Performance Evaluation:

ROI-RI-EVA®
 Performance Evaluation: is formal determination of an
individual’s job-related actions and their outcomes within
a particular position or setting.
 In financial trading, its objective is to assess the extent to
which the individual added wealth to the firm and/or its
clients, and whether his or her achievement was above or
below the market or industry norms also called
performance measurement.
 When a business owner wants to sell his business to
potential buyers, certain steps must be followed to ensure
the business is beneficial for the buyer at the present state.
The buyer wants to know what the business is worth
and what potential it has for the given market before
making the large investment.
 This is where a business performance evaluation enters the
picture.
DIVISIONAL PROFITABILITY
 Divisional profitability or Divisional income is a
measure of divisional performance that is equivalent to
corporate net income for evaluating overall company
performance.
For Example
Manager’s area of Typical financial
Responsibility structure responsibility performance measure
Cost centre Decisions over costs Standard costing variances
Decisions over costs and
Profit centre Controllable profit
revenues
Decisions over costs, Return on investment and
Investment centre
revenues, and assets residual income
DECENTRALIZATION
 Decentralization is the delegation of decision making to
the sub units of an organization. It is a matter of degree.
The lower the level where decisions are made, the greater
is the decentralization.
 Decentralization is most effective in organizations where
cost and profit measurement is necessary and is most
successful in organizations where subunits are totally
independent and autonomous.
 Two problems arise in a typical decentralized
organization: Performance Evaluation and Transfer
Pricing
EVALUATION OF DIVISIONAL
PERFORMANCE
 The ability to measure performance is essential in
developing management incentives and controlling the
operation toward the achievement of organizational goals.
 A typical decentralized subunit is an investment center,
which is responsible for an organization’s invested capital
(operating assets) and the related operating income.

There are two widely used measurements of performance for the investment
center:
1. THE RATE OF RETURN ON INVESTMENT (ROI) AND
2. RESIDUAL INCOME (RI).
1. ROI
 ROI relates net income to invested capital.
 Specifically, ROI  Operating Income
Operating Assets
 ROI = Margin X Capital turnover

OI Sales OI
 x 
Sales OA OA
Margin is a measure of profitability or operating efficiency,
Whereas turnover measures how well a division manages its assets
Example 1
 Consider the following financial data for a division:
 Operating assets $1,00,000
 Operating income 18,000
 Sales 2,00,000
ROI = Operating income / Operating assets
$18,000 /$100,000 = 18%

Alternatively, Margin = Operating income/Sales = $18000/$200000 = 9%

Turnover = Sales / Operating Assets = $200000/$100000 = 2 times

Therefore,
ROI = Margin X Turnover = 9% X 2 times = 18%
 The breakdown of ROI into margin and turnover (often
called the Du Pont formula) has several advantages over
the original formula in terms of Profit Planning. They
are:
1. The importance of turnover as a key to overall return on
investment is emphasized in the breakdown. In fact, turnover
is just as important as profit margin.
2. The importance of sales is explicitly recognized, which is not
reflected in the regular formula.
3. The breakdown stresses the possibility of trading one off for
the other in an attempt to improve the overall performance of
a division.
The breakdown of ROI into its two components shows that a number of
combinations of margin and turnover can yield the same rate of return, as
shown below.

Margin (%) Turnover = ROI (%)

1 9 x 2 times = 18
2 8 x 2.25 = 18
3 6 x 3 = 18
4 4 x 4.5 = 18
5 3 x 6 = 18
6 2 x 9 = 18
The turnover-margin relationship and its resulting ROI are depicted in Fig.
1. Figure 1indicates that the turnover and margin factors complement each
other. In other words, a weak margin can be complemented by a strong
turnover, and vice versa. It also shows how important turnover is as a key to
profit making. In fact, these two factors are equally important in overall
profit performance.
Figure 1
ROI AND PROFIT PLANNING
 The breakdown of ROI into turnover and margin gives
management insight into planning for profit improvement.
Generally speaking, management can:
 1. Improve margin
 2. Improve turnover
 3. Improve both
 Alternative 1 demonstrates a popular way of improving
performance. Margins may be increased by reducing
expenses, raising selling prices, or increasing sales faster
than expenses.
 Alternative 2 may be achieved by increasing sales while
holding the investment in assets relatively constant, or by
reducing assets.
 Alternative 3 may be achieved by increasing sales revenue
or by any combinations of alternatives 1 and 2.
 Assume that management sets a 20 percent ROI as a profit
target. It is currently making an 18 percent return on its
investment.
OI Sales OI
ROI  x 
Sales OA OA
Present:18% = 18,000/2,00,000 * 2,00, 000/1,00,000

Alternative 1: Increase margin by reducing expenses.

20%= 20,000/2,00,000 * 2,00,000/1,00,000

Alternative 2: Increase turnover by reducing investment in assets.

20% = 18,000/2,00,000 * 2,00,000/90,000

Alternative 3: Increase both margin and turnover by disposing of obsolete and

redundant inventories.
20% = 19,000/2,00,000 * 2,00 000/95,000
 Excessive investment in assets is just as much of a drag on
profitability as excessive expenses.
 In this case, cutting unnecessary inventories also helps cut
down expenses of carrying those inventories, so that both
margin and turnover are improved at the same time.
 In practice, alternative 3 is much more common than alternative
1 or 2.
Operating
Alternative Operating Income Sales Margin Turnover ROI(%)
Assets
0 18000 200000 100000 0.090 2.000 18

1 20000 200000 100000 0.100 2.000 20

2 18000 200000 90000 0.090 2.222 20

3 19000 200000 95000 0.095 2.105 20

RESIDUAL INCOME (RI)
 Another approach to measuring performance in an
investment center is residual income (RI).
 RI is the operating income which an investment center is
able to earn above some minimum rate of return on its
operating assets.
 RI, unlike ROI, is an absolute amount of income rather than a
specific rate of return.
 When RI is used to evaluate divisional performance, the
objective is to maximize the total amount of residual income,
not to maximize the overall ROI figure.

RI = Operating income - (Minimum required rate of return X Operating assets)

 In Example 1, assume the minimum required rate of return
is 13 percent. Then the residual income of the division is

RI = $18,000 - (13% X $100,000)

= $18,000 - $13,000
= $5,000

RI is regarded as a better measure of performance than ROI because it encourages

investment in projects that would be rejected under ROI.

A major disadvantage of RI, however, is that it cannot be used to compare divisions

of different sizes. RI tends to favor larger divisions because of the larger amount of
dollars involved.
 The decision whether to use ROI or RI as a measure of
divisional performance affects managers’ investment
decisions.

1. Under the ROI method, division managers tend to accept only the
investments whose returns exceed the division’s ROI; otherwise, the
division’s overall ROI would decrease.
2. Under the RI method, on the other hand, division managers would
accept an investment as long as it earns a rate in excess of the minimum
required rate of return. The addition of such an investment will increase
the division’s overall RI.
 Consider the same data given in Examples 1
 Operating assets $1,00,000
 Operating income $ 18,000
 Minimum required rate of return 13%
 ROI = 18% and RI = $5,000

Assume that the division is presented with a

project that would yield 15 percent on a
$10,000 investment.
 The division manager would not accept this project under
the ROI approach, since the division is already earning 18
percent. Acquiring this project will bring down the present
ROI Approach ROI to 17.73 percent

New
Present Project Overall
Operating assets (a) $100,000 $l0,000 $110,000
Operating income (b) 18,000 1,500* 19,500
ROI (b / a) 18% 15% 17.73%
*$l0.000 X 15% = $1,500

Under the RI approach, the manager would accept the new project, since
it provides a higher rate than the minimum required rate of return (15
RI Approach percent vs. 13 percent). Accepting the new project will increase the
overall residual income to $5,200

Present New Project Overall

Operating assets (a) $100,000 $10,000 $1,10,000
Operating income (b) 18,000 1,500 19,500
Minimum required income at 13% (c) 13,000 1,300* 14,300
Rl(b-c) $5,000 $200 $5,200
*$10,000 X 13% = $1,300.
Example 2
Division A and B are both considering an outlay on new investment
projects.
Division A Division B
Investment outlay ` 1,00,000 ` 1,00,000
Net return on the new investment ` 16,000 ` 11,000
Current ROI 18% 11%
The company’s cost of capital is 13%. Should the project be accepted or
rejected?
(i) Using ROI

ROI on New investment = Net Return / New investment

Division A = ` 16,000 / ` 1,00,000 × 100 = 16%
Division B = ` 11,000 / ` 1,00,000 × 100 = 11%
Division A should reject the new investment as its ROI is 16% which is less than the current ROI of 18%.
Division B can accept the investment as its current ROI of 11% is equal to new ROI on new investments.

(ii) Using RI

Division A Division B
Investment ` 1,00,000 ` 1,00,000
Net Income on new Investment 16,000 11,000
Less : Imputed Cost of capital 13% 13,000 13,000
Residual Income 3,000 -2,000
Division A should accept the investment as it will make RI of ` 3,000 and Division B should reject it because
it will give a loss of ` 2,000.
Example 3
 Consider a firm that has a cost of capital of 15%.
Consider a division that has the opportunity of making an
additional investment of ` 120 lakhs which will yield an
annual return of ` 24 lakhs. Assume that the division has at
present an investment base of ` 240 lakhs on which it
earns an annual return of ` 60 lakhs.
ROI RI
 ROI on the proposed new investment  Now analyze the same situation on the
 = (24/120) x 100 = 20 %. basis of Residual Income.
 Since this is higher than the cost of capital of 15%,  Current RI = 60 - (240 x 0.15) = 24
this investment proposal will qualify for top
management approval (assuming other aspects of  RI after the new investment
investment has been approved.)  = 84 - (360 x 0.15) = 30
 The division may still not want to make this
investment. Consider the position of the division if
 Thus the division’s performance would
this investment is made. apparently show an improvement on
 Total investment residual income, justifying the new
 = 240 + 120 = 360. investment.
 Total annual return
 = 60 + 24 = 84.
 ROI = 84 / 360 = 23.3 %.
 Thus with the new investment it would appear that
the division’s performance as adjudged by ROI has
declined.
 Present ROI = 60/240 × 100 = 25%
Return on investment (ROI)
 Strengths:  Weaknesses:
1. The amount of return (earnings) is
related to the investment base required 1. Where is no incentive for
to generate that return. Thus, the a division to expand to the
emphasis is on the rational allocation point where the marginal
of scarce capital resources.
2. ROA normalizes the size effect since it
return on investment
is a ratio. Thus, we can compare equals the cost of capital.
entities of different sizes.
2. ROA can be improved by
3. As a percentage-return measure, ROA
is comparable to cost-of-capital and selling low-return but
market rate of return measures. acceptable projects.
4. Changes in ROA will lead to changes
3. As an accounting measure,
in EPS. Thus, achieving ROA
objectives consistent with a firm’s cost ROA has all of the defects
ROI may be used as a
of capital will lead to the achievement measure of performance but it is not
of such measures.
of desirable advisable to use
levels of total it as a measure of decision
earnings, making on
investment.
EPS and corporate ROA.
Residual Income (RI)
 Strengths:
 The amount of return (earnings) is related to both the investment base required to generate
that return and the required rate of return on investment (cost of capital). Thus, the emphasis
is on the rational allocation of scarce capital resources.
 Residual income focuses on the magnitude of income earned in excess of the cost of capital.
Some writers believe managers are primarily interested in magnitudes, not rates of return.
 RI is more consistent with the net present value method of selecting capital investments, the
preferred method in theory and practice.
 RI converts the interest computation to a periodic flow measure which quickly translates
into its effect on residual income. Thus, it is easy to translate a change in the cost of capital
into its effect on residual income, a flow measure.
 The method by which RI is calculated lends itself to the use of different required rates of
return for activities with different risk levels.
 Changes in RI will lead to changes in EPS. Thus, achieving RI objectives will lead to the
achievement of desirable levels of total earnings and EPS at the corporate level.
 Weakness:
 As an accounting measure, RI has all of the defects of such measures.
 Note:
 Whatever appraisal measure be used, a target level of performance
must be set. Factors to be considered include:
 Cost of capital,
 Risks,
 Inter-firm comparisons,
 Economic conditions, and so on.
 To control all the facets of divisional operations other appraisal
measures should be set in such areas as:
 Sales,
 Growth,
 Productivity,
 Labour relations,
 Quality.
3. Return on Capital Employed (ROCE)
 Investment centers are almost like profit centers with the added
power of decisions on investment in assets for the division.
 The performance measure used is the ability of the centre to
generate sufficiently high returns on investments.
 Relating profits to capital investment is a well known concept. This
can be used as a measure of performance of investment centers.
 A financial ratio that measures a company’s profitability and the
efficiency with which its capital is employed. Return on Capital
Employed (ROCE) is calculated as:
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed

“Capital Employed” as shown in the denominator is the sum of shareholders’ equity and debt liabilities; it
can be simplified as (Total Assets – Current Liabilities). Instead of using capital employed at an arbitrary
point in time, analysts and investors often calculate ROCE based on “Average Capital Employed,” which
takes the average of opening and closing capital employed for the time period.
Example 4
 A company earns a profit of ` 3,00,000 p.a. after meeting its
interest liability of `1,20,000 on 12% Debentures.
 The tax rate is 50%.
 The number of equity shares of `10 each are 80,000 and
retained earnings amount to ` 12,00,000.
 The company proposes to take up an expansion scheme for
which a sum of ` 4,00,000 is required.
 It is anticipated that after expansion, the company will be able
to achieve the same return on investment as at present.
 The funds required for an expansion can be raised either
through debt at the rate of 12% or by issuing equity shares at
par.
(1) Capital Employed before expansion Plan (`)
Equity Shares 8,00,000
Debentures (` 1,20,000 /12) x 100 10,00,000
Retained Earnings 12,00,000
Total Capital Employed 30,00,000

(2) Earnings before the Payment of Interest and Tax (EBIT) (`)
Profit 3,00,000
Interest 1,20,000
EBIT 4,20,000

(3) Return on Capital Employed (ROCE)

ROCE = EBIT /Capital Employed × 100
= 4,20,000 /30,00,000 x 100
= 14%
ECONOMIC VALUE ADDED (RESIDUAL
INCOME)EVA®
 EVA for short is primarily a benchmark to measure earnings
efficiency.
 Though the term “Economic Profit” was very much there since the
inception of “Economics’”.
 Stern Stewart & Co., of USA has got a registered Trade Mark for
this by the name “EVA”.
 An acronym for Economic Value Added.
 EVA as a residual income measure of financial performance is
simply the operating profit after tax less a charge for the capital,
equity as well as debt, used in the business.
 Because EVA includes profit and loss as well as balance sheet efficiency as
well as opportunity cost of investor capital-it is better linked to changes in
shareholder wealth and is superior to traditional financial metrics such as
PAT or percentage rate of return measures such as ROCE or ROE.
 In addition EVA is a management tool to focus managers
on the impact of their decisions in increasing shareholder
wealth.
 These include both strategic decisions such as what
investments to make, which business to exist, what
financing structure is optimal as well as operational
decisions involving trade-offs between profit and asset
efficiency such as whether to make in house or outsource,
repair or replace a piece of equipment, whether to make
short or long production runs etc.
Computation of EVA
 The computation of EVA is a three- step process.
 (1) Compute the Net Operating Profit After Tax (NOPAT)
 (2) Find out WACC for the firm, and the capital employed and
 (3) Find EVA as below:

EVA = NOPAT – WACC x Capital Employed

 Stewart defines NOPAT as the profits derived from the
company’s operations after taxes but before financing costs and
non cash entries, except for depreciation, which is reckoned as
“a true economic expense”.
 Stewart’s definition of NOPAT incorporates regular non operating
income.
 This is a deviation from the traditional concept of operating profit
which restricts the operating profits definition to profits from main
operations ignoring other income.
 But Stewart’s definition is more relevant in present day business.
Stewart identified 164 adjustments to be made to the accounting
profits as reported in the Profits and Loss Account to eliminate
potential distortions in the accounting results based on the Generally
Accepted Accounting Principles (GAAP).
CASE STUDY 1:SBI and HDFC
Economic Value Added (%)
(EVA – As a measure of value creation through Management of Profits)
Economic Value Added Statement of SBI Economic Value Added Statement of HDFC
Particulars / Years 2007-08 2006-07 2005-06 2007-08 2006-07 2005-06
Average Capital Employed 15,976 9,248 8,158 1,00,760 71,002 58,285
Weight of Debt 0.28 0.3 0.35 0.51 0.56 0.53
Weight of Equity 0.72 0.7 0.65 0.49 0.44 0.47
Beta (β) 0.93 1.22 1.03 0.91 1.22 1.1
Risk free rate (Rf) 4.55% 4.55% 4.55% 4.55% 4.55% 4.55%
Market Risk Premium (Rm) 2.18 1.11 5.57 2.18 1.11 5.57
Cost of equity (Ke) 6.75 8.75 3.49 6.7 8.75 3.42
Cost of debt (Kd) 0.078831 0.120371 0.090625 0.06512 0.061345 0.063
WACOC 0.070664 0.054395 0.03612 0.066337 0.049464 0.039328
ROIC (NOPAT/ CAP EMPLOYED) 0.19 0.23 0.2 0.12 0.13 0.17
EVA (ROIC- WACOC) 0.1193 0.1756 0.1639 0.0537 0.0805 0.1357

0.2
0.15
0.1 SBI
HDFC
0.05
0
2005-06 2006-07 2007-08
 Economic Value Added (in`)
Economic Value Added (in`)
(EVA - As a measure of value creation through Management of Capital)
This scenario is used by the following consequence:- NOPAT including net operating profit less tax subtracting capital charge
comprising of cost of capital multiplied by capital employed gives the title at a substantial exposure.
NOPAT - (WACC x Invested Capital)
Banks/Year NOPAT Capital Charge EVA
2007-08 2006-07 2005-06 2007-08 2006-07 2005-06 2007-08 2006-07 2005-06
SBI 12,574 9,435 9,841 6,684 3,512 2,001 5,890 5,923 7,840
HDFC 2,988 2,134 1,644 1,129 503 295 1,859 1,631 1,349
 After the detailed analysis of financial data and information of SBI &
HDFC bank following findings have been derived.
 • It was seen during the analysis that in Public Sector SBI ruled the market in
terms of creating shareholders value in terms of amount where in the Private
Sector HDFC was at the top spot in terms of percentage.
 • After bearing all the expenditures including firms’ return to all stakeholders,
the remaining wealth i.e. EVA is accumulated by the shareholders after being
reinvested so as to create an increment in its wealth resources.
 • All SBI and HDFC Bank have been creating an EVA and value addition for
its shareholders throughout 3 years.
 • All banks are creating shareholders’ value in terms of capital gain as well as
reinvestment of the remaining profit into the business which will surely
influence the stock prices in future.
 • It was found that the reinvestment criteria and its impact will be a great deal
for the firm’s expected success and value creations for the firm in the near
future.
 When will EVA increase?
 EVA will increase if:
 (1) operating profits can be made to grow without employing
more capital, i.e. greater efficiency;
 (2) additional capital is invested in projects that return more
than the cost of obtaining new capital, i.e. profitable growth;
and
 (3) capital is curtailed in activities that do not cover the cost of
capital, i.e. liquidate unproductive capital
 CASE STUDY 2:Hindustan Unilever
Limited
EVA in practice at Hindustan Lever Ltd.
Hindustan Lever, the goal of sustainable long-term value creation for the shareholders is well understood by all the business groups.
Following table shows the EVA trend of the company from 1997 to 2005 —
(` in crore) 1997 1998 1999 2000 2001 2002 2003 2004 2005
Cost of Capital
Employed
Average Debt 160 165 162 93 50 45 881 1,588 360
Average Equity 1,127 1,487 1,908 2,296 2,766 3,351 2,899 2,116 2,200
Average Capital Employed 1,287 1,652 2,070 2,389 2,816 3,396 3,780 3,704 2,560
Cost of Debt, post-tax % 8.82 9.1 8.61 8.46 7.72 6.45 4.88 5.19 3.38
Cost of Equity % 19.7 19.7 19.7 19.7 16.7 14.4 12.95 14.77 15.5
WACC 18.34 18.64 18.83 19.27 16.54 14.3 11.07 10.66 13.8
COCE 236 308 390 460 466 486 418 395 353
EVA
PAT before exceptional items 580 837 1,070 1,310 1,541 1,716 1,804 1,199 1,355
Add: Interest after taxes 21 19 14 8 5 6 43 82 12
NOPAT 601 856 1,084 1,318 1,546 1,722 1,847 1,282 1,367
Less: COCE 236 308 390 460 466 486 418 395 353
EVA 365 548 694 858 1,080 1,236 1,429 887 1,014
2000

1800

1600

1400

1200

NOPAT
1000
COCE
EVA
800

600

400

200

0
1997 1998 1999 2000 2001 2002 2003 2004 2005