Lecture 5: ROI vs. RI vs. EVA

Question 1

What is the purpose of relating profits to assets employed?

Answer 1

• To provide information that is useful in decision-making about assets employed
• To motivate managers to make appropriate (i.e. goal congruent) decision
• To measure the performance of the business unit as an economic entity

We cannot only focus on profit when we are also responsible for capital. Profitability requires that we take capital into account.

Question 2

What are the performance objectives of a BU managers when profits are related to assets employed?

Answer 2

• Are the profits of current operations adequate, given the resources at the disposal of the BU?
• Can future investment in additional resources be justified by an adequate return?

Question 3

What are the three ways of relating profit to assets employed?

Answer 3

CAMP 1:
Return on investment (ROI) - ratio. Profit/Capital. Example: ROE, ROA, ROCE, ROIC.

CAMP 2:
Residual income (RI) - monetary amount. Profit - (cost of capital * capital).

Economic value added (EVA) - monetary amount. Profit - (cost of capital * capital).

Question 4

What is the formula for ROE and what are its pros and cons?

Answer 4

ROE = Net profit / Equity

Financial performance for owners.

• Useful for investors evaluating the profitability of an entire company (external).
• Less useful for internal performance management due to difficulties of defining equity in the organizational units. (operational managers are not responsible for equity).
• Internal performance management should ultimately lead to increasing ROE.

Question 5

What is the formula for ROA and what are its pros and cons?

Answer 5

ROA = EBIE / Total assets

Operating profitability.

• Captures income statement and balance sheet performance in a single measure.
• Useful for comparing the performance of different divisions and companies (within similar markets).
• Well-known and easy to communicate (terminology and operating profit is understood by operational managers).
• Does not take into account financing with “free capital” (NIBL). → No incentive to improve this.

Question 6

What is the formula for ROCE and why is it good?

Answer 6

ROCE = EBIE / Capital employed

Operating profitability.

• Captures income statement and balance sheet performance in a single measure of operating performance.
• Used to compare performance of different units and over time.
• Well-known and easy to communicate.
• Gives managers motivation to find cheap financing (don’t require return on NIBL).

Question 7

Which definition of capital employed should we use and why?

Answer 7

CE = Assets - NIBL

Since we are looking internally, these are components that managers can influence, so it creates motivation.

Question 8

What is the decision rule for ROI?

Answer 8

Undertake all activities that maintain or improve the ROI

Question 9

What are problems associated with ROI?

Answer 9

Misleading signals due to the asset base.

May risk suboptimal investment decisions:
- BUs with high ROI: not invest in new assets which in fact are profitable for the company (project’s acceptability depends on the BU selected). → underinvestment.
- Retain old assets beyond their optimal life and thereby stifle innovation and sustainability.
- BUs with low ROI: invest in new assets which in fact are not profitable for the company (project’s acceptability depends on the BU selected). → Overinvestment.

Asset base in ROCE calculation is based on numbers from the financial accounting reports (e.g. conservative in nature, external numbers used for internal purposes, distortion)

Can’t just add up percentages, so what we had before matters.

Question 10

What is true profit?

Answer 10

Until a business returns a profit that is greater than its cost of capital, it operates at a loss. True profit is hence when it is actually value creating.

Question 11

What should ROI be compared to?

Answer 11

The cost of capital (WACC), to see if it is good enough –> Residual income

Question 12

In what 3 ways can you improve residual income?

Answer 12

• Increasing RI by growing revenues or reducing expenses on existing capital.
• Grow the business by investing where the returns exceed the WACC.
• Divesting losing operations, where the return is less than the WACC and there is (almost) no hope for improvement.

Question 13

What are the pros and cons of using residual income?

Answer 13

+ Consistent with economic theory and can be used as the basis for corporate and business unit valuations.
+ An absolute single measure of performance which provides all managers with the right incentives for investment decisions.

• Difficult to make comparisons between units of different sizes.
• Distortion effects caused by the use of traditional accounting numbers could undermine the validity of the calculations (e.g. conservative in nature, external numbers used for internal purposes).

Question 14

What is the key point of EVA?

Answer 14

We need to make adjustments to operating profit and capital to compensate for distortions caused by financial accounting policies. Arrive at better measurements of profit and assets employed than if book values are used

Question 15

What is the difference between RI and EVA?

Answer 15

Which profit and capital is used

Question 16

What four tests should an EVA adjustment pass?

Answer 16

• Is it likely to have a material impact on EVA?
• Can the managers influence the outcome?
• Can the operating people readily grasp it?
• Is the required information relatively easy to track or derive?

Question 17

What are the key adjustments of EVA?

Answer 17

• The capitalization (and subsequent amortization) of R&D expenses. (may loosen up R&D capitalization rules internally).
• The capitalization of internally generated trademarks and other market-building activities.
• Adjust the capital base and depreciation to compensate for effects of inflation.

Question 18

How should EVA be linked to rewards?

Answer 18

EVA is powerful in changing behavior throughout the organization, which depends crucially on using it as the basis for incentive compensation.

The traditional model where the shareholders claim all surplus is wrong.

Instead, profit in the EVA system is shared. Based on the EVA, shareholders get excess value returned, and managers/employees get bonuses. Hence, there is no payout until we are sure of True profit.

Makes managers think and act like owners –> goal congruence.

Question 19

What are EVA bonus plans?

Answer 19

The bonuses don’t have any caps. The more EVA increases, the bigger the bonus, without limits. A portion of any exceptional bonus award goes into a bonus bank for payment in future years, and is forfeited if EVA subsequently falls.

The bonus banks help take the long-term into account

Question 20

How can we summarise the use of ROI?

Answer 20

• Comprehensive and well-known measure
• Simple to calculate, easy to grasp (e.g. DuPont tree)
• Directly comparable performance metric of units of different size
• Risk of suboptimal investment decisions
• Asset base in ROI calculation is based on numbers from the financial accounting reports.

Question 21

How can we summarise the use of RI and EVA?

Answer 21

• Core idea: value is created only when the operating profit is larger than the capital charge
• Managers should be incentivized to think and act like owners (rewards are essential in the EVA framework)
• BUs have the same profit objectives for comparable investments (i.e. not related to current BU ROI) –> Clear decision rule: everything greater than 0 is good!
• Improved goal congruence
• EVA calculation follows the same principles as residual income but with adjustments for accounting deficiencies
• Not automatically comparable between units since larger size tends to have larger RI or EVA

Question 22

In a multiperiod setting, what do we want our performance measurement system to align with?

Answer 22

The NPV of the project

Question 23

Which dimensions are good to use in a discussion on methods and calculations?

Answer 23

• Relative component (which one is better?): ROI
• Absolute component (is it good enough?)