Performance Measurement

Question 1

How is ROI calculated and what does it indicate?

Answer 1

ROI = (Operating Income/ Avg operating Assets) x 100
It indicates the efficiency of an investment, with higher values showing better return efficiencies.

Question 2

What is Residual Income and how is it used?

Answer 2

RI is the income that exceeds the minimum required return on operating assets. Its used to assess whether a division has covered its cost of capital.

Question 3

RI formula?

Answer 3

RI = Net operating income - (RRRx Avg operating assets)

Question 4

How do you calculate EVA and what does it measure?

Answer 4

EVA = NOPAT - (WACC x (Total Assets - Current Liabilities))
It measures the value created beyond the required return on capital

Question 5

What are the advantages and disadvantages of using ROI and RI?

Answer 5

ROI is simple but can promote short-term gains. RI considers the cost of capital, promoting more sustainable decisions but is complex to calculate.

Question 6

Advantages of EVA?

Answer 6

• Focuses on long-term value creation
• Adjusts for accounting distortions

Question 7

Disadvantages of EVA?

Answer 7

• Complex to calculate
• Requires many adjustments which can be subjective

Question 8

What are some common examples of management behaviour issues in ROI, RI and EVA?

Answer 8

• Manipulating earnings
• Delaying necessary expenses
• Changing investment timings to enhance reported performance

Question 9

How can firms address management behaviour issues in ROI, RI, and EVA?

Answer 9

• Designing compensation so that it rewards long-term performance
• Using diverse metrics for performance measurement
• Ensuring rigorous external and internal audits