3 Measuring Managers Performance Evaluation ToolCost/RevenueCenterStandard Cost/FlexibleBudget VariancesProfitCenterBudgeted incomestatementInvestmentCenterReturn on investment,residual income and EVA
4 Accounting-Based Performance Measure Example Relax Inns owns three small hotels –one each in Boston, Denver, and Miami.At present, Relax Inns does notallocate the total long-term debt ofthe company to the three separate hotels.
5 Denver Hotel Current assets $ 400,000 Long-term assets 600,000 Total assets $1,000,000Current liabilities $ 150,000Revenues $1,200,000Variable costs ,000Fixed costs ,000Operating income $ 240,000
6 Relax Inns Balance Sheet Total current assets $1,350,000Total long-term assets 6,150,000Total assets $7,500,000Total current liabilities $ 500,000Long-term debt ,800,000Stockholders’ equity 2,200,000Total liabilities and equity $7,500,000
7 Approaches to Measuring Performance Three approaches include a measure of investment:Return on investment (ROI)Residual income (RI)Economic value added (EVA®)
8 Return on investment (ROI) is an accounting measure of income divided by an accountingmeasure of investment.Return on investment (ROI)= Income ÷ Investment
9 What is the return on investment for the Denver Hotel?Denver Hotel: $240,000 Operating income÷ $1,000,000 Total assets = 24%
10 The DuPont method of profitability analysis recognizes that there are two basicingredients in profit making:1. Using assets to generate more revenues2. Increasing income per dollar of revenues
11 Return on sales = Income ÷ Revenues DuPont MethodReturn on sales = Income ÷ RevenuesInvestment turnover = Revenues ÷ InvestmentROI = Return on sales × Investment turnover
12 How can Relax Inns attain a 30% target ROI for the Denver Hotel? DuPont MethodHow can Relax Inns attain a 30% targetROI for the Denver Hotel?Present situation: Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20Operating income ÷ Revenues= $240,000 ÷ $1,200, = 0.201.20 × 0.20 = 24%
13 Alternative A: Decrease assets, keeping DuPont MethodAlternative A: Decrease assets, keepingrevenues and operating income perdollar of revenue constant.Revenues ÷ Total assets= $1,200,000 ÷ $800,000 = 1.501.50 × 0.20 = 30%
14 Alternative B: Increase revenues, keeping DuPont MethodAlternative B: Increase revenues, keepingassets and operating income per dollarof revenues constant.Revenues ÷ Total assets= $1,500,000 ÷ $1,000,000 = 1.50Operating income ÷ Revenues= $300,000 ÷ $1,500, = 0.201.50 × 0.20 = 30%
15 Alternative C: Decrease costs to increase DuPont MethodAlternative C: Decrease costs to increaseoperating income per dollar of revenues,keeping revenues and assets constant.Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20Operating income ÷ Revenues= $300,000 ÷ $1,200, = 0.251.20 × 0.25 = 30%
16 – (Required rate of return × Investment) Residual IncomeResidual income (RI)= Income– (Required rate of return × Investment)Assume that Relax Inns’ requiredrate of return is 12%.What is the residual income from the Denver hotel?
17 Residual Income = $240,000 - ($1,000,000 X 12%) Denver Hotel:Residual Income = $240, ($1,000,000 X 12%)= $120,000
18 Economic value added (EVA®) = After-tax operating income– [Weighted-average cost of capital× (Total assets – current liabilities)]
19 Total assets minus current liabilities can also be computed as: Economic Value AddedTotal assets minus current liabilitiescan also be computed as:Long-term assets + Current assets– Current liabilities, or…Long-term assets + Working capital
20 Economic value added (EVA®) substitutes the following specific numbers in the RI calculations:1. Income equal to after-tax operating income2. A required rate of return equal to theweighted-average cost of capital3. Investment equal to total assets minuscurrent liabilities
21 Economic Value Added Example Assume that Relax Inns has two sources oflong-term funds:1. Long-term debt with a market value andbook value of $4,800,000 issued at aninterest rate of 10%2. Equity capital that also has a market value of$4,800,000 and a book value of $2,200,000Tax rate is 30%.
22 Economic Value Added Example What is the after-tax cost of debt?0.10 × (1 – Tax rate) = 0.07, or 7%Assume that Relax Inns’ cost ofequity capital is 14%.What is the weighted-average cost of capital?
23 Economic Value Added Example WACC = [(7% × Market value of debt)+ (14% × Market value of equity)]÷ (Market value of debt + Market value of equity)WACC = [(0.07 × 4,800,000)+ (0.14 × 4,800,000)] ÷ $9,600,000WACC = $336,000 + $672,000 ÷ $9,600,000WACC = 0.105, or 10.5%
24 Economic Value Added Example What is the after-tax operating incomefor the Denver Hotel?Denver Hotel:Operating income $240,000 × 0.7 = $168,000
25 Economic Value Added Example What is the investment?Denver Hotel: Total assets $1,000,000– Current liabilities $150,000 = $850,000
26 Economic Value Added Example What is the weighted-average cost of capitaltimes the investment for Denver?Denver Hotel: $850,000 × 10.5% = $89,250
27 Economic Value Added Example What is the economic value added?Denver Hotel: $168,000 – $89,250 = $78,750The EVA® charges managers for the costof their investments in long-term assetsand working capital.