Performance Management Part: 2_M5 Flashcards
What is Economic Value Added?
- Economic value added is a firm’s (investment center’s) net operating profit after taxes (NOPAT) - RR required return (after-tax cost of capital on the investment).
- NOPAT is calculated: EBIT × (1 – Taxes)
-
RR is calculated by:
the investment (total assets) x the cost of capital or WACC. - Economic Value Added performance measurement that is calculated after-tax operating income - total assets x cost of capital (WACC)?
- Each of these components is calculated on an annual basis, so this model is well suited for evaluating performance in a given year.
- Economic value-added is a residual income technique used for
capital budgeting and performance evaluation. - It represents the residual (excess) income of project earnings in excess of the cost of capital (including cost of equity) associated with invested capital.
What is ROI Ratio?
- Income / investment capital.
- Income / Working capital plus other assets.
- Income / Total assets available.
- Income / Total assets employed.
Most criticized for the effects of operating decisions made at another organization level
- Income / Shareholder’s equity.
What characteristics does ROI have?
STRENGHTS
- ROI is a well-understood concept.
- ROI is a simple and relatively objective computation that can be drawn from accounting records.
WEAKNESS
- The primary disadvantage of using return on investment (ROI)
rather than residual income (RI) to evaluate the performance of investment center managers that ROI may lead to rejecting projects that yield positive cash flows. - Profitable investment center managers might be reluctant to invest in projects that might lower their ROI (especially if their bonuses are based only on their investment center’s ROI). This characteristic is often known as the “disincentive to invest.”
- Short-term benefits are analyzed over long-term periods
- ROI is controlled or influenced by managers and can be
manipulated. - Criticized for not being well-balanced.
- ROI encourages shortsighted behavior that defers or avoids investment for the sake of current ROI performance. Short-term benefits are emphasized over long-term commitments.
- ROI is controlled or influenced by managers and can be manipulated.
- Use of the ROI exclusively as a measure of performance can inadvertently focus managers purely on maximizing short-term returns. Profitable units are reluctant to invest in additional productive resources because their short-term result will be to reduce ROI.
What is Residual Income?
Net Income - Required Return = Residual Income
- Residual income methods Including economic value-added focus on target return and amount and encourage managers to invest in projects that exceed the hurdle rate.
- Residual income measures profitability in excess of a target rate of return.
- Historical weighted average cost of capital is usually used as the target or hurdle rate.
- The optimal imputed interest rate can best be described as the target return on investment set by the company’s management.
- Residual income is defined as income in excess of a desired minimum return.
- Residual income is an accrual method.
- Measures the amount of operating income earned above the imputed cost of capital for the operating unit. If the measure is positive, returns exceed the cost of financing the operating unit.
Calculate Residual Income?
Residual income:
Net Income $400 - Required Return $160 = $240
Required Return
Net book value $1,600
Hurdle rate × 10%
Required return 160
What is Gross Profit Margin?
Is a measure of profitability that indicates how much is left of each sales dollar to cover operating expenses and interest expense.
What is the profitability index?
- The present value of the net future cash inflows/the present value of the net initial investment.
- A profitability index greater than one is associated with a positive NPV capital budgeting project.
- The profitability index is a method for ranking previously screened investments and rationing available capital.
What is Net Realizable Value?
- Is the amount (value) the company expects to receive from an asset.
- For example, the net realizable value on accounts receivable is the balance of gross accounts receivable less the allowance for uncollectible account.
What is the asset turnover ratio and how is it analyzed?
- The asset turnover ratio is a measure of the degree of efficiency with which a company is using its assets.
- sales/average total assets
- Measures asset activity and the ability of the firm to generate sales through the use of assets. Generally, the more sales dollars generated per dollar of assets used, the better the net income of an entity.
What is ROA?
- Net Income / Assets
- It is a profitability measure that can be used to evaluate the efficiency of asset usage and management, and the effectiveness of business strategies to create profits.
Additional Ratios
EBIT margin: EBIT/Sales
Interest burden: EBT/EBIT
Tax burden: Net income/EBT
What is the difference between evaluating the Operation Income Budget and a capital budget?
Operating Income annual budget uses:
- Return on assets.
- Long range profit objectives.
- Industry average for earnings on sales.
- EPS.
Capital budget uses:
IRR.
What is IRR used for?
Internal rate of return (IRR) is used to evaluate the overall rate
of return over the life of a project relative to a required return.
What is NPV used for?
Net present value (NPV) is used to evaluate the overall dollar
return for a project over its entire life.
What is Payback Period used for?
The payback method is used to evaluate how long it will take to
recover cash outflows for a project.
