Question

What are the strengths and weaknesses of using Residual Income (RI), Return on Investment (ROI), or Economic Value Added (EVA®) as methods to evaluate management performance? Which method would you like to be assessed by, if you were a manager? Would it make a difference if you were in charge of a department, plant, or major division? Why or why not? Support you answer with examples.

Answer 1

Residual Income-

The residual income approach is the measurement of the net income that an investment earns above the threshold established by the minimum rate of return assigned to the investment. It can be used as a way to approve or reject a capital investment, or to estimate the value of a business.

Residual Income (RI) = A − (B × C)

In the above formula,
   A = Net operating income;
   B = Minimum required return on assets; and
   C = Average operating assets

Example-

ABC International has invested $1 million in the assets assigned to its Idaho subsidiary. As an investment center, the facility is judged based on its return on invested funds. The subsidiary must meet an annual return on investment target of 12%. In its most recent accounting period, Idaho has generated net income of $180,000. The return can be measured in two ways:

• Return on investment. ABC's return on investment is 18%, which is calculated as the $180,000 profit divided by the investment of $1 million.
• Residual income. The residual income is $60,000, which is calculated as the profit exceeding the minimum rate of return of $120,000 (12% x $1 million)

Strength-

• It encourages investment managers to make new investments if they add to RI. A new investment might add to RI but reduce ROI. In such a situation, measuring performance by RI would not result in dysfunctional behaviour, i.e. the best decision will be made for the business as a whole.
• Making a specific charge for interest helps to make investment managers more aware of the cost of the assets under their control.

Weekness-

• It does not facilitate comparisons between divisions since the RI is driven by the size of divisions and of their investments.
• It is based on accounting measures of profit and capital employed which may be subject to manipulation, e.g. in order to obtain a bonus payment.

Return On Income-

ROI is another vital investment evaluation technique that can be made by companies to measure performance. This helps to calculate how much returns are made compared to the amount of capital invested. ROI can be calculated as a whole for the company as well as for each division in case of a large-scale company. ROI is calculated using the following formula.

ROI = Earnings Before Interest and Tax (EBIT) / Capital Employed

EBIT – Net operating profit before deducting interest and tax

Capital Employed – Addition of debt and equity

Example-

An investor has the following options to invest in stocks of two companies

Company A’s stock – cost = $ 900, value at the end of one year = $ 1,130

Company B’s stock – cost = $ 746, value at the end of one year=$ 843

The ROI of the two investments are 25% ((1,130 – 900) /900) for Company A’s stock and 13% ((843 – 746) /746) for Company B’s stock.

Strength-

• It helps the investors and the financial professional to quickly check the prospect of an investment and thus no time and money get wasted.
• ROI also helps in exploring as well as measuring the potential returns on different investment opportunities.
• It assists in understanding and measuring the benefits of investment in particular departments as well.
• It helps to measure the competition around in the market.
• The most important benefit of using ROI for investment decision is that it is simple but effective.
• The calculation of the ROI is one of the simplest calculations in financial ratios.
• ROI is understood by the layman as well, it is universally accepted the concept of finance and investment and business as well.

Weakness-

• In ROI calculation, the time factor is completely ignored which is a major drawback of the measure. To understand these let’s see an example, MR. X invested INR 10000 in shares of Wipro in 2011 and sell off his investment in 2013 for INR 15000. So, his ROI is 50% while Mr. Y invested the same amount in the shares of SBI and sell off the shares in 2015 for INR 15000. So ROI of Mr. Y’s investment is 50% as well. But the time for which Mr. X and Mr. Y invested the amount is different. When the former ripped 50% profit on investment in just 2 years, the latter took 4 years to earn the same. As it is said, “time is money”, the actual worth of the 50% profit is not same to both the investors. In real terms, if we include inflation and time value of moneythen the profit earned by Mr. Y is less than the 50% profit of Mr. X.
• Different calculation process of the ROI makes it confusing to a different While a company calculates using one formula, the investor might calculate using other, and then there creates a difference of opinion and confusion.

Economic Value Added-

EVA (Economic Value Added) is a performance measure normally used to assess the performance of business divisions, in which a finance charge is deducted from the profits to indicate the usage of assets. This finance charge represents the cost of capital in monetary terms (derived by multiplying the operating assets by the cost of capital). EVA is calculated as below.

EVA = Net Operating Profit After Tax – (Operating Assets* Cost of Capital)

Net Operating Profit After Tax (NOPAT)

A profit from business operations (gross profit less operating expenses) after deduction of interest and taxes.

Example-

Let us say, gold seems to be a good instrument to invest with a high profit margin.

• Total investment (i.e. price at which gold is purchased) = $ 1000
• Brokerage paid to the dealer for purchase of gold = $ 15

In a year, I would like to sell off the gold on account of liquidity crunch.

• Selling price of gold = $ 1200
• Brokerage paid to the dealer on sale of gold = $ 10

In the above Economic Value Added example,

• Economic Value Added = Selling price – Expenses associated with selling the asset – Purchase price – Expenses associated with buying the asset
• Economic Value Added = $ 1200 – $ 10 – $ 1000 – $ 15 = $ 175

If we just see the profit, then the profit on selling gold was $ 1200 – $ 1000 i.e. $ 200. But the actual creation of wealth is only $ 175 on account of expenses incurred. This is a very crude example of Economic Value Added (EVA).

Strength-

(i) EVA is a tool which helps to focus managers’ attention on the impact of their decisions in increasing shareholders’ wealth.

(ii) EVA is a good guide for investors; as on the bias of EVA, they can decide whether a particular company is worth investing money in or not.

(iii) EVA can be used as a basis for valuation of goodwill and shares.

(iv) EVA is a good controlling device in a decentralised enterprise. Management can apply EVA to find out EVA contribution of each decentralised unit or segment of the company.

(v) EVA linked compensation schemes (for both operatives and managers) can be developed towards protecting (or rather improving) shareholders’ wealth

Weakness-

The disadvantage is the practicability of the calculations. The first difficulty is in finding a correct cost of equity. It is not suitable for all kinds of companies. It may not correctly understand efficiency as the EVA of a bigger plant will always be more than smaller plant even when they are more efficient and maintain a better ROI comparatively.

Conclusion-

In order to undertake investment decisions and to measure the performance of companies many ratios and performance figure have been established. The ROI can be a misleading figure and leads ultimately to the result that companies only keep the most profitable products and undertake the most profitable investments. Nonetheless, the residual income also contributes to the performance of companies. The RI is based on the internal usage of current assets, which only point to residual income above the current usage of these assets. The ‘real’ residual income however is best measured by the EVA, since only real cost comparisons matter as it takes the WACC into consideration and not the minimum required return. EVA is also more useful to shareholders and allows in most cases more investments. Finally, RI is still a good measure to compare investments in IC’s and PC’s.