Required Calculate ROI for each of the five years and comment on the results ACTIVITY 3 Required: Calculate ROI for each investment centre and comment on the results The arguments for using net book values for calculating ROI (a) It is the 'normally accepted' method of calculating ROI. (b) Organisations are continually buying new non-current assets to replace old ones that wear out, and so on the whole, the total net book value of all non-current assets together will remain fairly constant (assuming nil inflation and nil growth). 2. Profit/gross capital employed (gross assets employed) Gross capital employed=non-current assets (before depreciation)+working capital ACTIVITY 4 If a company acquired a non-current asset costing $40,000, which it intends to depreciate by $10,000 p.a for 4 years, and if the asset earns a profit of $8,000 p.a after depreciation, Calculate for each of the four years, ROI based on; (i)net book values (ii)gross values (iii)Comment on the results 3. Constituent elements of the investment base Although we have looked at how the investment base should be valued, we need to consider its appropriate constituent elements. (a) If a manager's performance is being evaluated, only those assets which can be traced directly to the division and are controllable by the manager should be included. Head office assets or investment centre assets controlled by head office should not be included. So, for example, only those cash balances actually maintained within an investment centre itself should be included. (b) If it is the performance of the investment centre that is being appraised, a proportion of the investment in head office assets would need to be included because an investment centre could not operate without the support of head office assets and administrative backup. 4. Profits We have looked at how to define the asset base used in the calculations but what about profit? If the performance of the investment centre manager is being assessed it should seem reasonable to base profit on the revenues and costs controllable by the manager and exclude service and head office costs except those costs specifically attributable to the investment centre.
If it is the performance of the investment centre that is being assessed, however, the inclusion of general service and head office costs would seem reasonable. The profit figure for ROI should always be the amount before any interest is charged. 1.5.2 Shortcomings of ROI a) Ignoring time value of money ROI ignores the time value for money. The concept of time value for money is that the value of money changes over time i.e. the value of a dollar / pound today is different from the value of a dollar / pound tomorrow and accordingly the purchasing power of the same unit of money undergoes a change. b) Ignores risk associated with the project ROI also ignores the risks associated with the project. Therefore, while taking a decision regarding projects with different levels of risk, using ROI may result in ignoring a good project which has less risk and accepting a project with high return and corresponding high risks. c) Flexibility It is good that ROI can be modified to fit the situation. However, this advantage becomes a disadvantage when the flexibility is used to manipulate the results so that they are expressed in a different way. d) Inconsistency The terms income and investment can be interpreted in various ways. Income is sometimes taken as before interest and tax; sometimes as after interest and tax. Likewise, investment also sometimes considers net assets and, sometimes, the gross value of assets. e) Short-term analysis The calculation of ROI takes into consideration short-term investments only. Long-term costs such as maintenance, software upgrades etc. are ignored. Therefore, projects with heavy long-term costs may show a high return on investment in the initial period of time. f) Variation in calculations If the depreciation calculation methods are different for the different units, it is difficult to compare their performances. 1.6 Residual Income An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost. (a) The centre's profit is after deducting depreciation on capital equipment. (b) The imputed cost of capital might be the organisation's cost of borrowing or its weighted average cost of capital. Residual income (RI) is the operating income that an investment centre is able to earn above a particular minimum return on its assets.