Chap 7
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This document discusses investment centers and methods for measuring assets employed and business unit performance. An investment center compares profit to the assets used to generate that profit. Measuring assets employed and return on investment (ROI) provides information for decision making and motivates managers. ROI is profit divided by assets employed. Economic value added (EVA) measures wealth creation by subtracting a capital charge from net operating profit after taxes. EVA attempts to capture true economic profit by considering the cost of capital.
Chap 7
- 1. Chapter-7 Measuring and Controlling Assets Employed Investment center
- 2. When profit is compared with the assets employed in earning it, the division is called investment center.
- 3. Objectives Provide information that is useful for making sound decision. To measure the performance of business unit as an economic entity. To motivate the managers to make such sound decisions.
- 4. Focusing on profit without considering the investment will not serve the purpose. Unless the amount of assets employed is taken into consideration, it is difficult for senior management to compare the profit performance of one business unit with another.
- 5. Example Golden grain, a business unit of Quaker Oats, had very high profitability and appeared to be one of Quaker Oats’ best division. It was however acquired by Quaker Oats at a premium above its book value. Based on the assets employed as measured by this premium, Golden grain actually was undertaken.
- 6. Objectives of business units They should generate adequate profits out of the resources at their disposal. They should invest in additional resources only when the investment will produce an adequate retun, discounted at the company’s earning rate.
- 7. Retun on Investment ROI is a ratio The numerator is income as reported on the income statement. The denominator is assets employed.
- 8. Assets Employed= Total Assets- Current liabilities OR Non Current Assets+ Working capital
- 9. Economic Value Added is a dollar amount rather than a ratio. It is found by subtracting a capital charge from the net operating profit. Coca-Cola, GE and AT&T, employ EVA internally to measure wealth creation performance.
- 10. A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".)
- 11. EVA= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital) This measure was devised by Stern Stewart & Co. Economic value added attempts to capture the true economic profit of a company.
- 12. There are four steps in the calculation of EVA: 1. Calculate (NOPAT) 2. Calculate Total Invested Capital (TC) 3. Determine a Cost of Capital (WACC) 4. Calculate EVA = NOPAT – WACC% * (TC)
- 13. Example If Operating Profit= 1,oo,ooo Total investment=1mn. ROI= 1,00,000/10,00,000=10%
- 14. If capital is $100 million - including debt and shareholder equity - and the cost of using that capital (interest on debt and the cost of underwriting the equity) is $13 million a year, it will add economic value for his shareholders only when profits are more than $13 million a year. If it earns $20 million, the company's EVA will be $7 million.
- 15. Measuring Assets Employed What practices will induce business unit managers to use their assets most efficiently? What practices best measure the performance of the unit as an economic entity?
- 16. Working Capital Component Cash Receivables Inventories Working capital in general Property ,Plant and Equipment Leased Assets Idle Assets Intangible Assets
- 17. Cash Centralized v/s Decentralized Higher amountv/s Lower amount
- 18. Receivables End of the year balance or Intra period balance At selling price or at COGS
- 19. Inventories End of the period amount v/s Intra period amount Which method of inventory valuation to be followed
- 20. Working capital in general Accounts payable
- 21. Property ,Plant and Equipment Acquisition of new Equipment Gross book value Disposition of Assets Annuity Depreciation
- 22. Acquisition of new Equipment Business unit that have old almost fully depreciated asset will tend to report larger economic value added than units that have newer assets.
- 23. If depreciable assets are included in the investment base at net book value, business unit profitability is misstated and business unit managers may not be motivated to make correct acquisition decisions.
- 24. Non Current liabilities The capital Charge
- 25. EVA v/s ROI