EVA vs ROI Positive features of ROI: 1 ROI is a comprehensive measure in that anything that affects financial sttements is reflected

in this ratio. 2 ROI is simple to calculates, easy to understand, and meaningful in an absolute sense. 3 Can be applied to any organizational unit responsible for profitability, regardless of size or type of business. The performance of different units can be compared directly to one another. Also ROI data is available for competitors and can be used for comparison. (The amount of EVA does not provide such a basis for comparison). Reasons for using EVA over ROI: 1 With EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other hand, provides different incentives for investments across business units. For example, a business unit hat currently is achieving an ROI of 30% would be reluctant to expand unless it is able to earn an ROI of 30% or more on additional assets; a lesser ROI would decrease its overall ROI below its current 30% level, thereby adversely affecting the current performance incentives. This business unit will forego investment opportunities whose ROI is above the cost of capital and below 30%. This will deprive the company of additional value added. Similarly, a business unit that currently is achieving a low ROI of say 5% will benefit (in compensation) from anything over 5% on additional assets. As a consequence, ROI creates a bias towards little or no expansion in high-profit business units while, low-profit units are making investments at rates of return where shareholder value is destroyed.

example

A situation 1 cost of capital current new investment after investment B situation 2 cost of capital current new investment after investment assets 100 20 120 assets 100 20 120

2 Decisions that increase a center's ROI may decrease its overall profit. For instance, in an investment center whose current ROI is 30%, the manager can increase the its overall ROI

example

A purely on basis of ROI before assets ROI asset category 1 100 31.25%

by disposing of an asset whose ROI is 25%. However, if the cost of capital tied up in the investment center is less than 25%, the absolute amount of profit after deducting capital costs will decrease.

asset category 2 total assets after asset category 1

25 25.00% 125 30.00%

assets ROI 100 31.25%

B with cost of capital tied up cost of capital before assets ROI asset category 1 100 31.25% asset category 2 25 25.00% total assets 125 30.00% after asset category 1 3 Different rates of interest may be used for different types of assets. For exampple, a low rate may be used for inventories, while a higher rate may be used for fixed assets. Further, different rates may be used for different types of assets may be used based on different degrees of risk. In short, MCS may be made consistent with the capital investment and the assets allocation. 4 EVA, in contrast to ROI, has a stronger correlation with changes in the company's market value. EVA is considered as the best proxy for creating and growing EVA. assets ROI 100 31.25%

Real life examples relating to use of EVA over ROI: 1 pg 271: Golden Grain, a business unit of Quaker Oats, had a very high profitability and appeared to be one of Quaker Oats' best divisions. It was, however, acquired by Quaker Oats at a premium

above its book value. Based on the assets employedas measured by this premium, Golden Grain actually was underperforming. (which becomes clear if EVA is worked out). 2 p 284: Based on ROI, Wal-Mart would have chsoen to stop expanding since the late 1980s because its ROI on new stores slipped from 25% to 20% - even though both rates were substantially above its cost of capital. (Wal-Mart was on of the early companies to make every store report EVA).

15% ROI 30% 25% 29.17%

Profit cost of cap 30 15 5 3 35 18

EVA 15 2 17

15% ROI 10% 12% 10.33%

Profit cost of cap 10 15 2.4 3 12.4 18

EVA -5.0 -0.6 -5.6

15% Profit cost of cap 31.25 16.25 6.25 2.5 37.5 18.75 decrease profit & EVA Profit 31.25 16.25 EVA 15.00 3.75 18.75

15.00