Question

1. A shortcoming of return on investment (ROI) is that it may not lead managers to accept good investment opportunities if

a.	ROI of the investment is higher than the present ROI of the division.
b.	the ROI of the investment is the same as the present ROI of the division.
c.	the ROI of the investment is lower than the present ROI of the division.
d.	None of the answers is correct.

   2.   Which of the following statements is true concerning economic value added (EVA)?

a.	EVA alleviates the shortcoming of the return on investment measurement.
b.	EVA calculates a percentage for comparison purposes.
c.	EVA is required by the New York Stock Exchange.
d.	EVA is the same as economic payback analysis.

   3.   Which of the following defines Economic value added (EVA)?

a.	annual after-tax operating profit minus the total annual cost of capital.
b.	annual before-tax operating profit minus the total annual cost of capital.
c.	annual after-tax operating profit plus the total annual cost of capital.
d.	annual before-tax operating profit plus the total annual cost of capital.

Answer 1

Solution 1:

The shortcomings of ROI (Return of investment) is that it may not lead managers to accept good investment opportunity if ROI of the investment is lower than the present ROI of the divison because in that case overall ROI of the divison including new investment will decline. This will result in decrease in rewards of manager if their rewards are based on achieving target ROI.

Hence choice c is correct.

Solution 2:

The true statement with regards to economic value added (EVA) is "EVA alleviates the shortcoming of the return on investment measurement." If manager incentive are based on EVA then they will accept investment opportunity giving ROI less than ROI of divison because in that case overall ROI will decline but overall EVA will increase. Hence it will motivate manager to do new investment if ROI is greater than their WACC.

Thus choice a is correct.

Solution 3:

Economic value added (EVA) is calculated by subtracting total annual cost of capital from annual operating profit after taxes.

Hence choice a is correct.