity calculations, if they are ever needed. 

Using a market cost of capital automatically provides a reality check to management's ROE desires. For example, if competitors' ROE averages 10% then the market cost of capital will generally be of the same magnitude; management's desire for a 20% ROE will be tempered by the realities of what is required and feasible. It is better and easier to let the capital market, rather than management, determine the market cost of capital. 

AFTF provides simple direct guidance for dividend policy. If a company is adding value then dividends should not be paid and a new stock issue (negative dividend) might be considered. If a company is losing value then dividends should be maximized and retiring stock (positive dividend) or selling the company might be considered. 

With traditional accounting, there is a natural reluctance to discontinue unprofitable operations (those not meeting the cost of capital) since an accounting loss is generated. With AFTF the value of that continued operation will be negative. The cost of discontinued operations will be a smaller negative. The value of the decision to discontinue will consequently be positive. The valuation is aligned with the decision; positive results are reported positively. 

It is possible to associate all cash flows with decisions. This is the preferred perspective. AFTF, viewed as accounting for decisions, is relevant at all levels: for product evaluation and pricing, for capital budgeting for projects, for evaluating lines of business, or for the capital markets to evaluate the company. A line of business may be the result of many past decisions and may be the embodiment of a current decision to maintain that line. Viewing and valuing a line of business as a continuing decision encourages management to make important decisions while providing the information needed to optimize those decisions. 

AFTF does not use cost or market values. Although these measures may be "objective" they may not satisfy the objective of the shareholder. For example, a bond purchased at par might yield 8%, but, if the cost of capital is 12%, then value will be lost each year. The present value of those losses will be the difference between the bond’s purchase price and the present value at 12% of the bond’s expected cash flows (coupons and maturity value). It is not a good decision to buy such bonds: the present value of that decision is negative. The AFTF value of a bond purchase provides direct decision useful information; cost or market values do not. If the market value of a bond is greater than the AFTF value, it should be sold. If the reverse is true, more bonds should be purchased. 

Idle or less productive financial assets will be exposed, a necessity in an increasingly competitive environment. The historic cost of capital is the cost of equity capital only. This is used to discount and evaluate from the shareholders’ perspective. If a project or investment has a positive AFTF value then it cannot dilute earnings even if financed with equity. If a project is financed with debt, the project / debt package can be evaluated as a unit, using the same equity cost of capital. 

AFTF is prospective and uses only expected cash flows and a cost of capital. For new decisions, the expected cash flows include the investment, a normal capital budgeting approach. For older decisions the prospective view ignores the original capital outlay. Is this a correct approach? If the older decision was originally properly evaluated there is no problem. If the original profit goal is not being met then the question becomes: does the prospective AFTF approach serve to maximize shareholder returns? The prospective view evaluates only the future to determine whether the cost of capital is being met or exceeded. If it is being met, then the company would be better off maintaining the investment regardless of the past. This prospective view ignores past costs, which have already been sunk into an endeavor (product, project, line of business, or entire company). Ignoring sunk cost is the proper decision technique. The traditional accounting practice of allocating equity to a line of business and then determining a return on equity may produce sub-optimal decisions. AFTF automatically recognizes that the past is irrelevant and ignores sunk costs in making decisions.


Useful as a Day-to-Day Management Tool

 Although designed primarily as a measurement, decision, and reporting tool, AFTF can be used effectively in daily management. The cash flow model will help managers understand the process under their control and can be used to identify the inputs or drivers that create value. These drivers can then be monitored and reported on as a real-time early warning system. The actual-to-expected cash flow ratios will provide periodic feedback. The AFTF technology can be used for capital budgeting, appraisals, cost/benefit analyses, and pricing, since it incorporates those technologies. By providing a cost of capital it simplifies those technologies. It either provides or utilizes the models needed for those technologies. Among other things, AFTF can be the basis for a unified and complete operational management system.

The management process will be given a qualitative boost by AFTF. Quality control depends critically on quality measurements, which AFTF provides. Managers can be given the power and responsibility to create value, with the knowledge that decisions and results will be carefully measured. The manager will have to construct detailed, explicit, and objective cash flow models, which AFTF requires. He will have to formalize his knowledge, understanding, and judgments, a process which will enhance his knowledge, understanding and judgments. He will have to publicly disclose his plans, expectations, and commitments in the AFTF business plan. Where necessary he will have to coordinate and cooperate with others. Once installed, AFTF provides common measures and a common purpose. Getting people to speak the same language and adopt common goals will unify their efforts and coordinate their activities. 

The AFTF historic cost of capital will force the manager to adopt the shareholder’s perspective and precise goals. The manager will be forced and encouraged to focus on value and on the future. He can be given more authority and can be held more responsible. He will be the master of his fate.

  

Incentives 

AFTF can be the basis of incentives, which provide motivation to management. AFTF is especially appropriate as a base for incentives in that AFTF measures the long-term not the short-term. The best strategy may be to invest, but traditional retrospective earnings are generally penalized by investment. Basing incentives on traditional accounting earnings may send just the wrong message. 

Even without incentives AFTF may motivate. AFTF focuses on the future and requires explicit judgments about to the future. Managers may have a better understanding of the future and may feel a commitment to see their judgments vindicated. AFTF will provide ongoing actual-to-expected ratios related to specific decisions. Managers will be exposed for what they are. Careful and active management will evolve more quickly as the forces of selection operate more openly. AFTF also requires continual re-evaluation so that changing conditions are reacted to. Once people know that value is being visibly measured they may work more creatively to add value. 

AFTF is the ideal base for bonuses or incentive compensation; it closely associates the effect (value creation) with the cause (management actions or decisions). The reason for its effectiveness is that AFTF immediately and accurately measures the essential management activity, namely, decision making. Immediate recognition of value immediately recognizes and rewards the value of decisions. The actual-to-expected cash flow ratios can be a continuing basis for incentives. 

AFTF has the ability to separate and measure management performance for the current year. Unlike earnings, which are generally positive, value added is a residual and is quite likely to be negative. Hence incentive compensation may conveniently include a negative incentive for value lost. Management will quickly become sensitized to the company’s and shareholders’ interests. Greed and fear can be put to a good use. For example, an AFTF bonus to a division head might be phrased as, 

AFTF Bonus = Division Head’s Salary *Division Value Added / Division Value

Where,

Value Added = New Value Added + (Actual NOCF - Expected NOCF) 

AFTF provides a more appropriate basis for incentives, but at the same time makes incentives less necessary. The AFTF accounting and reporting requirements encourage managers to add value. The use of the historic cost of capital in valuations guarantees that managers measure results taking into account shareholders’ requirements. The manager will be informed. He can’t ignore the shareholder. It will be clear to all if value is not being added. 

  

Flexible 

An accounting system should be flexible. It should be able to adapt to differing or changing environments. Each company should use its own experience and expectations. There is no loss of generality in using cash flows or market costs of capital. AFTF can be applied to any company or industry. 

An accounting system should provide management the flexibility to adapt and change. AFTF allows management complete freedom of thought and action, while, at the same time, providing a means of assessing potential actions. With AFTF management can give free reign to its imagination since it is not tethered by the tyranny of short-term accounting or reporting perspectives. As capital markets understand and adjust to AFTF, management should be able to communicate more clearly and thus gain support for its plans. Management should also have greater ability to identify, communicate, and correct problems. 

AFTF is general enough to permit broad use and to allow some degree of appropriate customization. This flexibility of AFTF stems from its atomic cash flow base. Starting at the atomic level, all compounds are possible. 

AFTF can be used for the whole company, major divisions, lines of business, projects, or products. Since it is couched in decision terms, it is easy to ask whether a line of business, for example, is adding value or losing value. This is the effective question, which can lead to effective decisions at an appropriate level. What is not effective is trying to identify, allocate, and value tangible assets and liabilities that may or may not affect cash flows. The traditional accounting value of a building, a computer, or a pencil has little relevance to future value creation; for the most part, these are sunk cost which are not germane to decisions. If we want to effectively create value then we must make the decision process a valuation process; we must make the valuation process a decision process. 

AFTF methods are easy to adapt to pricing; AFTF can be used either in a best estimate or a probability weighted stochastic mode in order to capture embedded options. In any case, the same language of cash flows and the market cost of capital is used throughout. 

AFTF can also be used in a dynamic mode to capture the risk element. The Value Added Analysis and Sensitivity Analysis will provide some reasonable measures of risk. If a standard deviation in a single experience factor causes the company valuation to go negative then there are solvency concerns. If two standard deviations for all factors combined still produce a positive company valuation then there seems to be little cause for concern.

  

Conclusions 

AFTF provides management with improved decision tools and an improved environment in which to make decisions. AFTF will actively encourage and support value creation. It guarantees that shareholder needs are at least considered and may help meeting those needs. AFTF is flexible enough to be used for tactical or strategic management. It forms an ideal base for incentive compensation.

 

   

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