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13.

3
Some positive outcomes that may occur if the manager is asked to improve ROI include:
Assets (eg: publishing machinery/printing materials) may only be replaced when it is
necessary.
Assets (eg: publishing machinery/printing materials) may be maintained rather than
replaced
Assets (eg: publishing machinery/printing materials) may be fully utilised in the
generation of profit.
13.4
There are several ways to minimise the negative behavioural effects of ROI:
Use a broader set of performance measures which encompass both long-term and short-
term measures, and financial and non-financial measures. This de-emphasises ROI as a
performance measure.
Consider alternative ways of measuring invested capital so that the replacement of an
asset does not have such an adverse effect on ROI. Use of market values or acquisition
cost can help here.
Use alternate profit measures, such as residual income, to minimise some of the
investment disincentives associated with ROI.
13.11
There are two major ways a company can improve its economic value added, or EVA:
increase revenues or decrease capital costs. Revenue can be increased by raising prices or by
selling additional goods and services. Capital costs can be minimized in several ways,
including increasing economies of scale. It is also possible for a firm to offset capital costs by
choosing investments that earn more than their associated capital charges.
In the EVA formula, a firm's revenue is expressed as being equal to net operating profits after
tax, or NOPAT. Capital costs are traditionally estimated using a weighted average cost of
capital, or WACC or $WACC. EVA is the result of subtracting all net capital charges from
NOPAT and is also referred to as "economic profit." It is one of the most popular profitability
metrics used by companies and fundamental analysts.
If a company wants to improve its EVA by adding to its revenues, it must ensure the marginal
revenue gain is larger than the accompanying marginal costs, including taxes. This makes
sense; you would not spend $150 to earn $100 in revenue. Since revenue generation is
usually uncertain, it is often easier for a company to reduce its net capital costs.
Net capital costs can be lowered by reducing operating expenses, increasing marginal
productivity or both. A company might renegotiate with its creditor to acquire a lower interest
rate on debt or call in preferred shares and reissue them at a lower rate.
Economic value added is sometimes also referred to as shareholder value added, or SVA,
although some companies might make different adjustments in their NOPAT and cost of
capital calculations. These are not the same as cash value added, or CVA, which is a metric
used by value investors to see how well a company can generate cash flow.
13.13
Linking pay to performance is something employers increasingly seek to achieve. Jobs with
performance related pay (PRP) attract workers of higher ability and induce workers to
provide greater effort. Much of the academic and policy literature on PRP focuses on its role
as an incentive system. In the public policy debate, it has been common to associate the
introduction of PRP with the aim of improving incentives and motivation among public
employees.
13.18
The implication of Vroom's expectancy theory is that people change their level of effort
according to the value they place on the bonus they receive from the process and on their
perception of the strength of the links between effort and outcome.
So, if someone perceives that any one of these is true:
My increased effort will not increase my performance
My increased performance will not increase my rewards
I don't value the rewards on offer
...then Vroom's expectancy theory suggests that this individual will not be motivated. This
means that even if an organisation achieves two out of three, that employees would still not
be motivated, all three are required for positive motivation.
For financial bonuses as an incentive scheme, it implies that people need to feel that their
increased effort will be able to attain the level needed to get the bonus. Or, if no additional
effort is needed, none will be added. This means a balance must be created, if a financial
bonus is to be given, between making it achievable and not making it too easy to achieve.
There need to be clear standards of achievement.
On top of that, the question is to what extent financial bonuses are really valued by people. If
we look at the needs theories and Herzberg's motivation factors, money is just a small part of
a much larger picture.

E13.26
1. The weighted average cost of capital (WACC) is defined as follows:
The interest rate on the Williamstown Construction Companys $90 million debt is 10
per cent, and the companys tax rate is 40 per cent. Therefore, Williamstown
Construction Companys after-tax cost of debt is 6 per cent [10% x (1 40%)]. The
cost of Williamstown Construction Companys equity capital is 15 per cent.
Moreover, the market value of the companys equity is $135 million. The following
calculation shows that Williamstown Construction Companys WACC is 11.4 per
cent.
( 0.06 ) ( 90 000 000 ) +(0.15)(135 000 000)
Weighted average cost of capital= =0.114
90 000 000+135 000 000
2. The economic value added (EVA) is defined as follows:
EVA= net operating profit after tax (capital employed x WACC)
For the Constructo construction company, the EVA for the two divisions can be
calculated as follows:
Division After tax operating profit [(Total assets Current liabilities) x WACC] EVA
Real estate 30 (1-0.40) [(150 9) x 0.114]= 18 16.074 1.926
Construction 27 (1-0.40) [(90 6) x 0.114] = 16.2 9.576 6.624
Note calculations are all in millions
P13.32
1. Average investment in productive assets:
Average investment in productive assets: Last year ending balance $25 200 000
Prior year ending balance ($25 200 000/ 1.05) $24 000 000
Beginning balance plus ending balance $49 200 000
Average balance (49 200 000/ 2) $24 600 000

a) ROI = Profit from operations before income taxes/ average productive assets
= 4 920 000/ 2 460 000
= 20%
b) Profit from operations before income taxes $4 920 000
Less: Imputed interest charge: $24 600 000 x 0.15
(Average productive assets x imputed interest rate) $3 690 000
Residual income $1 230 000

2. Yes, Rams management probably would have accepted the investment if residual income
were used. The investment opportunity would have lowered Rams ROI last year because
the projects expected return (18 per cent) was lower than the divisions historical returns
(19.3 to 22.1 per cent) as well as its actual ROI (20 per cent) last year. Management may
have rejected the investment because bonuses are based in part on the ROI performance
measure. If residual income were used as a performance measure (and as a basis for
bonuses), management would accept any and all investments that would increase residual
income (that is, a dollar amount rather than a percentage), including the investment
opportunity it had in last year.
3. Changes in scenarios
a) When profit from operations was $5 400 000.
ROI = Profit from operations before income taxes/ average productive assets
= 5 400 000/ 2 460 000
= 21.95%
b) When productive assets at year end were $36 000 000
Average productive assets = $35 142 857 (recalculate the balance at start of year and
find the average as before)
ROI = Profit from operations before income taxes/ average productive assets
= $4 920 000/ $35 142 857
= 0.14%

P13.33

1
Plumbing Industrial Retail
Division Division Division
Sales revenue $40 000 000 $8 000 000e $3 200
000l
Profit 8 000 000 1 600 000 800 000k
Average investment 10 000 000 8 000 000f 4 000 000j
Return on sales 20%a 20% 25%
Investment turnover 4b 1 0.8i
ROI 80%c 20%g 20%
$7 800 000d
Residual income...................................................... $960 000h $480 000

Explanatory notes:

profit $8 000 000



sales revenue $40 000 000
a
Return on sales = = 20%

sales revenue $40 000 000



invested capital $10 000 000
b
Investment turnover = =4
c
ROI = Return on sales investment turnover = 20% 4 = 80%
d
Residual income = profit (imputed interest rate)(invested capital)

= $8 000 000 (8%)($10 000 000) = $7 200 000

profit
e
Return on sales = sales revenue

$1 600 000
20% = sales revenue

Therefore, sales revenue = $8 000 000

sales revenue
f
Investment =
invested capital
turnover

$8 000 000
1 = invested capital
Therefore, invested capital = $8 000 000
g
ROI = return on sales investment turnover

ROI = 20% 1.0 =


20%
h
Residual income = profit (imputed interest rate)(invested capital)

= $1 600 000 (8%)($8 000 000)

= $960 000
i
ROI = return on sales investment turnover

20% = 25% capital turnover

Therefore, investment turnover = 0.8

profit
j
ROI = invested capital = 20%

Therefore, profit = (20%)(invested capital)

Residual income = profit (imputed interest rate)(invested capital)

= $480 000

Substituting from above for profit:

(20%)(invested capital) (8%)(invested capital) = $480 000

Therefore, (12%)(invested capital) = $480 000

So, invested capital = $4 000 000


profit
k
ROI = investedcapital

profit
20% = $4 000 000

Therefore, profit = $800 000

l
profit
Return on sales = sales revenue
$800 000
25% = sales revenue

Therefore, sales revenue = $3 200 000

2 Three ways to increase the Industrial Divisions ROI:


(a) Increase profit, while keeping invested capital the same. Suppose profit increases
to
$2 400 000. The new ROI is:
profit $2 400 000
investedcapital $8 000 000
ROI = = = 30%
(b) Decrease invested capital, while keeping profit the same. Suppose invested capital
decreases to
$6 000 000. The new ROI is:
profit $1 600 000
investedcapital $6 000 000
ROI = = = 26.67%
(c) Increase profit and decrease invested capital. Suppose profit increases to $600 000
and invested capital decreases to $1 500 000. The new ROI is:
profit $2 400 000
investedcapital $6 000 000
ROI = = = 40%

3 ROIPlumbing Division = return on sales investment turnover = 25%


4
= 100 %
4 ROI does not provide a suitable basis for comparing the performance of the three
divisions. Each division operates in a different industry, has different degrees of
dependence on assets, and manage assets of differing ages. For example, the Plumbing
Division is using old machinery, which may be fully depreciated, so its asset base is
low. This would boost the ROI, making it appear much more profitable than the other
two divisions. The Industrial Division is machine-intensive and has recently acquired
expensive computerised machinery. This would tend to reduce the ROI in the earlier
years of acquisition. The Plumbing Division has the highest ROI of the group. What is
not known is whether an ROI of 80 per cent is considered good performance within its
own industry. The Retail Division has the lowest reliance on assets, and it is difficult
to evaluate this divisions performance unless the performance of similar retail
venture within the industry is known.
P13.38
1. If New Age Industries continues to use return on investment as the sole measure of
division performance, Fun Times Company (FTC) would be reluctant to acquire
Arcade Unlimited Ltd. (AUL), because the post-acquisition combined ROI would
decrease.

ROI = Income/ Investment desired ROI is 20%

FTC ROI = $3,000,000/ $12,000,000= 0.25


AUL ROI = $900,000/ $4,800,000=0.1875
Combined ROI = total operating profit/ total assets = $3,900,000/$16,800,000= 0.232

Note that the asset cost used for AUL is the post-acquisition cost of 4.8 million NOT
the pre-acquisition value of 4.5 million.

The result would be that FTCs management would either lose their bonuses or have
their bonuses limited to 50 per cent of the eligible amounts. The assumption is that
management could provide convincing explanations for the decline in return on
investment.

2. Residual income is the profit earned that exceeds an amount charged for funds
committed to a business unit. The amount charged for funds is equal to an imputed
interest rate multiplied by the business units invested capital. If New Age Industries
could be persuaded to use residual income to measure performance, FTC would be
more willing to acquire AUL, because the residual income of the combined operations
would increase.

Residual income = Income (Investment x Target ROI) bonuses based on 15% cost
of capital.

FTC residual income = $3,000,000 ($12,000,000 x 0.15) = $1,200,000


AUL residual income = $900,000 ($4,500,000 x 0.15) = $225,000
Combined residual income = $1,200,000 + $225,000 = $1,425,000

Residual income is the difference between operating income and the minimum dollar
return required on an investment. It encourages investment in all projects that earn at
least the minimum rate of return.

3. The likely effect on the behaviour of division managers whose performance is


measured by return on investment includes incentives to do the following:
Defer capital improvements or modernisation to avoid undertaking capital
expenditures.
Avoid profitable opportunities or investments that would yield more than the
companys cost of capital but that could lower ROI.
If residual income were used the likely effect on the behaviour of division managers
includes incentives to do the following:
Seek any opportunity or investment that will increase overall residual income.
Seek to reduce the level of assets employed in the business.
EVA could also be used to measure and reward divisional managers and that would
have similar advantages to the use of RI.