ROI vs RI vs EVA Flashcards
Allocation of responsibility contingent on?
- Measurement of input - output
- Understanding of causality between input - output
- Decision possibility of accountable individual
- Motivational factors related to individual
The purpose of relating profit to capital (assets employed)?
- To provide information that is useful in decision-making about assets
- To motivate managers to make appropriate (i.e. goal congruent) decisions
- To measure the performance of the business unit as an economic entity
Performance objectives for BUs managers when relating profit to assets employed
- Are the profits of current operations adequate, given the resources at disposal?
- Can future investments in additional resources be justified by an adequate return?
Three ways of relating profits to capital
- ROI (ratio)
- Residual income (monetary)
- Economic value added (monetary)
ROE = Net profit / E
- Financial performance for owners
- Useful for investors evaluating the profitability of an entire company
- Less useful for internal performance management due to difficulties of defining equity in the BUs
- Internal performance should ultimately increase return on equity
ROA = EBIT+interest income / Assets
- Operating profitability
- Captures income statement and balance sheet performance in a single measure
- Useful for comparing performance of different divisions and companies
- Well-known and easy to communicate
- Does not take into account financing with “free capital” (NIBL)
ROCE = EBIT+interest income / A-NIBL
- Operating profitability
- Captures income statement and balance sheet performance in a single measure
- Useful for comparing performance of different divisions and companies
- Well-known and easy to communicate
- Motivate managers to find cheap financing
Problems with ROCE
May risk suboptimal investment decisions
- May encourage managers to not invest in new assets which in fact are profitable for the company
- Encourage managers to give up profitable activities
May encourage managers to retain old assets and thereby stifle innovation
May lead managers to over-allocate resources to divisions with older assets
Asset base is based on numbers from the financial accounting reports
Cost of capital show true value creation
Value is only generated if profit is larger than the cost of capital
- ROCE > WACC
Residual income
(EBIT+interest income) - WACC * CE
How improve residual income?
- Growing revenues or reducing expenses on existing capital
- Grow the business by investing where returns exceed the WACC
- Divest where the return is less than WACC and there is no hope for improvement
Pros and cons of using RI
+ Consistent with economic theory and can be used as a basis for corporate valuation
+ An absolute single measure of performance which provides managers with rights incentives for investment decisions
- Difficult to make comparisons between units of different size
- Distortion effect caused by the use of traditional accounting can undermine the validity of the calculations
EVA (1)
Adjusted operating profit after tax - WACC after tax * Adjusted capital
EVA (2)
Sales
- Adjusted operating expenses (including tax)
= Adjusted operating profit after tax
- Adjusted capital charge (WACC after tax * Adjusted capital)
= EVA
Different EVA adjustments - four tests?
- Is it likely to have a material impact on EVA?
- Can managers influence the outcome?
- Can the operating people readily grasp it?
- Is the required information relatively easy to track?
EVA: Key adjustments?
- The capitalisation of R&D expenses
- The capitalisation of internally generated trademarks and other market-building activities
- Adjust the capital base and depreciation to compensate for effects of inflation
EVA and rewards
- Basis for incentive compensation
- Profit is shared
- Make managers think and act like owners by paying them like owners
- Bonuses don’t have any caps - exceptional bonuses goes into bonus banks for payment in future years
Summary ROI
- Comprehensive and well-known
- Simple to calculate and easy to grasp
- Directly comparable
- Risk of suboptimal investment decision making
Summary RI and EVA
- Core idea: value is created only when operating profit is larger than cost of capital (in monetary terms - capital charge)
- Managers should be incentivized to act and think like owners - reward essential
Summary RI and EVA (2)
- BUs have the same profit objectives for comparable investments (not related to current ROI or a starting point)
- Improved goal congruence
- Adjustments for accounting deficiencies
- Not comparable between units
