Fifth edition Alnoor Bhimani Charles T. Horngren Srikant M. Datar Madhav V. Rajan Farah Ahamed
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| Points to stress In the Hôtels Desfleurs example, ROI is measured as operating income divided by total assets. This definition matches operating income, which is the entire income pie (before it is split up between (a) creditors in the form of interest, (b) the government in the form of taxes and (c) investors in the form of dividends and increased RE, with total assets, the entire amount of investment available to earn the entire income pie. What rate of return should management use to calculate residual income Students who have studied finance should realise that the cost of capital is the appropriate rate of return. Conceptually, it should be the cost of capital for that particular business segment’s risk level. For example, an oil exploration segment might warrant a higher required rate of return than an oil refining segment. Generally, residual income (RI) is more likely to foster goal congruence than what ROI is. Managers evaluated on RI have incentives to accept all projects that cover more than the cost of capital. In contrast, managers evaluated on ROI will attempt to maximise the ROI rate, rather than the RI amount. These managers have incentives to reject projects with ROI below their division’s average ROI, even if the projects are expected to return more than the cost of capital. This preference for RI over ROI parallels the preference for NPV over IRR in capital budgeting see Chapter 13). Chapter 19 discusses the economic value added (EVA) measure, which is a specific variant of RI. EVA ® defines income as the after-tax operating income, required rate of return as the weighted average cost of capital (WACC) and investment as the TA–CL. Since TA–CL = LTL + SE, investment is defined as funds invested for the long term. Intuitively, EVA ® is the income pie available to creditors and stockholders (i.e. operating income minus taxes) minus the required return on funds invested for the long term by creditors and stockholders. Example Very low levels of investment lead to very high investment turnover ratios that can dominate the ROI calculation – even if management of the few assets is economically less critical than management of income margin. Consider an accounting firm within revenue, €200,000 in operating income and €10,000 in PPE. The partners want to double their investment in PPE. Pre- and post-expansion ROIs follow € 1, 000, 000 € 200, 000 = 100× 0.2 = 200% 10, 000 1, 000, 000 × € 1, 000, 000 € 200, 000 × = 50× 0.2 = 10% 20, 000 1, 000, Spending 5% of one year’s income on PPE would halve ROI. But, real performance has not deteriorated. Hence, ROS (20%) would probably be a more informative measure of the firm’s profitability. This example illustrates why firms in service industries often use ROS. Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5 th Edition, Instructor’s Manual © Pearson Education Limited 2012 Download 1.72 Mb. Share with your friends:
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