investscenter.ppt

8/12/2019 investscenter.ppt

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EVALUATING THE

PERFORMANCE OF AN

INVESTMENT CENTER

ROE

ROIEVA


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THE ALTERNATIVES

Return on Equity [ROE]

Earnings [cash flows] divided by

shareholders equity [Balance sheetassets minus liabilities]

Return on Investment [ROI]

Earnings [cash flows?] divided by

assets [usually Balance Sheet Assets]

Economic Value Added [EVA]

- Cash Flows divided by Capital less the

Cost of Capital multiplied by Capital


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Return on Equity [ROE]

The FIRM PerspectiveReturn on equity encompasses the three

main financial "levers" by whichmanagement can poke and prod the

organization to excel -- profitability,Asset Management, and Leverage.

Definition

An Example


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RETURN ON EQUITY

(Income) (Assets) (Liabilities)

Profit Margin Turnover Leverage

Operating Margin Inventory Turns Debt-to-Whatever

Gross Margin Days Sales Out. Times InterestEarned

By looking at trends in return on equity and analyzingthe components, the investor is forced to not onlyexamine the Statement of Operations, or the IncomeStatement, but also to balance this against the left and

right sides of the Balance Sheet.


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Return on Investment (ROI)

ROI is good because targets can be adjusted to focusmanagers attentions on key success factors and alsobecause every manager can be measured by thesame metric.

ROI is bad because under certain circumstances itcauses managers to make decisions that are bad fortheir organization. Two situations are critical: the ROI target is not consistent with the entitys capital

cost, in which case the investment center manager willunder-invest [sometimes over-invest] in assets.

the depreciation rate used in calculating ROI is not the trueeconomic rate of depreciation, in which case managers maymake bad decisions about both the maintenance and theacquisition of assets.

ROI versus ROE
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An Example

Calculated using book values and tax depreciationrates, the accounting rate of return is:

Rac(t) = Accounting Income (t)/

Accounting Book Value (t)

BUT Rac is the true ROI (R), if and only if and taxdepreciation rates = the true rate of depreciation (D)

are equal. For example, if R = .05 and D = .15, if thedepreciation rate used is .2, even though the true R isconstant and equals .05, the measured Racis -.06 inYear 1 and .08 in Year 2 (.91 in year 20) (assume I =100

in t-1, so real income = 4.5 in year 1 and 3.6 in year 2).


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Economic Value Added (EVA) EVA measures the value created from investments.

Returns on capital should be defined in terms of truecash flows resulting from investments.

The cost of capital is the weighted average of the costs ofthe different financing instruments used to financeinvestments.

EVA is measured in dollar values, not the percentagedifference in returns.

It is closest in both theory and construct to the netpresent value of a project in capital budgeting, asopposed to IRR.

The value of a firm, in DCF terms is the EVA of projectsin place plus the present value of the EVA of future

projects.


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An Example (a)

Assume that you have a firm with

IA = 100 In each year 1-5, assume that

ROCA= 15% I = 10 (Investments at beginning of each year)

WACCA= 10% ROC(New Projects) = 15%

WACC = 10%

Assume that all of these projects will have infinite lives.

After year 5, assume that

* Investments will grow at 5% a year forever

* ROC on projects will be equal to the cost of capital (10%)


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An Example (b)

Capital Invested in Assets in Place = $ 100

EVA from Assets in Place = (.15 - .10) (100)/.10 = $ 50

+ PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10] = $ 5

+ PV of EVA from New Investments in Year 2 = [(.15 - .10)(10)/.10]/1.12

= $ 4.55


= $ 4.13


= $ 3.76+ PV of EVA from New Investments in Year 5 = [(.15 - .10)(10)/.10]/1.15

= $ 3.42

Value of Firm = $ 170.86


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Invested Capital (1)

How do you measure the capital invested in assets?

Many firms use the book value of capital invested as

their measure of capital invested. To the degree that

book value reflects accounting choices made overtime, this may not be reflect the economic value of the

investment.

In some cases, capital and the after-tax operating

income have to be adjusted to reflect true capitalinvested.


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Invested Capital (2)Normally the charge for invested capital is the bookvalue of working capital plus fixed capita times adiscount rate, which reflects the entitys averagenominal cost of capitol. This approach contains threeerrors: HC is used rather than replacement cost; anominal rather than a real rate is used (not adjusted forinflation), and an average rate is used rather than amarginal rate.

The BEST way to measure the use of invested capital

would be to measure the market rental that could beearned on each item. However, the market wontprovide that info on assets that are specific to the firm --I.e., those that have the greatest value to the firm.


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Invested Capital (3)

For example, Public utility regulators throughout the United States use thefollowing procedure to convert the replacement price of a wasting asset intoa periodic rental price. This approach differs in two significant ways fromstandard business practice: it uses current replacement cost and it adjusts

the rate of depreciation for investments in maintenance. It also appliesdifferent depreciation rates to different kinds of assets.

R(t) = rental price for one unit of equipment at time t,

p(t) = purchase price of one piece of equipment at time t,

K(t) = amount of equipment remaining at time t, if n units were purchased at time 0,

r = discount rate

d = rate of depreciation

(which is defined as the rate at which the equipment declines in its productive capacity, a function of use,wear and tear, and maintenance levels; d = -K/K, where an apostrophe indicates differentiation withrespect to time).


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Invested Capital (4)It is a fundamental law of capital theory that the price of an asset equals the discounted

present value of the rentals one could obtain from the asset. If K(t) units of equipmentremain at time t, then the total rental at time t would be R(t) K(t). Therefore:

p(t=0) = xoR(t) K(t) e-rtdt, when K(0) = 1.

This formula for the asset price applies not just at time 0, but at any time y. Hence:

K(y) p(y) =xyR(t) K(t) e-r(t-y)dt,

By taking the derivative of this equation with respect to y, one obtains:

K(y) p(y) + K(y) p(y) = r(y) K(y) + rxyR(t) K(t) e-r(t-y)dt

= R(y) k(y) + r[p(y)] K(y),

Hence:

R(y) = (r + d - [p/p]) p(y).

This means that that the rental rate per asset equals interest foregone, plus depreciation,minus any price appreciation or decline.


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Invested Capital (5)The basic notion is that R(y) = (r + d - [p/p]) p(y).

This means that that the rental rate per unit of asset R(y) equals

interest foregone (r), plus depreciation (d, which is defined as the rate

at which the equipment declines in its productive capacity, a function of

use, wear and tear, and maintenance levels; d = -K/K, where an apostrophe

indicates differentiation with respect to time), minus any priceappreciation or decline (p/p). Summing those rates and multiplying them

times the replacement price of the asset in time y, gives us the economic

rent per unit in time y.

For example, if we started with 2 units of investment:

p(y) = 100 (replacement cost per unit)

p'(y) = 8

d = .1 (where k' = .the change in life of the asset remaining 05, k =.5

the life of the asset remaining)

r = .05

R(y) = .07

R(y)P(y) = .07(100) = 7, the rent per unit

Hence the total asset rent is 14 = 2(7)


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Returns

How do you measure return on capital?

* Again, the accounting definition of return on capital may not reflect theeconomic return on capital.

* In particular, the operating income has to be cleansed of any expenses which

are really capital expenses (in the sense that they create future value). Oneexample would be R& D.

* The operating income also has to be cleansed of any cosmetic or temporaryeffects.

How do you estimate cost of capital?

* DCF valuation assumes that cost of capital is calculated using market values of

debt and equity.* If it assumed that both assets in place and future growth are financed using the

market value mix, the EVA should also be calculated using the market value.

* If instead, the entire debt is assumed to be carried by assets in place, the bookvalue debt ratio will be used to calculate cost of capital. Implicit then is theassumption that as the firm grows, its debt ratio will approach its book value

debt ratio.

investscenter.ppt

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