2 Accounting profits or returns ... Timeliness —measured in short time periods.Precision —accounting rules (FASB).Objectivity —independent auditors.CongruenceIn for-profit firms, accounting profits or returns are relatively congruent with the true firm goal of maximizing shareholder value.Positive correlations between accounting profits and changes in stock prices.UnderstandableInexpensive —financial reporting requirements.
3 Limitations ...Accounting income does not reflect economic income perfectly, because accounting measures:Are transactions oriented;Are dependent on the choice of measurement method;Are conservatively biased;Ignore intangibles;Ignore the cost of investments in working capital;Ignore the cost of equity capital;Ignore risk;Focus on the past.The change in the value of the entityover a given period, where “value” isobtained by discounting future cash flows.
4 Myopia ... Investment myopia Reduce or postpone investments that promise payoffs in future measurement periods.cf., accounting number’s conservative bias.Operational myopiae.g., destroying goodwill with customers, suppliers, employees, or the society at large.
5 ROI performance measures ... Return on InvestmentROI is a ratio of the accounting profits earned by the business unit divided by the investment assigned to it;ROI = profits ÷ investment base.Residual IncomeRI is a dollar amount obtained by subtracting a capital charge from the reported accounting profits;RI = profits - capital charge.ROI is the most commonly used measureROI is easy to calculate, easy to understand, and meaningful in an absolute sense.
6 Labels ... Return on investment (ROI) Return on equity (ROE) Return on capital employed (ROCE)Return on net assets (RONA)The profit measure in the numerator can be a fully allocated after-tax profit measure —or, a before-tax operating income measure.The denominator can include all the line-items of assets and liabilities, including allocations of assets and liabilities not directly controlled by the division manager —or, it can include only controllable assets which include receivables and inventories at a minimum.
7 Problems caused by ROI-measures ... Numerator ...Accounting profits, hence, ...ROI contains all problems associated with these profit measures.Denominator ...How to measure the fixed assets portion?Suboptimization ...ROI-measures can lead division managers to make decisions that improve division ROI even though the decisions are not in the corporation's best interest.
9 Suboptimization ...ROI provides different incentives for investments across business unitsSBU-manager will not invest if ...SBU-manager will invest if ...Hence, if corporate cost of capital is 10%.,IRR of project is 11%, then A and B are unlikely to invest;IRR of project is 9%, then D and E are still likely to invest.CorporateCost ofCapitalIRRofProjectBusinessUnitROI<>
10 Suboptimization ... Assume Corporate cost of capital = 10% Investment of $10 to earn $1,1 per yearWorthwhile !Base situationProfit Before taxInvestment baseROINew situationProfit before taxInvestmentUnit A$ 24$ 12020 %$ 25.1$ 13019.30 %Unit C$ 10.5$ 10510 %$ 11.6$ 11510.08 %Unit D$ 3.8$ 755 %$ 4.9$ 855,76%“WRONG”“RIGHT”DOES NOT INVESTINVEST
11 Suboptimization ... Assume Corporate cost of capital = 15% Investment of $10 to earn $1,1 per yearNot worthwhile !Base situationProfit Before taxInvestment baseROINew situationProfit before taxInvestmentUnit A$ 24$ 12020 %$ 25.1$ 13019.30 %Unit C$ 10.5$ 10510 %$ 11.6$ 11510.08 %Unit D$ 3.8$ 755 %$ 4.9$ 855,76%“RIGHT”“WRONG”DOES NOT INVESTINVEST
12 Suboptimization ...Residual income makes performance targets uniform, and divisions will invest if IRR of project is greater than the capital charge (which could be set equal to the corporate cost of capital).Capital charge for fixed assets is 10%;Investment of $10 to earn $1,1 per year.Base situationProfit Before taxInvestment baseRINew situationProfit before taxInvestmentUnit A$ 24$ 120$ 15.6$ 25.1$ 130$ 15.7(= )Unit C$ 10.5$ 105$ 5.7$ 11.6$ 115$ 5.8(= )Unit D$ 3.8$ 75($ 1.6)$ 4.9$ 85($ 1.5)(= )INVEST
13 Miscellaneous ...Residual Income (RI) allows to use different interest charges for different types of assetse.g., fixed assets - longer term / higher risk - higher charge.Return on equity (ROE)-measures induce managers to use debt financingThis is not the case with RI if the capital charge is equal to the corporate cost of capital (i.e., weighted average of debt + equity).ROI-measures create incentives for managers to lease assetsThis is also true for RI if the interest charge that is built into the rental cost is less than the capital charge applied to the business unit's investment base.
14 The fixed assets portion ... Net Book ValueBoth ROI and RI get better merely to passage of time.Both ROI and RI are usually overstated if the business unit includes a relatively large number of older assets.ExampleInvest $100; Cash flow $27 per year; Depreciation $20 (5 years)Yr12345NBV10080604020IncrementalIncome7CapitalCharge1086RI-3-1ROI7%9%12%18%35%(=27-20)10 %
15 Misleading performance signals ... SBU-managers are encouraged to retain assets beyond their optimal life and not to invest in new assets.Corporate managers are induced to over-allocate resources to business units with older assets.Combined with the suboptimization issues discussed above, manager of units with older assets, and, hence, a higher ROI, are likely to be more reluctant to invest in "desirable" projects with an IRR higher than the corporate cost of capital.Gross Book Value (GBV)?However, in periods of inflation, old assets valued at GBV are still expressed at lower values than new assets, so ROI is still overstated.
16 Economic Value Added (EVA) ... Modified after-tax operating profit – (total capital x weighted average cost of capital)Similar to RI (=profit–capital charge), except for the modifications (164 in total, as suggested by Stern Stewart & Co)e.g., Capitalization and subsequent amortization of intangible investments (e.g., in R&D, employee training, etc.); Adding LIFO-reserves to correct for undervalued inventories; etc.