Prepared by Diane Tanner University of North Florida

1. Chapter 25 Return on Investment and Residual Income Prepared by Diane Tanner University of North Florida

2. Segmenting a Company 2 Corporate Headquarters By Plant Jax Plant Chicago Plant Catalog Sales Retail Sales Web Sales Wholesale Sales Miami Plant Atlanta Plant Companies segment operations using different approaches. By Geographic Area By Customer Channel

3. Managerial goal To maximize return on investment Evaluation of managers Based on a rate of return (%) relative to a benchmark/budgeted rate of return or Relative to other investment centers Often compensation-based The higher the ROI, the larger the bonus Performance Evaluation of Investment Centers 3

4. A primary tool for evaluating the performance of investment centers A broader measurement than income Focuses on income and investment Removes the bias of larger investments over smaller investments Tells us the percentage of every dollar of assets invested that is returned as profit Return on Investment 4 NOPAT Invested Capital ROI =

5. Measuring Profit 5 NOPAT • Various approaches • EBIT – earnings before interest and taxes • Does not hold managers responsible for interest or taxes • Net Operating Income Before Taxes • Net Operating Profit After Taxes • Referred to as NOPAT • Commonly used approach • Does not hold managers responsible for interest (financing costs) or other items beyond their control

6. Companies must obtain financing in order to acquire assets Not all assets have a financing costs attached Assets with free financing Non-interest bearing current liabilities Includes accounts payable, income taxes payable, accrued liabilities, etc. Assets are measured for computing ROI as Total assets ‒ NIBCL NIBCL = non interest bearing current liabilities Measuring Assets 6 Invested Capital

7. Provides information on what causes changes in ROI from period to period Two Components of ROI 7 Profit Margin Investment Turnover × ROI = = Sales Operating Assets Net Operating Income Sales × = Sales Invested Capital NOPAT Sales × How much sales dollar is generated out of each dollar of assets invested How much of each sales dollar is generated as profit

8. Controlling the Rate of Return 8 Three ways to improve ROI . . . • Reduce • Expenses • Reduce • Assets • Increase • Sales

9. Criticisms of ROI 9 Management may not know how to increase ROI. Managers often inherit many ‘committed’ costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities.

10. Residual Income Residual Income • Definition • The income that exceeds the cost of financing the assets invested • Objective is to maximize the total amount of residual income, not to maximize ROI • Used to measure performance • Measures the value added to the company RI = NOPAT – CC% × Invested capital

11. As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. Problems with ROI 11 I thought we were supposed to do what was best for the company! As division manager, I won’t invest in that project because it will lower my bonus! Invest or not?

12. Motivation and Residual Income • Residual income encourages managers to make profitable investments that would be rejected by managers using ROI • An indicator of wealth • Shows the increase/decrease in corporate shareholder value RI should not be used to compare locations of different sizes

13. Divisional Comparison 13 • Bigger segments are expected to have more residual income than a smaller division • Why? • Simply because they are bigger • Not because of better management ROI = 2.00% 6.00%

14. Problems with Performance Evaluation based on Profit • Managers that are evaluated on profit are more willing to invest in assets • Because every investment that generates even $1 of profit improves performance • Leads to over-investment • Example • AB Division has profit of $10,000 based on assets of $100,000, or a 10% ROI • AB invests in a project that will cost $14,000 and generate $280 of profit, or an ROI of 2% • If the manager accepts the investment, profit increases by $200 making the manager look good, even though the ROI is very low

15. The denominator, invested capital Based on historical costs net of depreciation Depreciation decreases it ROI appears high Often causes managers to defer new equipment acquisitions Managers unwilling to invest if project will decrease current ROI, even if greater than RRR Problems with ROI used in Performance Evaluation Result = Under Investment

16. The End