Question

Alternative Investment Bases

Chapter 7 in the textbook discusses how differences in the amounts used to calculate ROI can impact performance evaluation. I found the reading very tedious and difficult to understand. This problem provides a simple example of how alternative investments bases affect the calculation of ROI (and therefore, affect performance evaluation).

Basic Information:

The T Division of A.T. Enterprises has depreciable assets costing $2 million. The cash flows from these assets for 3 years follow:

            Year                                                                Cash Flow

$600,000

$700,000

$600,000

Depreciation of these assets is 10% per year; the assets have no salvage value.  

Assumptions:

A.T. calculates Return on Investment as follows:

ROI = NOI / Investment

Required:

Compute ROI for each year by recreating the tables on the following pages assuming that investment is calculated using:

Net book value

Gross book value

Visually compare each method separately across the three years (i.e., don’t compare Net Book Value to Gross Book Value). Based on your visual comparison, which method is better for evaluating performance? Why?

Alternative Investment Bases

NET BOOK VALUE

For Net Book Value:

NOI = Cash Flows – Depreciation Expense

Investment Base = Depreciable Assets – Accumulated Depreciation at year end

Year 1 has been completed as an example.

	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%) $400,000
Investment Base (b)	$2,000,000 x 90%* $1,800,000
ROI (a)/(b)	$400,000   = 22.22% $1,800,000

* Alternatively, $2,000,000 – ($2,000,000 x 10%)

Alternative Investment Bases

GROSS BOOK VALUE o For Net Book Value:

o NOI = Cash Flows – Depreciation Expense o Investment Base = Depreciable Assets

Year 1 has been completed as an example.

	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%) $400,000
Investment Base (b)	$2,000,000
ROI (a)/(b)	$400,000      = 20% $2,000,000

Note that this example only manipulates one variable – Investment Base Net Book Value vs. Gross Book Value. Other Investment Base variations include: (1) Beginning of the Year vs. End of the Year vs. Average Book Balance and (2) Historical Cost vs. Current Cost. It can be quite complicated to ensure that the performance evaluation method being used is encouraging goal congruent behavior.

Answer 1

NET BOOK VALUE
	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%)	$700,000 – ($2,000,000 x 20%)	$600,000 – ($2,000,000 x 20%)
	$400,000	$500,000	$400,000
Investment Base (b)	$2,000,000 x 90%*	$2,000,000 x 80%*	$2,000,000 x 70%*
	$1,800,000	$1,600,000	$1,400,000
ROI (a)/(b)	$400,000   = 22.22%	$400,000   = 31.25%	$400,000   = 28.57%
	$1,800,000	$1,600,000	$1,400,000
GROSS BOOK VALUE
	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%)	$700,000 – ($2,000,000 x 20%)	$600,000 – ($2,000,000 x 20%)
	$400,000	$500,000	$400,000
Investment Base (b)	$2,000,000	$2,000,000	$2,000,000
ROI (a)/(b)	$400,000   = 20%	$500,000   = 25%	$400,000   = 20%
	$2,000,000	$2,000,000	$2,000,000
Beginning of the Year vs. End of the Year vs. Average Book Balance
Begining Year
	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%)	$700,000 – ($2,000,000 x 20%)	$600,000 – ($2,000,000 x 20%)
	$400,000	$500,000	$400,000
Investment Base (b)	$2,000,000	$2,000,000 x 90%*	$2,000,000 x 80%*
		$1,800,000	$1,600,000
ROI (a)/(b)	$400,000   = 20%	$500,000   = 27.78%	$400,000   = 25%
	$2,000,000	$1,800,000	$1,600,000
End of Year
	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%)	$700,000 – ($2,000,000 x 20%)	$600,000 – ($2,000,000 x 20%)
	$400,000	$500,000	$400,000
Investment Base (b)	$2,000,000 x 90%*	$2,000,000 x 80%*	$2,000,000 x 70%*
	$1,800,000	$1,600,000	$1,400,000
ROI (a)/(b)	$400,000   = 22.22%	$500,000   = 31.25%	$400,000   = 28.57%
	$1,800,000	$1,600,000	$1,400,000
Average Book Balance
	Year 1	Year 2	Year 3
NOI (a)	$600,000 – ($2,000,000 x 10%)	$700,000 – ($2,000,000 x 20%)	$600,000 – ($2,000,000 x 20%)
	$400,000	$500,000	$400,000
Investment Base (b)	($2,000,000+$1,800,000)/2	($1,800,000+$1,600,000)/2	($1,600,000+$1,400,000)/2
	$1,900,000	$1,700,000	$1,500,000
ROI (a)/(b)	$400,000   = 21.05%	$500,000   = 31.25%	$400,000   = 26.67%
	$1,900,000	$1,700,000	$1,500,000
In the absence of current cost, ROI for hostorical cost Vs Current cost could not be derived
Note-
Best effort have been made to answer the question correctly, in case of any discrepencies kindly comment and i will try to resolve it as soon as possible.
Please provide positive feedback.

Since, we are trying to figure out the ROI under different scenerio so we are comparing ROI taking different bases. As per my view, Net Book value or the End of the year value is better method for evaluating performance, because it shows us the real picture of the firm, as the assets are depriciated over year and this it is currect that the investment would decreased by depreciation amount every year. Also it shows that the company has better rate of return.