Performance Evaluation Return on Investment EBIT / Operating Assets Problems with formula EBIT Why not net income? Operating Assets Book value versus fair market value Book value for depreciable assets Average for year? What is acceptable ROI?

Performance Evaluation Margin EBIT / Sales What happens if margin increases? What happens if sales increase? Turnover Sales / Operating Assets

Performance Evaluation Residual Income EBIT – (Operating Assets x Minimum Rate of Return) Accept investment even if ROI less than current ROI for business But…ROI has to be more than minimum rate of return Implications What is minimum return? What happens if operating income increases? What happens if operating assets increase? What happens if minimum rate of return increases?

Performance Evaluation EVA Net Income – (Capital Employed x Cost of Capital) Implications Should a profitable firm be liquidated? What happens if profit margin increases? What happens if sales increase? What happens if capital employed increases? What happens if cost of capital increases?

Performance Evaluation Transfer pricing Vertically integrated company Caterpillar: parts distribution through Switzerland saved $2.4 billion in tax Possibilities Cost plus Possible issues Negotiated price Possible issues Textbook: Minimum: market – avoided costs Maximum: market price

Performance Evaluation Transfer pricing Market value Possible issues Most logical value to use