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Investments in Assets Both A Strategic and A Control Issue
Investments in Assets Both A Strategic and A Control Issue
Before we discuss measurement of long-term assets and alternative measurement methods, let us discuss why it is important to measure long term assets and what specific factors confound the valuation process.
Why relate profits to investments? The Managers Responsibility First, 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 Assets (ROA) and Economic Value Added (EVA).
Return on Assets (ROA) (let us use Exhibit 7.1 of your textbook) ROA is a ratio of two numbers:
Income ROI = -------------------------------------Average Assets (or Investment)
Note: Most times, average assets is - (the beginning of the year equity + end of the year equity / 2). Equity for this purpose would be defined as the stockholders equity + long term liabilities. From exhibit 7.1, ROA = 100 (net income) / 500 (Equity) = 20% (In exhibit 7.1, there are no long term liabilities).
How asset values can distort ROA and EVA Computations ROA and EVA computations are simple. However, depending on the asset based used, they can give misleading signals. Most long term assets are depreciated. Everyone comfortable with depreciation computations? Depreciation reduces the book value of the assets as they age.
See computations for before and after purchase of asset - ROI and EVA are overstated (See exhibit 7.1) Before 1 year after
Profit before depreciation Expenses (w/o Deprecn.) Profit before depreciation Depreciation Profits after depreciation Purchase Purchase of asset of asset $ 1,000,000 $ 1,000,000 ( 850,000) ( 823,000) 150,000 177,000 (50,000) (70,000) $ 100,000 $ 107,000 500,000 $ 50,000 50,000 20% 500,000 60,000 47,000 21.4%
One more example of ROA increase just by the passage of time and even without acquiring a new asset.
Year 1
Profit before depreciation $ 110,000 Depreciation $ 50,000 Profit after depreciation $ 60,000 Equity ROI $ 500,000 12.0%
Year 2
$ 110,000 $ 50,000 $ 60,000 $ 450,000 13.3%
Year 3
$110,000 $ 50,000 $ 60,000 $400,000 15%
Before
Profit before depreciation Expenses (w/o Deprecn.) Profit before depreciation Equity Capital charge at 10% ROA