RETURN ON INVESTMENT (ROI) NOTES

Net operating Income xxx ROI

Divided by Average operating Assets xxx 1. NOI pertains to EBIT (Earnings before
Return on Investment (ROI) xxx Interest and Taxes)
2. Operating Assets are Cash, accounts
Long way: receivable, inventory, PPE and other operating
assets; this shall not include nonoperating assets
Margin = Net operating Income ROI = Margin x Turnover such as land held for future use, investment in
Sales other company, or leased property to others
3. Uses net/book value (carrying amount =
Turnover = Sales cost less AD) to calculate the average operating
Average operating Assets aseets
4. Margin is improved by increasing sales and
reducing operating expenses
REDISUAL INCOME (RI) 5. The lower Operating expenses, the higher
Net operating Income xxxx margin earned
less: 6. Turnover - investment in operating assets
Average operating assets (AOA) xxxx - excessive funds tied up in operating assets
Multiply by minimum required rate of return xxxx xxxx depress TO and lowers ROI
Residual Income xxxx 7. Increase in ROI involves:
a. Increased sales
ECONOMIC VALUE ADDED (EVA) b. Reduced Operating expenses
Net operating Income xxxx c. Reduced Operating assets
Less: Income tax expense xxxx
Net operating profit less adjusted taxes (NOPLAT) xxxx RI
Less: 1. NOI earned less the minimum required return
Total assets xxxx on AOA
less: Current liabilities xxxx 2. NOI that investment center earned above the
Invested capital xxxx minimum required return on its operating
Multplied by cost of capital xxxx xxxx assets
Economic value added (EVA) xxxx 3. It encourages managers to make profitable
investments that would be rejected by
SEGMENT REPORTING managers using ROI
Product 1 Product 2 Total 4. RI cannot be used to compare the performance
Sales xxxx xxxx xxxx of segments of different sizes
Less: Variable cost xxxx xxxx xxxx
Contribution margin xxxx xxxx xxxx EVA
Less: Traceable fixed expenses xxxx xxxx xxxx 1. business unit's income after taxes and after
Divisional segment margin xxxx xxxx xxxx deducting the cost of capital
Less: Common fixed expenses xxxx
Net Operating income xxxx SEGMENT REPORTING
1. Traceable fixed expenses
- fixed cost incurred because of the existence of
the segment
2. Common fixed expenses
- fixed costs that supports the operations of more
than one segment, but is not traceable in whole
or in part to any one segment
- even if a segment were entirely eliminated there
would be no change in a true common fixed cost
Illustrative 1
Net operating income $ 50,000
Average operating assets $ 230,000
Sales $ 535,000
Operating expenses $ 485,000
Minimum required rate of return 14%
Required:
1. Determine the Return on Investment
2. Determine the Margin
3. Determine the Turnover
4. Determine the residual income

Solution:

Net operating Income $ 50,000 Margin 9.35%

Divided by Average operating Assets $ 230,000 Multiply by Turnover 2.3261
Return on Investment (ROI) 21.74 Return on Investment 0.21749035
Interpretation: 21.74% of average of operating assets is earned and converted to NOI

Net operating income 50,000 Sales 535,000

divided by Sales 535,000 divided by Average operating Assets 230,000
Margin 9.35% Turnover 2.32608695652174
Interpretation: 9.35% of sales is earned as NOI Interpretation: AOA is 2.3261 times converted into Sales

Net operating Income 50,000

less:
Average operating assets (AOA) 230,000
Multiply by minimum required rate of return 0.14 32,200
Residual Income 17,800
Interpretation: P17,800 is the residual income after considering the minimum required rate of return of AOA

Illustrative 2
The related data of Amihan Company :
Invested capital 900,000
Sales 615,000
Cost of Goods sold 250,000
Operating expenses 185,000 Sales 615,000
Cost of capital 12% Less: COGS 250,000
Required: Gross Margin 365,000
Determine the EVA Less: OPEX 185,000
NOI 180,000
Net operating Income 180,000 Multiply tax rate 30%
Less: Income tax expense 54,000 Income tax expense 54,000
Net operating profit less adjusted taxes (NOPLAT) 126,000
Less:
Total assets -
less: Current liabilities -
Invested capital 900,000
Multplied by cost of capital 12% 108,000
Economic value added (EVA) 18,000
Interpretation: The business unit NOI is P18,000 more than the invested cost of capital
 COST OF CAPITAL
Long-term debt 3,000,000
Number of common stock outstanding 60,000
Selling price per common stock 100
Number of preferred stock outstanding 5,000
Selling price per preferred stock 200
Cost of preferred equity 14%
Cost of common equity 15%
Cost of debt, before tax 12%
Tax rate 30%
What is the WACC?

Common Stock Preferred Stock

Number of stock outstanding 60,000 5,000
Multiply by price per share P 100 P 200
Total amount P 6,000,000 P 1,000,000

Market Value Weight

Long term debt 3,000,000 30%
Preferred Stocks 1,000,000 10%
Common Stocks 6,000,000 60%
Total Capital 10,000,000

Cost of Debt
Target capital structure of debt 30%
Yield to maturity of the company's bonds 12%
1-Tax rate 70% 2.52%

Cost of Common Equity

Target capital structure of common equity 60%
Cost of common equity 15% 9%

Cost of Preferred Equity

Target capital structure of preferred equity 10%
Cost of preferred equity 14% 1.40%
WACC 12.92%