EVALUATING THE PERFORMANCE OF AN INVESTMENT CENTER

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EVALUATING THE PERFORMANCE OF AN INVESTMENT CENTER

• ROE
• ROI
• EVA

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THE ALTERNATIVES

• Return on Equity ROE
• Earnings cash flows divided by shareholders
  equity Balance sheet assets minus liabilities
• Return on Investment ROI
• Earnings cash flows? divided by assets usually
  Balance Sheet Assets
• Economic Value Added EVA
• - Cash Flows divided by Capital less the Cost of
  Capital multiplied by Capital

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Return on Equity ROEThe FIRM Perspective

• Return on equity encompasses the three main
  financial "levers" by which management can poke
  and prod the organization to excel --
  profitability, Asset Management, and Leverage.
• Definition
• An Example

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Return on Equity ROEThe SHAREHOLDERS
Perspective

• Businesses that generate high returns relative to
  their shareholder's equity are businesses that
  pay their shareholders off handsomely, creating
  substantial assets for each dollar invested.
• By relating the earnings generated to the
  shareholder's equity, an investor can quickly see
  how much cash is created from the existing
  assets. If the return on equity is 20, for
  instance, then twenty cents of assets are created
  for each dollar that was originally invested. As
  additional cash investments increase the asset
  side of the balance sheet, this number ensures
  that additional dollars invested to not appear to
  be dollars of return from previous investments.
• The best Worst ROE

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  RETURN ON EQUITY (Income) (Assets) (Liabil
ities) Profit Margin Turnover Leverage
Operating Margin Inventory Turns Debt-to- Wh
atever Gross Margin Days Sales Out. Times
Interest Earned By looking at trends in
return on equity and analyzing the components,
the investor is forced to not only examine the
Statement of Operations, or the Income Statement,
but also to balance this against the left and
right sides of the Balance Sheet.
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Return on Investment (ROI)

• ROI is good because targets can be adjusted to
  focus managers attentions on key success factors
  and also because every manager can be measured by
  the same metric.
• ROI is bad because under certain circumstances it
  causes managers to make decisions that are bad
  for their organization. Two situations are
  critical
• the ROI target is not consistent with the
  entitys capital cost, in which case the
  investment center manager will under-invest
  sometimes over-invest in assets.
• the depreciation rate used in calculating ROI is
  not the true economic rate of depreciation, in
  which case managers may make bad decisions about
  both the maintenance and the acquisition of
  assets.
• ROI versus ROE

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An Example

• Calculated using book values and tax
  depreciation rates, the accounting rate of return
  is
• Rac(t) Accounting Income (t)/
• Accounting Book Value (t)
• BUT Rac is the true ROI (R), if and only if and
  tax depreciation rates the true rate of
  depreciation (D) are equal. For example, if R
  .05 and D .15, if the depreciation rate used is
  .2, even though the true R is constant and equals
  .05, the measured Rac is -.06 in Year 1 and .08
  in Year 2 (.91 in year 20) (assume I 100 in t-1,
  so real income 4.5 in year 1 and 3.6 in year 2).

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Economic Value Added (EVA)

• EVA measures the value created from investments.
• Returns on capital should be defined in terms of
  true cash flows resulting from investments.
• The cost of capital is the weighted average of
  the costs of the different financing instruments
  used to finance investments.
• EVA is measured in dollar values, not the
  percentage difference in returns.
• It is closest in both theory and construct to the
  net present value of a project in capital
  budgeting, as opposed to IRR.
• The value of a firm, in DCF terms is the EVA of
  projects in place plus the present value of the
  EVA of future projects.

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An Example (a)

• Assume that you have a firm with
• IA 100 In each year 1-5, assume that
• ROCA 15 D I 10 (Investments at beginning of
  each year)
• WACCA 10 ROC(New Projects) 15
• WACC 10
• Assume that all of these projects will have
  infinite lives.
• After year 5, assume that
• Investments will grow at 5 a year forever
• ROC on projects will be equal to the cost of
  capital (10)

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An Example (b)

• Capital Invested in Assets in Place 100
• EVA from Assets in Place (.15 - .10) (100)/.10
  50
• PV of EVA from New Investments in Year 1
  (.15 - .10)(10)/.10 5
• PV of EVA from New Investments in Year 2
  (.15 - .10)(10)/.10/1.12 4.55
• PV of EVA from New Investments in Year 3
  (.15 - .10)(10)/.10/1.13 4.13
• PV of EVA from New Investments in Year 4
  (.15 - .10)(10)/.10/1.14 3.76
• PV of EVA from New Investments in Year 5
  (.15 - .10)(10)/.10/1.15 3.42
• Value of Firm 170.86

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Invested Capital (1)

• How do you measure the capital invested in
  assets?
• Many firms use the book value of capital
  invested as their measure of capital invested. To
  the degree that book value reflects accounting
  choices made over time, this may not be reflect
  the economic value of the investment.
• In some cases, capital and the after-tax
  operating income have to be adjusted to reflect
  true capital invested.

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Invested Capital (2)
Normally the charge for invested capital is the
book value of working capital plus fixed capita
times a discount rate, which reflects the
entitys average nominal cost of capitol. This
approach contains three errors HC is used rather
than replacement cost a nominal rather than a
real rate is used (not adjusted for inflation),
and an average rate is used rather than a
marginal rate. The BEST way to measure the use
of invested capital would be to measure the
market rental that could be earned on each item.
However, the market wont provide that info on
assets that are specific to the firm -- I.e.,
those that have the greatest value to the firm.
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Invested Capital (3)

• For example, Public utility regulators
  throughout the United States use the following
  procedure to convert the replacement price of a
  wasting asset into a periodic rental price. This
  approach differs in two significant ways from
  standard business practice it uses current
  replacement cost and it adjusts the rate of
  depreciation for investments in maintenance. It
  also applies different depreciation rates to
  different kinds of assets.
• R(t) rental price for one unit of equipment at
  time t,
• p(t) purchase price of one piece of equipment
  at time t,
• K(t) amount of equipment remaining at time t,
  if n units were purchased at time 0,
• r discount rate
• d rate of depreciation
• (which is defined as the rate at which the
  equipment declines in its productive capacity, a
  function of use, wear and tear, and maintenance
  levels d -K/K, where an apostrophe indicates
  differentiation with respect to time).

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Invested Capital (4)

• It is a fundamental law of capital theory that
  the price of an asset equals the discounted
  present value of the rentals one could obtain
  from the asset. If K(t) units of equipment remain
  at time t, then the total rental at time t would
  be R(t) K(t). Therefore
• p(t0) ºx o R(t) K(t) e-rt dt, when K(0) 1.
• This formula for the asset price applies not just
  at time 0, but at any time y. Hence
• K(y) p(y) ºxy R(t) K(t) e-r(t-y) dt,
• By taking the derivative of this equation with
  respect to y, one obtains
• K(y) p(y) K(y) p(y) r(y) K(y) r ºxy R(t)
  K(t) e-r(t-y) dt
• R(y) k(y) rp(y) K(y),
• Hence
• R(y) (r d - p/p) p(y).
• This means that that the rental rate per asset
  equals interest foregone, plus depreciation,
  minus any price appreciation or decline.

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Invested Capital (5)

• The basic notion is that R(y) (r d - p/p)
  p(y).
• This means that that the rental rate per unit of
  asset R(y) equals
• interest foregone (r), plus depreciation (d,
  which is defined as the rate
• at which the equipment declines in its productive
  capacity, a function of
• use, wear and tear, and maintenance levels d
  -K/K, where an apostrophe
• indicates differentiation with respect to time),
  minus any price
• appreciation or decline (p/p). Summing those
  rates and multiplying them
• times the replacement price of the asset in time
  y, gives us the economic
• rent per unit in time y.
• For example, if we started with 2 units of
  investment
• p(y) 100 (replacement cost per unit)
• p'(y) 8
• d .1 (where k' .the change in life of the
  asset remaining 05, k .5
• the life of the asset remaining)
• r .05
• R(y) .07

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Returns

• How do you measure return on capital?
• Again, the accounting definition of return on
  capital may not reflect the economic return on
  capital.
• In particular, the operating income has to be
  cleansed of any expenses which are really capital
  expenses (in the sense that they create future
  value). One example would be R D.
• The operating income also has to be cleansed of
  any cosmetic or temporary effects.
• How do you estimate cost of capital?
• DCF valuation assumes that cost of capital is
  calculated using market values of debt and
  equity.
• If it assumed that both assets in place and
  future growth are financed using the market value
  mix, the EVA should also be calculated using the
  market value.
• If instead, the entire debt is assumed to be
  carried by assets in place, the book value debt
  ratio will be used to calculate cost of capital.
  Implicit then is the assumption that as the firm
  grows, its debt ratio will approach its book
  value debt ratio.