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Q3) what are the concept of ROI .What is its advantage and disadvantage. Manyexperts regard EVA as a concept is superior to ROI and yet in certain cases EVA doesnot do justice to the evaluation of investment centre. Explain this phenomenon withillustration. Explain +ve and ve feature of EVA.

Ans :-

Rate of Return on Investment (ROI)

Meaning

A performance measure used to evaluate the efficiency of an investment or tocompare the efficiency of a number of different investments. To calculate ROI, the

benefit (return) of an investment is divided by the cost of the investment; the result isexpressed as a percentage or a ratio.

Formula:

ROI = Profit After TaxCapital Employed

Return on investment is a very popular metric because of its versatility and simplicity.That is, if an investment does not have a positive ROI, or if there are otheropportunities with a higher ROI, then the investment should be not be undertaken.

Advantages:

ROI allows management to assess both profitability and efficiency in usingassets.

Divisions of unequal size can be compared.

Management is provided with information to make decisions on where toinvest additional company funds. The company knows where it is getting "themost bang for its buck."

Disadvantage:

If a manager is evaluated based on ROI, he or she will not invest in any project that will lower the division's ROI, even if it would increase thecompany's profitability.

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EVA

EVA is a value-based measure that was intended to evaluate business strategies,capital projects and to maximize long-term shareholders wealth. Value that has beencreated or destroyed by the firm during the period can be measured by comparing

profits with the cost of capital used to produce them.

Mathematically, the EVA can be calculated as

EVA = NOPAT (WACC X Capital Employed)

Where,NOPAT means Net Operating Profit before Interest and after TaxWACC represents Weighted Average Cost of Capital.

COMPONENTS OF EVA

Net Operating Profit After Taxes

NOPAT is easy to calculate. From the income statement we take the operating incomeand subtract taxes. Operating income is sales less cost of sales and less selling,general and administrative expenses.

Net Operating Income

Net Operating Income or NOI is a means of expressing pure operating results. Inother words, financial results of NOI do not have the impact of financing (borrowing),investing, or accounting adjustments, which can distort a purely operational analysis.

NOI is the amount of money generated exclusively from operations.

Calculating Cost of Capital

Many businesses dont know their true cost of capital, which means that theyprobably dont know if their company is increasing in value each year. There are twotypes of capital, borrowed and equity. The cost of borrowed capital is the interest ratecharged by the bondholders and the banks. Equity capital is provided by the

shareholders. An investors expected rate of return on an investment is equal to therisk free rate plus the market price for the risk that is assumed with the investment.The risk of a company can be decomposed into two parts. An investor can eliminatethe first component of risk by combining the investment with a diversified portfolio.The diversifiable component of risk is referred to as non-systematic risk. The secondcomponent of risk is non-diversifiable and is called the systematic risk. It stems fromgeneral market fluctuations which reflect the relationship of the company to othercompanies in the market. The non-diversifiable risk creates the risk premium required

by the investor. In the security markets the non-diversifiable risk is measured by afirms beta. The higher a companys non-diversifiable risk, the larger their beta. Asthe beta increases the investors expected rate of return also increases.

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EVA is much better than RO as a controlling tool and as a performance measure

1. Steering failure in ROI

Increase in RO is not necessarily good for shareholders i.e. maximizing RO cannot be set as a target. (Increase in RO would be unambiguously good only in thecompanies where capital can be neither increased or decreased -> however weleave in a world where both operations are easily executed in almost allcompanies)2. EVA is more practical and understandable than ROAs an absolute and income statement -based measure EVA is quite easilyexplained to non-financial employees and furthermore the impacts o differentday-to-day actions can be easily turned into EVA-figures since an additional $100cost decreases EVA with $100. (RO is neither easy to explain to employees orcan day-to-day actions easily be expressed in terms of ROI)

EVA vs return on investment (steering failure)

Example: ROI 30%. How ROI and EVA change after an investment producinga return of 20% ?

ROI does not take into account the increase or decrease in invested capital.Therefore it does not necessarily describe whether the profitability has decreasedor improved .

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R O I fa l l s 3 0 . 0 %= > 2 7 . 5

O p e r a t i n g p r o f i t

r i s e s 3 0 , 0 0 0= > 3 3 , 0

E V A r i s e s 2 1 , 0 0 0= > 2 2 , 2

Beginning

Operatingprofit 30,000

Capital invested 100,000 ROI 30.0%

Cost of capital 9% x 100,000 = 9,000

EVA 30,000 - 9,000 = 21,000

Investment

Investment AIncreaseinoperatingprofit 3,000

Increaseincapital invested 20,000 ( areturnof 15.0% )

S i t u a t i o n i f in ve s t m e n t d o n e

R O I a n d E V A a f te r i n ve s t m e n t d o n e :

O p era t in g p ro fit 3 0 , 0 0 0 + 3 0 0 0 = 3 3 , 0 0 0

C ap ita l in ve s te d 1 0 0, 0 00 + 2 0 ,0 0 0= 1 2 0, 0 0 0 RO I 2 7 .5

C o s t o f c a p it a l 9 % x 1 2 0 , 0 0 0 = 1 0 ,8 0 0

EV A 33 ,00 0- 1 0 , 80 0 = 22 , 200

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ADVANTAGES AND DISADVANTAGES OF EVA

Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as amotivational, compensation-based management system that facilitates economicactivity and accountability at all levels in the firm.

Stern Stewart reports that companies that have adopted EVA have outperformed theircompetitors when compared on the basis of comparable market capitalization.

Several advantages claimed for EVA are:

EVA eliminates economic distortions of GAAP to focus decisions on realeconomic results

EVA provides for better assessment of decisions that affect balance sheet andincome statement or tradeoffs between each through the use of the capitalcharge against NOPAT

EVA decouples bonus plans from budgetary targets EVA covers all aspects of the business cycle EVA aligns and speeds decision making, and enhances communication and

teamwork

Limitations of EVA

EVA also has its critics. The biggest limitation is that the only major publicly-available sample evidence on the evidence of EVA adoption on firm performance isan in-house study conducted by Stern Stewart and except that there are only a numberof single-firm or industry field studies.

EVA does not control for size differences across plants or divisions EVA is based on financial accounting methods that can be manipulated by

managers EVA may focus on immediate results which diminishes innovation EVA provides information that is obvious but offers no solutions in much the

same way as historical financial statement do.

Given the emphasis of EVA on improving business-unit performance, it doesnot encourage collaborative relationship between business unit managers EVA although a better measure than EPS, PAT and RONW is still not a

perfect measure

Q.4) Explain concept of ROI.Give +ve and ve fetures. Show calculation withDupont analysis.

ROI

A performance measure used to evaluate the efficiency of an investment or

to compare the efficiency of a number of different investments. To

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calculate ROI, the benefit (return) of an investment is divided by the cost

of the investment; the result is expressed as a percentage or a ratio.

There are two ways of calculating ROI: the traditional formula and the DuPontformula. The traditional approach presents a single, static measure of a company's

past performance. In contrast, the approach developed by the DuPont Corporationuses two factors, net profit margin and total asset turnover, to measure success inrecognition of the fact that excessive funds tied up in assets can be just as much of adrag on profitability as excessive expenses.

Traditional Formula:

ROI = Net Profit After Taxes Total Assets

DuPont Formula:

ROI = (Net Profit Margin) x (Total Asset Turnover)ROI = (Net Profit After Taxes Sales) x (Sales Total Assets)

For example, using the traditional formula, a company with $100,000 in total assetsand $18,000 in net profit after taxes would have an ROI of 18%. The DuPont formulatakes the analysis one step further by factoring in sales. Using the previous example,if sales are $200,000, then the net profit margin is only 9% and the total asset turnoveris 2. This still yields an ROI of 18% but provides more insight into how the companywas managed and what might be changed to improve profitability. The breakdown ofROI into its two components reveals that a number of combinations of net profitmargin (M) and total asset turnover (T) can produce the same return on investment.For example:

ROI = M x T18% = 9% x 218% = 6% x 318% = 3% x 618% = 2% x 9

Advantages:

ROI allows management to assess both profitability and efficiency in usingassets.

Divisions of unequal size can be compared. Management is provided with information to make decisions on where to

invest additional company funds. The company knows where it is getting "themost bang for its buck."

Disadvantage:

If a manager is evaluated based on ROI, he or she will not invest inany project that will lower the division's ROI, even if it wouldincrease the company's profitability.

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