Measuring And Controlling

Assets Employed
 Why long term investment is
a strategic issue?
 Long term investment decisions are made
after long term strategy is decided (not the
other way around).
 Also, strategic leverage affects how much
investments in long term assets are
necessary.
 Consequently, if decisions about long term
investments are made incorrectly, strategy
and strategic leverage are less likely to be
accomplished.
Why long term investments is
a control issue?
 Long term investments are generally huge
in their monetary and non-monetary
impact.
 As such, if managers and others do not take
all precautions when investing and later, in
measuring the usefulness of the assets and
their contribution, it will have significant
adverse impact.
 Therefore, measuring long term assets is
also a control issue of great importance.
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.
 Characteristics of long-term
assets
 Long-term assets (Building, Plant, Machinery,
Information Technology)
 Short-term assets (Inventory, Accounts
Receivable, Cash)
 Long-term assets - an organization is committed
for a long period of time.
 The lack of investment could cause opportunity
losses or the investment could cause excess
capacity.
 The investment amount is usually large.
 Regardless, when an
organization makes long term
investment
The investment must:
– Lead to generation of adequate profits
and
– the return (ratio of profits generated
compared to total investments) must be
adequate.
– What is “adequate” return and which
investment is better than other
alternatives are the focus of this chapter.
 Please remember that
 Every investment competes with alternative
investments and,
 No organization, however large it is, has
resource constraints; and therefore,
 A company must choose its investment
strategy judiciously and such a strategy
 Must be carried out within the overall
strategic framework – deciding priorities
and allocating resources.
 Before choosing an evaluative
methodology, a manager must
determine the following:
 How to determine investment priorities
(what tangible and intangible benefits
must be taken into account)?
 How to assess the risk of each
investment?
 How to establish a process for managing
the realization of expected benefits? This
is a long term issue, and
 How to justify the investments (how it fits
within the overall strategy)?
Performing investment analysis
 Why relate profits to investments?

 Unless an organization is a 100% service

organization, profits are generated ONLY if
you have investments.
 Therefore, earning a satisfactory return on
the investments employed is necessary.
 The investors in stock compute such a
return routinely (e.g. Ford and G.M.).
 To compare two units, A and B, without
considering the investment made in each is
meaningless.
 Why relate profits to investments?
The Manager’s 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 our 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).
 Economic Value Added (EVA)

EVA= Net income - (operating

assets)*cost of capital

Capital Charge = (operating

assets)*cost of capital

 EVA = Net Income – Capital Charge

 Exhibit 7.1
 Current Assets: Current Liab.
Cash………….50 Accounts Payable…..90
Receivables….150 Other Current……...110
Inventory…….200
Total C.A…….400 Total C.L…………..200
Fixed Assets:
Cost………….600 Corporate equity…500
Depreciation…(300)
Book Value…..300
Total Assets…..700 Total Equities…….700
 Exhibit 7.1 contd.
 Income Statement
Revenue…………………………………..1000
Expenses except depreciation……………..850
Depreciation………………………………….50
(900)
Income before taxes……………………….. 100
Capital charge(500*10%)…………………..50

So, Economic Value Added (EVA)…………50

ROA or ROI……………………100/500 = 20%
 EVA or Economic Value Added
EVA= Net income - (operating
assets*cost of capital)
Note: Unlike ROA, EVA is not a ratio but a
monetary amount
Note: Operating Assets*Cost of Capital =
Capital charge.
Use exhibit 7.1 to compute EVA -
Net Income = 100
Capital charge – Equity * .10 = 50
EVA = 100 – 50 = 50
 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.
 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.
 Depreciation distorts ROA, EVA
Computations
 We will use the numbers from Exhibit 7.1
 New Machine costs 100. Life 5 years
 Savings by using the new machine $27 per
year or on a Present Value basis for five
years, $102.4 with a net present value of
$2.4 (102.4 - $100).
 Before this new asset is acquired, the annual
depreciation on fixed assets was $50 per
year and
 After the new asset is purchased, the annual
depreciation will go up by 50 + (100 /5) = 70
 See computations for before and after
purchase of asset - ROI and EVA are
overstated (See exhibit 7.1)
Before 1 year after
Purchase Purchase
of asset of asset
Profit before depreciation…..... 1,000 1,000
Expenses (w/o Deprecn.)……… ( 850) ( 823)
Profit before depreciation……..150 177
Depreciation ……………………(50) (70)
Profits after depreciation……… 100 107

Equity ……………....... ………... 500 500

Capital charge at 10%................ 50 60
EVA (Profits – Cap. Charge)…..50 47

ROA 20% 21.4%

 Interpretation of the previous slide

 The profit before depreciation has remained constant at $100

before and after purchase of the asset and yet
 The ROA went up from 20% to 21.4%. Why? Simply because
the depreciation expenses went up.
 In contrast, the EVA declined from 50 to 47 making it look like
profits decline after purchase of the asset (even though the
income before taxes had actually increased from $100 to 107).
 That is, a manager can make the wrong decision not to
purchase the asset based on these computations.
 In later years, the EVA will go up and so will the ROA because
of additional depreciation.
One more example of ROA increase just
by the passage of time and even without
acquiring a new asset.

Year 1 Year 2 Year 3

Profit before depreciation….110 110 110

Depreciation…………………50 50 50
Profit after depreciation…….60 60 60

Equity ………………………..500 450 400

ROI……………………………12.0% 13.3% 15%
 ROI can lead to poor decisions
 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.
 ROI – the bad decisions

 Can lead to different inventory policies and

decisions in different divisions, even for
identical items of inventory.
 If corporate managers are not aware of
these distortions or do not adjust for them,
they can do a poor job of evaluating the
divisional managers and their
performances.
 How to deal with this issue?

 When computing ROA or EVA, don’t use

net book value of the asset but use gross
book value (original purchase price
ignoring depreciation).
See ROA computations from your exhibit
using gross value

Before 1 year after

Purchase Purchase
of asset of asset
Profit before depreciation…..1,000 1,000
Expenses (w/o Deprecn.)…….( 850) ( 823)
Profit before depreciation……150 177

Equity………………………… 500 500

Capital charge at 10%............. 50 60
ROA …………………………..50/500 177/500
= 30% 35.2%
 Advantages of using EVA (residual
income)
 EVA ranks project on profits in excess of
the cost of capital (EVA increases).
 With EVA, 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 firm’s
market value (it optimizes shareholder
value).
 ROA versus EVA

 In practice, most businesses use ROA because

it is simpler to compute and understand.
 It is also comprehensive in the sense that it
considers the entire balance sheet and income
statement.
 Unlike ROA – a percentage, EVA is a dollar
amount and does not allow for intra and inter
company comparisons.
 Then, why use EVA? The Advantages
 EVA uses the same profit objectives; this
overcomes the problem of depreciation and
varying incentives to invest in assets.
 EVA, on the contrary, finds any investment
that returns over the cost of capital as worth
investing.
 EVA permits use of different rates of interest
to each project (since some investments or
more/less risky than others.
 EVA (unlike ROA) is more positively
correlated to stock values.
 What are intangible assets?

 Not all benefits that accrue are so easy to

objectively measure and not all investments
are in tangible form (physical).
 Intangible assets include items that lack of a
physical form but are nevertheless
important for a firm to measure and
understand. e.g. R& D, Marketing
promotions, investments in IT.
Why should a firm invest in intangible
assets?
Intangible assets signal a firm’s ability
to:
Introduce new products
Develop customer relationships
(marketing, advertising, promotional
schemes)
Approach new customer segments
Improve product quality and services
Manage cost, reduce lead times, and
more. Benefits from these efforts accrue
over a long time and into the future,
these investments could be capitalized.
 How does an organization measure
intangible assets?
 Relative value. Measure progress, not a
quantitative target, that is the ultimate goal.
Example: have 80% of employees involved
with the customer in some meaningful way.
 Balanced scorecard: we will discuss these in
the performance measures chapter.
 Competency models. By observing and
classifying the behaviors of "successful"
employees ("competency models") and
calculating the market value of their output.
 Measuring Intangible Assets
 4. Subsystem performance. Sometimes it's
relatively easy to quantify success or progress
in one intellectual capital component. For
example, Dow Chemical was able to measure
an increase in licensing revenues from better
control of its patent assets.
 5. Benchmarking. Involves identifying
companies that are recognized leaders in
leveraging their intellectual assets,
determining how well they score on relevant
criteria, and then comparing your own company's
performance against that of the leaders.
 Measuring Intangible Assets

 6. Business worth. Ask 3 questions: What

would happen if the information we now use
disappeared altogether? What would
happen if we doubled the amount of key
information available? How does the value
of this information change after a day, a
week, a year? Evaluation focuses on the cost
of missing or underutilizing a business
opportunity, avoiding or minimizing a
threat.
 Measuring Intangible Assets
 7. Brand equity valuation. Methodology
that measures the economic impact of a
brand (or other intangible asset) on such
things as pricing power, distribution reach,
ability to launch new products as "line
extensions."
 8. "Calculated intangible value." Compares
a company's return on assets (ROA) with a
published average ROA for the industry.
 Measuring Intangible Assets

 9. "Colorized" reporting. Suggested by SEC

commissioner Steven Wallman, this method
supplements traditional financial statements
(which give a "black and white" picture)
with additional information (which add
"color"). Examples of "color" include
Brand values, customer satisfaction
measures, value of a trained work force.
 Intangible assets and
investment analysis
 Calculate ROA/EVA ignoring intangible
benefits. If the return is less than what is
acceptable, ask whether the intangible
benefits are worth at least the amount of the
difference between what is acceptable and
what the expected return is.
 Project rough, conservative estimates of the
value of the intangible benefits, and
incorporate these values into the investment
calculation.
Thanks

Presented By: Dalbir Singh

University Business School
Semester - 3