ROI, RI and EVA - Lecture notes 7 PDF

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lecture note 7...

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Divisional structures and financial performance measures Relative profitability measures: RETURN ON INVESTMENT – ROI ROI is a relative measure of performance that can be compared with other investments.    

It provides a useful summary measure of the ex post return on capital employed. A major disadvantage of ROI is that managers may be motivated to make decisions that make the company worse off. ROI can motivate managers to make incorrect asset disposal decisions. If the ROI of divisions at present is > return on proposed project = manager is motivated to invest.

ROI = PROFIT / INVESTMENT

RESIDUAL INCOME – RI    

Controllable profit less a cost of capital charge on the investment controllable by the manager = controllable residual income. RI is most likely to encourage goal congruence. RI enables different cost of capital percentages to be applied to different investments that have different levels of risk. RI is not widely used.

RI = CONTROLLABLE PROFIT / COST OF CAPITAL CHARGED ECONOMIC VALUE ADDED – EVA During the 1990s RI was refined and renamed EVA. EVA measures the difference between the return on a company’s capital and the cost of that capital. A positive EVA indicates that value has been created for shareholders; a negative EVA signifies value destruction. 

Adjustments intended to convert historical accounting profit to an approximation of economic profit. Usually include capitalization of discretionary expenses.

EVA = CONVENTIONAL DIVISIONAL PROFIT (GAAP) ± ACCOUNTING ADJUSTMENTS – COST OF CAPITAL CHARGED QUESTION: Making particular reference to the following paper: Young (1997) ‘EVA: A Primer for European Managers’, European Management Journal. 15 (4).

Explain how EVA differs from return on investment and residual income. EVA Calculation

EVA Calculation “EVA measures the difference between the return on a company’s capital and the cost of that capital. A positive EVA indicates that value has been created for shareholders; a negative EVA signifies value destruction” (Young 1997:335) During the 1990 ’s RI was refined and renamed EVA TM Residual income: Controllable residual income = Controllable profit less a cost of capital charge on the investment controllable by the manager. RI encourages goal congruence between managers and organisation

•MVA is the present value of the firm’s expected future EVAs •EVA measures performance annually •EVA = Net sales Less operating expenses (including tax) =Operating profit Less capital charges (debt and equity) =EVA Capital charges= company’s invested capital x weighted average cost of capital •Difference between EVA and RI? The accounting adjustments What is the invested capital? Shareholder’s equity, all interest bearing debt (short term and long term) Or capital can be calculated as operating liabilities from total assets (net assets) WACC the sum of the cost of each component of capital weighted by relative proportions...