EVALUATING THE

PERFORMANCE OF AN
INVESTMENT CENTER
ROE
ROI
EVA
 THE ALTERNATIVES
• Return on Equity [ROE]
– Earnings [cash flows] divided by
shareholders’ equity [Balance sheet
assets 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
 Return on Equity [ROE]
The FIRM Perspective
Return on equity encompasses the three
main financial "levers" by which
management can poke and prod the
organization to excel -- profitability,
Asset Management, and Leverage.

Definition

An Example
 Return on Equity [ROE]
The SHAREHOLDER’S Perspective
Businesses that generate high returns relative to their
shareholder's equity are businesses that pay their
shareholders off handsomely, creating substantial assets
for each dollar invested.

By relating the earnings generated to the shareholder's

equity, an investor can quickly see how much cash is
created from the existing assets. If the return on equity is
20%, for instance, then twenty cents of assets are
created for each dollar that was originally invested. As
additional cash investments increase the asset side of the
balance sheet, this number ensures that additional dollars
invested to not appear to be dollars of return from
previous investments.
The best & Worst ROE
 RETURN ON EQUITY

(Income) (Assets) (Liabilities)

Profit Margin Turnover Leverage

Operating Margin Inventory Turns Debt-to-

Whatever

Gross Margin Days Sales Out. Times Interest

Earned

By looking at trends in return on equity and analyzing

the components, the investor is forced to not only
examine the Statement of Operations, or the Income
Statement, but also to balance this against the left and
right sides of the Balance Sheet.
 Return on Investment (ROI)
• ROI is good because targets can be adjusted to
focus managers’ attentions on key success factors
and also because every manager can be measured
by the same metric.
• ROI is bad because under certain circumstances it
causes managers to make decisions that are bad
for their organization. Two situations are critical:
– the ROI target is not consistent with the entity’s capital
cost, in which case the investment center manager will
under-invest [sometimes over-invest] in assets.
– the depreciation rate used in calculating ROI is not the
true economic rate of depreciation, in which case
managers may make bad decisions about both the
maintenance and the acquisition of assets.
ROI versus ROE
 An Example
Calculated using book values and tax depreciation
rates, 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 tax
depreciation rates = the true rate of depreciation
(D) are equal. For example, if R = .05 and D = .15,
if the depreciation rate used is .2, even though the
true R is constant and equals .05, the measured
Rac is -.06 in Year 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).
 Economic Value Added (EVA)
• EVA measures the value created from investments.
• Returns on capital should be defined in terms of true
cash flows resulting from investments.
• The cost of capital is the weighted average of the costs of
the different financing instruments used to finance
investments.
• EVA is measured in dollar values, not the percentage
difference in returns.
• It is closest in both theory and construct to the net
present value of a project in capital budgeting, as
opposed to IRR.
• The value of a firm, in DCF terms is the EVA of projects
in place plus the present value of the EVA of future
projects.
 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%)
 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
+ PV of EVA from New Investments in Year 3 = [(.15 - .10)(10)/.10]/1.13 =
$ 4.13
+ PV of EVA from New Investments in Year 4 = [(.15 - .10)(10)/.10]/1.14 =
$ 3.76
+ PV of EVA from New Investments in Year 5 = [(.15 - .10)(10)/.10]/1.15 =
$ 3.42
………
Value of Firm = $ 170.86
 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 over
time, 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 capital
invested.
 Invested Capital (2)
Normally the charge for invested capital is the
book value of working capital plus fixed capita
times a discount rate, which reflects the entity’s
average nominal cost of capitol. This approach
contains three errors: HC is used rather than
replacement cost; a nominal rather than a real
rate is used (not adjusted for inflation), and an
average rate is used rather than a marginal rate.
The BEST way to measure the use of invested
capital would be to measure the market rental
that could be earned on each item. However,
the market won’t provide that info on assets that
are specific to the firm -- I.e., those that have the
greatest value to the firm.
 Invested Capital (3)
For example, Public utility regulators throughout the United States
use the following procedure to convert the replacement price of a
wasting asset into a periodic rental price. This approach differs in
two significant ways from standard business practice: it uses
current replacement cost and it adjusts the rate of depreciation for
investments in maintenance. It also applies different 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 with respect to time).
 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 equipment remain at time t, then the total rental at time t would be R(t)
K(t). Therefore:

p(t=0) = ºx o R(t) K(t) e-rt dt, 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) = ºxy R(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) + r ºxy R(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.
 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 price
appreciation 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)

 Returns
How do you measure return on capital?
* Again, the accounting definition of return on capital may not reflect the economic 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). One example would be R& D.
* The operating income also has to be cleansed of any cosmetic or temporary effects.
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 book value debt ratio will
be used to calculate cost of capital. Implicit then is the assumption that as the firm grows, its debt
ratio will approach its book value debt ratio.