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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-42 Calculating Return on Investment (ROI) and Residual Income (RI);
Comparing Results (25 minutes)
1. a. ROI = Operating Income ÷ Average Assets
= $2,440,000 ÷ {[$16,000,000 + ($16,000,000 ÷ 1.06)] ÷ 2}
b. RI = Operating Income – (Avg. Assets × Min. pre-tax rate of return)
= $2,440,000 – ($15,547,170 × 0.10)
2. In this case residual income (RI) provides the desired incentive for local
managers to make investments desired by top management. Delta
performance measure.
3. Like many organizations, Blackwood Industries should benefit from a
management control system which gives explicit attention to strategic
factors. The balanced scorecard (BSC) would be a useful approach to
accomplish this objective. The BSC considers not only financial factors,
but also non-financial factors such as progress with customer relations,
improvements in operations, and improvements in capabilities of
19-51
Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
19-52
Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
19-43 Residual Income (RI); Performance Evaluation Time Horizon; Spreadsheet Application (60
Minutes)
1. Estimated NPV of cash flows and estimated NPV of Residual Incomes (RI):
Time Period (Year)
0 1 2 3 4 5
Depreciation Expense =
$160,00
0 $160,000
$160,00
0 $160,000
$160,00
0
Beg.-of-Year NBV of asset =
$800,00
0 $640,000
$480,00
0 $320,000
$160,00
0
Time Period (Year)
0 1 2 3 4 5
Residual Incomes (RI):
Cash Inflow $300,000
$300,00
0
$300,00
0
$300,00
0
$300,00
0
$160,00
$160,00
$160,00
$160,00
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-43 (Continued)
Time Period (Year)
2. The basic issue illustrated in the calculations presented above in (1) pertains to the incentive effects of
financial performance metrics, such as ROI and Residual Income (RI). We know from Chapter 12 that
long-term investment decisions are typically made on the basis of a discounted cash flow (DCF) basis.
On the other hand, it is more typical that subsequent financial analysis of investment projects is
conducted using accrual-based accounting data, e.g., ROI or Residual Income (RI). This divergence
presents an issue of "goal congruency" and therefore the possibility of suboptimal decisions from the
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Chapter 19 - Strategic Performance Measurement—Investment Centers
budgeting decisions, then using multi-year RI to evaluate subsequent financial performance helps to
achieve goal congruency. (In this regard, see also Problem 19-37.)
Chapter 19 - Strategic Performance Measurement—Investment Centers
19-44 EVA® NOPAT and EVA® Capital; Operating Approach (60 Minutes)
Students should understand that EVA® is an approximation of an entity's true (i.e., "economic") profits
for a period. This measure of profitability is defined as the difference between the entity's NOPAT (net
operating profit after tax) and an imputed capital charge. NOPAT is supposed to approximate the
entity's actual cash yield generated for investors from recurring business activities during the period.
The amount of capital employed is supposed to represent the cash that investors have put at risk in
the firm, and upon which they expect an appropriate return. To estimate both NOPAT and the amount
of capital for a period, the analyst begins with reported financial statement amounts and then makes
adjustments. These adjustments, in the parlance of EVA®, are collectively referred to as "equity
equivalent adjustments."
The Operating Approach to NOPAT estimation starts by deducting operating expenses—including
depreciation--from sales. Next, equity-equivalent (EE) reserve adjustments are made. Interest
expense, because it is a financing charge, is ignored, but other (operating) income is added to get
pretax economic profits, or Net Operating Profit Before Tax (NOPBT). Finally, an estimate of cash tax
expense on these operating profits is deducted, resulting in NOPAT. Under the Operating Approach,
EVA® capital is defined as the sum of net assets less non-interest-bearing current liabilities (NIBCLS).
1. EVA®NOPAT—Operating Approach (see next page):
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-44 (Continued-1)
Net Sales $2,000
Less: CGS 1,670
Adjustments:
Increase in LIFO reserve (1) 2
Imputed Interest--Non-capitalized leases (2) 4
Net Operating Profit $66
Plus: Other Operating Income 12
NOPBT $78
Less: Cash taxes paid on net operating profit:
Reported Tax Expense $20
Less: Increase in Deferred Tax (3) 5
Plus: Tax Savings (foregone) on Interest (4) 10 25
NOPAT $53
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Chapter 19 - Strategic Performance Measurement—Investment Centers
Rationale for EE Adjustments made:
(1)LIFO Reserve: brings into earnings the current-period effect of unrealized gain attributable to
holding inventory during period of rising prices
(2)Imputed Interest--Non-Capitalized Leases: Puts Operating and Capital Leases on equal footing in
terms of effects on EVA® NOPAT. In both cases, we want to remove the interest cost associated
with leases because this is a financing, not operating, expense.
19-44 (Continued-2)
2. EVA® Capital—Operating Approach:
Reported Current Assets (CA) $510
Plus: LIFO Reserve (1) 10
Adjusted CA $520
Less: NIBCLS:
Net Working Capital $150
Net Plant, Property, Equipment $605
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Chapter 19 - Strategic Performance Measurement—Investment Centers
Rationale for Adjustments Made:
(1) LIFO Reserve: this adjustment converts the balance-sheet inventory amount from a LIFO to a
FIFO cost basis. In so doing, the resulting amount better approximates the current replacement
cost of inventories.
(2) PV of Non-capitalized leases: puts operating and capital leases on equal footing in terms of
determining the amount of "invested capital" in the business. (In essence, this adjustment
eliminates what some would consider an accounting "distortion.")
Chapter 19 - Strategic Performance Measurement—Investment Centers
19-44 (Continued-3)
3. EVA® estimate—Operating Approach:
EVA® NOPAT = $53
Capital Charge:
The negative EVA® amount suggests that during the most recent period, the company did not earn
a sufficient amount of economic (cash) profit to fully compensate the suppliers of capital. That is,
during the most recent period, stockholder value was not created.
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