Return on investment (ROI)
ROI is similar to the ROCE concept; it is the use and application of the measure that is different to ROCE. ROI is more commonly applied at the project or SBU (Strategic Business Unit) level.
|Calculations are very simple.||The timing of profit flows is completely ignored.|
|Profit is a well understood concept and easily obtainable.||There are a number of different definitions of ROI and various ways of calculating it which can lead to confusion.|
|The entire life of the project is taken into account.||The crucial factor in investment decisions is cash flow and the ROI uses profits.|
|As a relative measure ROI enables comparison against projects or SBUs of varying sizes.||The technique takes no account of the time value of money.|
|Helps as a measure of comparison in a scheme of merger through measuring the asset backing.||It takes no account of the incidence of profits;|
|Also helpful in valuing property investment companies.||Averages can be misleading.|
This is expressed as an absolute figure, it is normally calculated as: Profit (EBIT) – Imputed Interest Charge on Project/SBU Investment
The interest charge is a notional charge based normally on a risk adjusted cost of capital applied to the book value of the value of the investment at the start of each year. The interest charge is a notional charge based normally on a risk adjusted cost of capital applied to the book value of the value of the investment at the start of each year.
|It makes divisional managers aware of the cost of financing their divisions.||In common with most other divisional performance measures, problems exist in defining controllable and traceable income and investment.|
|It is an absolute measure of performance and not subject to the problems of relative measures such as return on investment.||Residual income gives the symptoms not the cause of problems. If residual income falls the figures give little clue as to why.|
|In the long run it supports the net present value approach to investment appraisal (the present value of a project’s residual income equals net present value of that project).||Residual income when applied on a short term basis is a short term measure of performance and may lead managers to overlook projects whose payoffs are long term.|
|As a relative measure ROI enables comparison against projects or SBUs of varying sizes.||Problems exist in comparing the performance of different sized divisions (large divisions will earn larger residual incomes simply due to their size.|
Economic Value Added
Stern Stewart New York Consultancy Group has ‘trademarked’ the term EVA (Economic Value Added) for what is an extension/refinement of the Residual Income concept. EVA, according to the book The Quest for Value – the EVA Management Guide, is simply the net operating profit after tax less the cost of capital (the weighted average cost of debt and equity) used in the business.
EVA is seen to the true economic profit made by an enterprise, the concept being that true shareholder value is created when an organisation generates economic profits in excess of the financing costs of the economic capital of an organisation. The economic profits are described as NOPAT (Net Operating Profits after Tax), this being a proxy measure for net cash flows.
NOPAT is arrived at by making a number of adjustments to accounting profit, example adjustments being for amortised goodwill, non-cash expenses, provisions and interest charges.
The economic capital is arrived at by making a number of adjustments to the accounting measure of capital, example adjustments being for amortised development costs and goodwill, provisions for doubtful debts.
The financing costs represent the target WACC applied to the economic capital.