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By:
Ahmad Fahmi Mubarok
3
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A manager should invest in assets only if the assets will produce adequate returns.
Second, when an asset is not providing adequate return (the expected return could change
over the years), it is time to disinvest or reduce further investments into this asset. Two
ways to relate profits and investments and to compare investment alternatives:
Return on Investments (ROI)
A performance measure used to evaluate the efficiency of an investment or to
compare the efficiency of a number of different investments. To calculate ROI, the
benefit (return) of an investment is divided by the cost of the investment; the result is
expressed as a percentage or a ratio. The return on investment formula:
ROI = (Gain from Investment Cost of Investment) / Cost of Investment
There are three apparent benefits with ROI:
It is a comprehensive measure in that anything that affects financial statements is
reflected in this ratio.
It is simple to calculate, easy to understand and meaningful on an absolute scale. It
is a common denominator regardless of size or type of business.
The performance of different business units may be compared directly to one
another.
ROI is available for competitors and may be used a basis for comparisons.
Economic Value Added (EVA)
A measure of a company's financial performance based on the residual wealth
calculated by deducting cost of capital from its operating profit (adjusted for taxes on
a cash basis). (Also referred to as "economic profit")
EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)
Advantages of using EVA:
EVA ranks project on profits in excess of the cost of capital (EVA increases).
All business units have the same profit objective for comparable investments.
EVA permits the use of different interest rates for different investment projects.
EVA has greater correlation with a firms market value (it optimizes shareholder
value).
The minimum return an organization must earn on its investments to meet investor
expectations. Cost of capital is specific to each organization and depends on several
factors such as the type of industry in which it operates, how risky the organization is, the
rate at which it can borrow from outside and more (borrowing, in this context, refers to
both debt and equity). If an investment returns more than the cost of its capital, the
investment is positive and if not, it is negative and as well not invested. Encourages
division managers to retain assets beyond their optimal life and not to invest in new assets
which would increase the denominator. Can cause corporate managers to over- allocate
resources to divisions with older assets because they appear to be relatively more
profitable. Capital may be allocated towards least profitable divisions, at the expense of
the most profitable divisions.
C. Case Evidence
Cash: 8% of total assets
The Banker Division maintained a cash account in a local bank, to which company
headquarters transferred funds as they were needed. The cash influence by deduction
of 40% of income for tax purpose, payment of dividend by the division to
headquarter, and if cash declined below the minimum or if extensive capital
expenditure had been approved.
Accounts receivable: 21% of total assets
3
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All accounts receivable for the Baker Division were collected at company head
quarter. In late 1996, accounts receivable made up 21% of total assets because 45 days
of sales. There is no control for accounts receivable.
Inventory:
1. Raw material metal stock: 3% of total investment
Inventory show the raw material (7%), work in process (9%), and finished goods
(2%). Purchases depended on the amounts on hand, expected consumption and
current delivery time and price expectations.
2. Purchased parts and manufactured parts: 10% of total assets, 4% in raw material,
6% in work in process.
Using data on part usage.
The forecast could then be adjusted by a factor entered to reflect known trends
for a specific part or as a constant for all parts.
The program then computed the EOQ in dollars and in units.
3. Floor stocks (3% of total investment)
Floor stock inventory consisted of parts and components which were being
worked on assembled. Items became parts of the floor stock inventory when they
were requisitioned from the storage areas or when delivered directly to the
production floor.
4. Finished goods: 2% of investment
Finished goods inventory consisted of those few pumps on which shipment was
delayed.
Land, buildings, and machinery (53% of total investment)
Since the Baker Division fixed assets stated at gross comprised 53% of total asstes at
the end of 1996. The capital budgeting procedure were described in planning manual,
they are: headquarters forecasts economic conditions, the divisions plan long-term
objectives, supporting programs are submitted, and annual objective submitted.
3
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To show the relation between profit and investment or the return of investment.
ROI show the comparison between income and assets.
Return on Investment has some advantages. All aspects that influence financial
statement is reflected in this ratio and it is not difficult to calculate ROI.