Which Investment

7/24/2019 Which Investment

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Which investment?

Four possible alternative defnitions oinvestment:

1.Total Assets Available- all assets

2.Total Assets Emploed-total assets availableless an idle assets or assets purchased ore!pansion in the uture

".Total Assets Emploed minus #urrent

$iabilities%.&toc'holders( E)uit

*ross or net?

1


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2

+easurin, ncome

n calculatin, /0 companies measureincome in a variet o 3as

net income ater ta!

/peratin, income ncome beore ta!

+ost common method is 4/5AT Net Operatin, ProftAter Ta!es

To calculate 4/5AT0 a compan must add bac' non-operatin, items to net income and ad6ust ta!e!pense accordin,l


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"

+easurin, ncome and nvested#apital or /

n calculatin, /0 companies measureinvested capital in a variet o 3as

Approach used here:Total assets less non-interest-bearin, current

liabilities


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%

5roblems 3ith /

nvested capital is tpicall based on historical costs

Full depreciated assets lead to a lo3 invested capitalnumber resultin, in hi,h /

+a'es comparison o investment centers usin, /

di7cult

+ana,ers ma put o8 purchase o ne3 e)uipment

+a lead to underinvestment

5ossible alternative defnitions o cost:1.#urrent #ost

2.*ross 9alue o Fi!ed Assets

".4et oo' 9alue o Fi!ed Assets


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;

5roblems o /verinvestment and


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=

Economic 9alue Added

>E9A E9A is residual income ad6usted or accountin,distortions that arise rom *AA5

A perormance measure approach to solvin,

overinvestment and underinvestment problems Advanta,e is that mana,ers are less tempted to cutthose costs that distort income under *AA5

For e!ample0 under *AA5 research anddevelopment costs are e!pensed0 but the costsbenefts uture periods

Thus0 under E9A research and development iscapitali@ed and amorti@ed over uture periods


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Economic 9alue Added>E9AB E9A is a specifc tpe o residual income

calculation that has recentl ,ainedpopularit

Wei,hted-avera,e cost o capital e)uals theater-ta! avera,e cost o all lon,-term undsin use


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C

esidual ncome

4#$ D 4et ncome eore#urrent $iabilities>e!cludin, debt


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Economic 5roft Economic

9alue Added E9AG ardstic' to measure i the business isearnin, above its cost o capital o resourcesit emplos

developed b &tern &te3art and #o.

E9AD 4/5AT #G'

4/5AT D operatin, proft ater ta! >ad6usted

# D capital base emploed net odepreciation

' D 3ei,hted avera,e cost o capital


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1H

E9A Ad6ustments to 4/5AT-/peratin, leases

operatin, lease e!penses: in a sense the assets underoperatin, lease should be part o the capital emploed thru o8 balance sheet fnancin,

operatin, lease >net o ta! is added bac' to operatin,

proft thereore uture paments o the operatin, lease is

discounted and added to assets and a related liabilit isalso established

then the present value o the operatin, lease is

amorti@ed over an appropriate period such as thecontract period0 and this derived amorti@ation amountis deducted rom net income


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11

E9A Ad6ustments to 4/5AT- esearch andIevelopment and Advertisin, and

5romotional E!penses

the benefts e!tend into the uture

thereore JI and AJ5 e!penses areremoved rom the income determination

JI and AJ5 e!penses are capitali@ed andamorti@ed over a reasonable period

the amorti@ed amount is then deducted inthe income determination


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12

E9A Ad6ustments to 4/5AT- nventor9alue Ad6ustment >$F/and Ieerred

ta! 3hen companies use $F/ as their inventor cost Ko30

then the value o the inventories on the balance sheet3ill be di8erent rom its current value because theamount that appears on the balance sheet is based on

old cost f,ures recent additions to inventor become part o #/*&

thus inventories are restated to current hi,her >themethod is usuall used under inKationar conditionsvalues 3ith an o8settin, increase to earnin,s- add

bac' the chan,e in $F/ reserves to income

add the chan,es in deerred ta!es to 4/5AT


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1"

E9A Ad6ustments to 4/5AT-

*ood3ill an amorti@ation o ,ood3ill is added bac'to operatin, proft beore ta!

assumption : total amount o ,ood3ill

should be reKected in the balance sheetbecause this asset is a permanent part othe capital base

so ad6ust 4/5AT b the amount o

amorti@ation and balance sheet to reKectthe total amount o ,ood3ill

F&-3atch or ,ood3ill impairment


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1%

E9A Ad6ustments to #apital

ase 4on-operatin, assets: such assets shouldbe e!cluded rom the capital basebecause the are not used in ,eneration

o earnin,s


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1;

Step 1 - Calculate the capital base

Current assets (excluding cash)

+ Net Fixed Assets+ Capitalization of Operating Leases

+ Other Long-term Assets

+/- !uit" !ui#alents- Current Lia$ilities (excluding de$t)- Long term lia$ilities (excluding de$t)% Capital mplo"ed ( Capital &ase)

Lo3 to compute E9AG


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1=

Step 2 - Calculate net operating profit after

tax

&'+/- Change in e!uit" e!ui#alents

+ operating lease pa"ments

- Cash tax

= NOA

Lo3 to compute E9AG


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1

Step 3 - Calculate Capital Charge =

Cost of Capital * Capital $ase (opening)

Step 4 - Calculate EVA *=NOA - Capital Charge

Lo3 to compute E9AG


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Wh


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;-1

#opri,ht 2HH +c*ra3-LillAustralia 5t $td

55Ts tMa Business Finance 10ebPeirson

&lides prepared b Farida A'htar and

Economic 9alue Added>E9A Alternative to discounted cash Ko3

methods0 accountin, rate o returnand pabac' period.

Ne actor is the re)uired rate oreturn.

E9A is the di8erence bet3een thepro6ect(s accountin, proft and there)uired return onthe capital invested in the pro6ect.

E9A can be improved b increasin,

accountin, proft or b reducin,


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;-2H

#opri,ht 2HH +c*ra3-Lill Australia 5t $td

55Ts tMa Business Finance 10eb Peirson&lides prepared b Farida A'htar and arr /liver0 Australian 4ational cont. EVA is given by:

Iiscounted sum o E9As e)uals 459 o pro6ect.

( )+ +t t t t t EVA C I I kI = +

+

,here

% net cash flo, generated $" pro.ect at time t

% in#estment #alue/ end of "ear

% in#estment #alue/ end of "ear -+

% re!uired rate of return

t

t

t

C

I t

I t

k


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21

eturn on investment

nvested capitalThe assets that the investment centre has

available to ,enerate profts

eturn on salesThe percenta,e o each sales dollar that

remains as proft ater all the e!penses arecovered

nvestment turnoverThe number o sales dollars ,enerated b

ever dollar o invested capital continued


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22

eturn on investment

mprovin, / ncrease return on salesOincrease sellin,

price or sales revenue0 or decrease e!penses

ncrease investment turnover b increasin,sales revenue or reducin, invested capital

Actions that are ta'en 3ith the sole purposeo ma'in, these ratios more avourable mahave adverse e8ects on perormance inuture ears


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2"

+easurin, invested capital

Total assets: investment centre mana,eris responsible or decisions about allassets

Total productive assets: investmentcentre mana,ers retains non-productiveassets

Total assets less current liabilities:investment centre responsible ordecisions about assets P mana,es short-term liabilities

#hoose avera,e or end-o-ear balances


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2%

Asset measurement

Advanta,es o net boo' value #onsistenc 3ith balance sheet prepared or

e!ternal reportin, purposes

#onsistent 3ith the defnition o proft

advanta,es o ,ross boo' value Iepreciation is arbitrar and should not be

allo3ed to a8ect calculations

Iepreciatin, non-current assets ma providea disincentive to invest in ne3 e)uipment


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After-tax Operating Income

Investment charge

=Economic value added

(Total assets current liabilities

!"eighted-average cost of capital

= Investment charge

After-tax cost oflong-term borro#ing

and the cost of e$uit%

Economic 9alue Added

Which Investment

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