9) Alternative measures of performance

Question 1

ROI (Return on investment) vs RI (Residual income) as divisional performance measures, pros and cons

Answer 1

1. ROI can result in dysfunctional behaviour when appraising new investments, as divisions will not necessarily act in the company’s best interests, but RI resolves this aspect.
2. ROI is a relative percentage, RI is based on absolute returns above the required minimum.
3. ROI does facilitate comparisons between divisions.
4. They both encourage divisional managers to manipulate both profit and capital employed figures.

Question 2

EVA (Economic Value Added), how to calculate

Answer 2

EVA = NOPAT - WACC x Capital Invested

WACC x Capital Invest is also known as finance charge

WACC = Weighted Avg. Cost of Capital
Capital Invested = Equity + Long term debt at the beginning of the period

Question 3

Residual income (RI), calculate

Answer 3

RI = Controllable profit - Notional interest on capital

Increase in profit, less, interest charge

Controllable profit, use the figure available in question closest to profit after depreciation and before tax

Notional interest on capital also known as “Imputed interest charge” is the capital employed x cost of capital (whatever interest rate provided in question)

Capital employed is total assets less current liabilities or total equity plus long term debt. Use net assets if capital employed is not given in the question.