ROI RI & EVA

Measuring The Measuring The Performance Of Performance Of

Investment CenterInvestment Center

Presented By:Anurag

SandeepHarshit

Sumit

METHODS

ROI RI EVA

10-2

Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers

Return on investment (ROI) is the most common measure of performance for an investment center.

ROI = Operating income / Average operating assets

= (Operating income / Sales) (Sales / Average operating assets)

= Operating income margin Operating asset turnover

Margin: portion of sales available for interest,

taxes and profit

Turnover: how productively assets are being used to

generate sales

Comparison of Divisional PerformanceComparison of Divisional PerformanceComparison of Divisional PerformanceComparison of Divisional Performance


Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)


aOperating income divided by average operating assets.

bOperating income divided by sales.

cSales divided by average operating assets.


Advantages of the ROI measure

1. Helps managers focus on the relationship between sales, expenses and investment.

2. Encourages cost efficiency.

3. Discourages excessive investment in operating assets

Disadvantages of the ROI measure

1. Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall.

2. Encourages managers to focus on the short-term at the expense of the long-term.


Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

Minimum rate of return Operating assets

Residual Income

=Operating

Income-


Project I

Residual income = $1,300,000 - (0.10 $10,000,000)

= $1,300,000 - $1,000,000

= $300,000

Project II

Residual income = $640,000 - (0.10 $4,000,000)

= $640,000 - $400,000

= $240,000

Residual Income


Project I Project II

Operating assets $60,000,000 $54,000,000

Operating income $ 8,800,000 $ 8,140,000

Minimum return* 6,000,000 5,400,000

Residual income $ 2,800,000 $ 2,740,000

*0.10 Operating assets.


Disadvantages of Residual Income (continued)

1. It is an absolute measure of return which make it difficult to directly compare the performance of divisions.

2. It does not discourage myopic behavior.


Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

Weighted average cost of capital Total capital

employedEVA =

After-tax operating income

-


After-Tax Weighted Amount Percent x Cost = Cost

Mortgage bonds $ 2,000,000 0.133 0.0480.006

Unsecured bonds 3,000,000 0.200 0.0600.012

Common stock 10,000,000 0.667 0.1200.080

Total $15,000,000

Weighted average cost of capital 0.098

EVA Example

$15,000,000 x .098 = $1,470,000$15,000,000 x .098 = $1,470,000


EVA Example (continued)

EVA is calculated as follows:

After-tax profit$1,583,000

Less: Weighted average cost of capital 1,470,000

EVA$ 113,000

The positive EVA means that earned operating profit over and above the cost of the capital used.

Tends to focus on long-run Discourages myopic behavior

Behavioral Aspects of EVA


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ROI RI & EVA