AMA Lecture 2
AMA Lecture 2
AMA Lecture 2
ACCOUNTING
Lecture 2
Investment Center Evaluation
Measuring the Performance of Investment Centers
Using ROI, Residual Income and Economic Value
Added
Dr. Abdullah Hamoud
Main source: Hansen & Mowen (2007). Managerial Accounting (8th ed.). Thomson.
Measuring the Performance of
Investment Centers Using ROI
Return on Investment (ROI)
3
Divisions that are investment centers will have an
income statement and a balance sheet.
So, could those divisions be ranked on the
basis of net income?
Suppose, for example, that a company has
two divisions, Alpha and Beta. Alpha’s net
income is $100,000, and Beta’s is $200,000.
Did Beta perform better than Alpha?
What if Alpha used an investment of
$500,000 to produce the contribution of
$100,000, while Beta used an investment of
$2 million to produce the $200,000
contribution?
Does your response change?
What is Return on Investment (ROI?
The Return on Investment (ROI) is a
profitability ratio that compares the net
profits received at exit to the original cost
of an investment, expressed as a percentage.
FORMULA: ROI
The formula for calculating the return on investment (ROI) is as
follows
The difference between the gross return and the cost of investment is the net return
Thus;
Alpha Beta
Operating income $ 100,000 $ 200,000
ROI: BETA
= Op. Income / Ave. Op. Assets
= $200,000 / $2,000,000 = .10
MARGIN & TURNOVER: ROI
Another way to calculate ROI is to separate the formula (Operating
income/Average operating assets) into margin and turnover.
Sales $ 480,000
The current ROI is the hurdle rate used to make decisions about changes.
Explanation
The ROI without the additional advertising is 15
percent; the ROI with the additional advertising and
$50,000 investment in assets is 15.24 percent.
* 10%
Example 1:
Compute for the residual income of an investment
center which had operating income of $500,000
and operating assets of $2,500,000. The cost of
capital is 12%.
❖ As you can see from the above example, using the concept of
residual income, although Company X is reporting a profit on its
income statement, once its cost of equity is included in relation to its
return to shareholders, it is actually economically unprofitable based
on the given level of risk.
Example 3:
Ethan would like to know how much residual income he’s making from
his meat shop. Ethan spent a total of $250,000 to buy meat-cutting
machines and other equipment. He has a net operating revenue of
$50,000 for the year. He presently earns a return of 10%, so he aims
for a minimum required return of 10%. What is Ethan’s Delicatessen’s
residual income?
Solation
Net operating income: 50,000
Minimum required return:10%
Cost of operating assets: 250,000
This means Ethan has a remaining net income of $25,000 after the
capital cost has been deducted. This also proves that his
meat shop is earning more than the minimum 10 percent required.
As a result, he can use his excess earnings to fund an expansion,
pay debts, or distribute dividends to any investors.
Measuring the Performance of Investment
Centers Using Economic Value Added
ECONOMIC VALUE ADDED
(EVA)
▪ Economic Value Added (EVA) is additional value
created above the cost of capital.
▪ A specific way of calculating residual income is
economic value added. Economic value added
(EVA)1 is net income (operating income minus
taxes) minus the total annual cost of capital.
▪ Economic Value Added (EVA), sometimes known as
Economic Profit, is a measure based on the residual
income technique, which measures the return
generated over and above investors’ required rate of
return.
ECONOMIC VALUE ADDED
(EVA)
▪ EVA serves as an indicator of the profitability of
projects in which a company invests.
▪ It is the excess profit above the cost of capital,
generated by the business.
▪ It represents the difference between the Rate of
Return and Cost of Capital and measures the value
generated by invested capital.
▪ The Economic Value Added (EVA) attempts to
capture the truest economic profitability of the
company. Therefore, we also refer to it as Economic
Profit.
ECONOMIC VALUE ADDED
(EVA)
▪ A negative EVA means that the business is
generating no value. Whereas, a positive EVA
implies the company is creating value for the
shareholders.
ECONOMIC VALUE ADDED
(EVA)
EVA is net income minus total annual cost of capital.
Where:
NOPAT = Net Operating Profit After Tax
WACC = Weighted Average Cost of Capital
Transfer Pricing
TRANSFER PRICING: Definition