• percentage return on investment (ROI) - most used despite problems
• ="Net Operating Income" / Investment Base" [(Revenue - Expenses)/ Revenue] x (Sales / Average Operating [employed] Assets)
• better to use average operating assets because assets could change ove time (subject to manipulation using total assets)
• EVA (residual income was used up until recently)

• using a % method, makes it easier to compare across large and small divisions
• simple to calculate, easy to understand, meaning in absolute sense
• comprehensive measure of evaluation

• provide information useful in making sound decisions about assets employed and motivate managers to make these sound decisions in the best interest of the company
• measure performance of business unit as an economic entity

to earn satisfactory profit

Ex. $1M profit using $10M capital isn't as good of a performance if $1M profit using $5M capital (assuming similar risk)

• comparing absolute differenes in profits is not meaninful if business units use different amounts of resources
• more resources used, greater the profits should be.

• generate adequate profits from resources at their disposal
• invest in additional resources only when investment will produce an adequate return (disinvest if expected annual profits are less than cash could be realized from the sale)

purpose of relating profits to investments is to motivate business unit managers to accomplish these objectives

• ratio
• numerator is income as reported on Income statement
• denominator is average assets employed (total assets - current liabilities and noncurrent assets plus working capital)

• dollar amount
• found by subtracting a capital charge from the net operating profit (multiplying amount of assets employed by a rate)

• EVA and RI are measured in dollar amount
• ROI is a percentage

• What practices will induce business unit manager to use their assets more efficiently to acquire proper amount and new kind of assets?
• What practices best measure the performance of the unit as an economic entity

• most companies control cash centrall because it permit use of smaller cash balance than there would be if every business unit held cash balances it needed to weather inflows and outflows
• actual cash balances at the business unit level tend to be smaller than required if business unit were an independent company
• some companies omit cash from investment base bceause amount of cash approximates current liabilites so sum of A/R and inventories will apprximate amount of working capital

• business unit managers can influence level of receivables indirectly, by ability to generate sales and by establishing credit terms and approving individual credit account and limits
• offten included in end-of-period balances although average intraperiod balances is better measure of amount related to profits
• if business unit doesn't control credits and collections, receivables may be calculated on a formula basis (consisten with normal payment period)

• business units real investment is only COGS and satisfactory return is probably enough
• business unit could reinvest money collected from A/R and it should be included at selling price

• recorded at end-of-period amounts (like A/R) even though intraperiod averages would be better
• different valuation method for LIFO because inventory balances tend to be unrealistically low in periods of inflation because they are valued at standards or average cost used to measure cost of sales on business unit income statement
• WIP financed by advanced payments or progress payments are subtracted from gross inventory amounts
• corporate capital required is the difference between gross inventory amount and  including A/P encourages managers to seek more favorable terms

• companies include all current assets in investment base with no offset for current liabilities
• all current liabilities may be deducted from current assets

• business unit can't influence accounts payable or other current liabilities
• overstates amount of corporate capital required to finance business unit, because current liabilities are a source of capital often at zero interest cost

• good measure of capital provided by a corporation expected to earn a return
• implies that business unit managers are responsible for current liabilities

• financial accounting: fixed assets are recorded at acquisition and cost is written off through depr
• companies use a similar approach bu there can be serious problems

• new machine being considered to replace existing machine with undepreciated book value, undepreciated book value is irrelevant in economic analysis of propsed purchase
• removing bv of old machine can affect claculation of business unit profitability
• gross bv will increase by difference between nbv after 1 year of new machine and nbv of old machine
• relevant amount of addl investment is understated and EVA is overstated which encourages managers to replace equip wihch isn't economically justified
• if asset is included in investment base at orig cost then business unit managers is motivated

• using annuity as opposed to straight line business unit profitability calcuation will show correct EVA and ROI
• this method matches recovery of invesmtent that is implicit in pv calc.
• annuity depr is opposite of accelerated deprciation, so annual amount is low in early years when investment values are high and increases each year as investment decreases, ROR is constant

• use NBV but set lower limit (usually 50%) of original cost can be written off
• diffuicult since this can decrease investment base by scrapping good assets
• other idea: appraise asset by adjusting original cost using index of changes in equipment prices or applying insurance values
• tends to be subjective and business unit profitability wont' be consisten with corporate profitabilty reported to shareholders.

• business unit sold its fixed assets for bv and leased back asets at rental rate
• income before taxes would decrease becauen ew rental expense would be higher than depreciation charge eliminated
• EVA would increase because higher cost would be more than offset by decrease in capital charge, so business unit mangers are induced to lease, rather than own , assets whenever interest charge built into rental cost is less than capital charge applied to business unit investement base

• if business unit has idle assets that can be used by another unit, it may be permitted to exclude them from investment base if it classifies them as available
• purpose is to encourage business unit managers to release underutilized assets to units that may have better use for them
• if fixed assets can't be used by other units, permitting manager to remove them from investment base could result in dysfunctional actions.

• advantages to capitalizing intangible assets and amortizing them over selected life
• by accounting for these assets as long-term investments, butsiness unit manager will gain less short-term benefit from reducing outlays of such items
• ex. if R&D expenditures are expensed immediately, each $ of R&D cut will be a dollar more on pretax profits but if they are capitalized, each dollar cut will reduce assets employed by a dollar

• business unit receives permanent capital from corporate pool of funds
• corporations obtained funds from debt proviers, equity investors, and retained earnings
• total amount of funds is relevant but not sources from which they were obtained.

• coprorate headquarters sets rate used to calculate capital charge
• should be higher than corporation's rate for debt financing because funds are a mixture of debt and hgiher cost equity.
• rate is somehwat below company's estimated cost of capital so EVA will be above zero.
• some companies use lower rate for working capital than for fixed assets because funds are committed for a shorter priod.

• most companies include fixed assets in investment base at NBV because this is the amount at which assets are caarried in the financial statements and represent amount of cpaital that corporation has employed in their division

• comprehensive measure that affects financial statements is reflected in that ratio
• simple to calculate, easy to undersatnd and meaningful in an absolute sense
• data is available for competitors and can be used as basis for comparison
• dollar amount of EVA doesn't allow comparison

• business units have same profit objectives for comparable investments, but ROI provides different incentives for investments across buisness units
• decisions that increase a center's ROI may decrease overall profits, but EVA relates to asset investment whose ROI falls between cost of capital and center's current ROI
• Different interest rates may be used for different types of assets
• Different interest rates may be used for differnet type of assets

• reduces risk of takeover
• creates currency for aggressivness in mergers and acquisitions
• reduces costs of capital

• EVA = Net profit after tax - Capital Charge where weighted average cost of capital = Cost of capital x Capital empoyed
• EVA = Capital Employed (ROI - Cost of Capital

• increase in ROI through business process reengineering and productivity gains
• divestment of assets, products and/or businesses whose ROI is less than cost of capital
• aggressive new investments in assets, products and/or businesses whose ROI exceeds cost of capital
• increase in sales, profit margins or capital efficiency (ratio of sales to capital employed) or decrease in cost of cpital percentage without affecting other variables in equation.

• doesn't solve problems of accounting for fixed assets unless annuity depreciation is also used and this is rarely done in practice
• gross book value is used, business unit can increase EVA by taking action contrary to interest of company
• using NBV, EVA will increase simply by passage of time.

• eocnomic reports are diagnostic instrument
• indicate whether current strategies of business unit are satisfactory and if not wehther a decision should be made about the business unit (sell, shrink, expand)
• also made up basis for arriving at value of company as a whole "breakup value"