Question

(Improving ROI)
• The following data pertain to British Isles
Aggregates Company, a producer of sand,
gravel, and cement, for the year just ended.

1
 £

Sales
revenue…………….………………
……………………………………... 2,000,000

Cost of goods
sold…………………………………
………………………….... 1,100,000

Operating
expenses……………………………
…………….…………….…… 800,000

Average invested
capital………………………………
………….……….……. 1,000,000

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• Required:
• Compute the company’s sales margin, capital
turnover, and ROI.
• If the sales and average invested capital
remain the same during the next year, to what
level would total expenses have to be reduced
in order to improve the firm’s ROI to 15
percent?
• Assume expenses are reduced, as calculated in
requirement (2). Compute the firm’s new sales
margin. Show how the new sales margin and
the old capital turnover together result in a
new ROI of 15 percent. 3
 Sales (Income/ Sales revenue)
(1). margin = *100
Sales margin
= (100000/ 2000000)*100
Sales margin
= 5%

Capital
turnover = Sales revenue/ Average invested capital
Capital
turnover = 2000000/ 1000000
Capital
turnover = 2 times

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Return On
Investment= (Income/ Average invested capital) *100
Return On
Investment= (100000/ 1000000)*100
Return On
Investment= 10%

Return On
Investment= Sales margin* Capital turnover
Return On
Investment= 5% * 2
Return On
Investment= 10%
5
Working:
Sales
revenue $2,000,000
Less:
COGS (1,100,000)
Gross
Profit 900,000
Less:
Operating
exp. (800,000)
Net
Income $100,000

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 Desired return on capital invested is 15%, i.e.
(2). 1,000,000*15% = 150,000
Therefore, the Net Income should be amounting 150,000,
if sales remain the same.

Sales
revenue $2,000,000
Less: COGS (1,100,000)
Gross Profit 900,000
Less:
Operating
exp. (750,000)
Net Income $150,000
The operating expenses are to be reduced by 800,000 -
750,000 = $50,000
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 Working:
Gross profit - Operating exp. = Net income
Operating exp.
i.e. = Gross Profit - Net income
Operating exp.
= 900000 - 150000
Operating exp.
= $750,000

New sales (New Income/ Sales revenue)

(3). margin = *100
New sales
margin = (150000/ 2000000)*100
New sales
margin = 7.5%

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 New sales margin*Old
ROI = capital turnover
7.5% *
ROI = 2
ROI = 15%

Note: If Sales and Capital Invested remaining the same, the

Capital Turnover will also remain the same.

9
 Economic Value Added
• The principle objective of financial
management is to maximize shareholders
wealth. This raise two questions:
– How can we measure whether shareholders value
is being created or destroyed?
– Which performance appraisal targets ensure that
managers act in such a way as to generate
shareholders value?

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 Economic Value Added
• Cash is Preferable to Profit: Cash flows have a
higher correlation with shareholders wealth than
profit.
• Exceeding the Cost of Capital: The return must be
sufficient to cover not the cost of debt but also
the cost of equity.
• Managing both Long & Short-term Perspective:
Investors are increasingly looking at long-term
value. When valuing a company’s shares, the
stock market places a value on the Company’s
future potential, not just the current profit level.

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 EVA ALTERNATES

• To survive in today’s corporate world the imperative for

the companies to create value for all stakeholders, not
least of which is the shareholder.
• The concept of economic profit, of which one of the
best known variant is the economic value added.
• Economic Profit recognizes that the one major cost
that the conventional profit & loss account does not
take into account is the cost of capital used in
generating profit.
– Economic Profit = Net Operating Profit After Tax (NOPAT) –
(Invested capital x Cost of Capital)
– EP = Rs. 1m – (Rs. 10m x 5%) = Rs. 0.5m

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 Economic Value Added
• Alternate Approach 1: Discounted Cash Flow
(DCF) & Net Present Value (NPV).
Most of us will be familiar with the NPV approach
to project appraisal. This method involves the
following steps:
1) Determine the relevant, incremental cash flows
for the project.
2) Discount the cash flows using an appropriate
rate that reflects the risk of the project.
3) Accept the project if the NPV > 0.

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 Economic Value Added
• Alternate Approach 2: Shareholder Value Analysis (SVA)
The SVA approach described by Alfred Rappaport, is a variation of
the DCF methodology in that it values the whole enterprise not just
individual projects. Central to the approach are seven value drivers;
– Sales growth
– Operating Profit Margin
– tax rate
– Incremental working capital investment (IWCI)
– Fixed Capital Investment to support current activity level (replacement
fixed capital investment (RFCI) to support future growth incremental
fixed capital investment (IFCI))
– Cost of Capital
– Competitive advantage period OR value growth duration during which
the firm is expected to generate superior returns in excess of its cost
of capital

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 Economic Value Added
• The SVA Method involves the following step:
• Estimate the free cash flows within the advantage period by
reference to the value drivers.
• Discount these cash flows using either a company-wise weighted
average cost of capital (WACC) or separate business unit discount
rates.
• Add to the result the present value of the firm at the end of the
forecast period.
• This is known as the ‘ residual value ‘ , and is usually calculated by
discounting simplified cash flows ( e.g. Zero or constant growth)
beyond the competitive advantage period.
• Add the market value of non -trade or non- operational assets to
the result to get the corporate value that belongs to all investor.
• The value of Equity is then determined by deducting the value of
debt.

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• Example 1: You have been asked to value a potential acquisition . The
following info regarding the target is available :
– Current sales – Rs 10 Million per annum
– Competitive advantage period – 5 years
– Value driver information
Year 1 2 3 4 5 Beyond
Sales Growth (%) 8 5 7 6 5 0
Operating Profit Margin (%) 20 20 17 15 12 10
tax Rate (%) 30 30 30 30 30 30
IFCI (%) 2 3 5 4 2 0
IWCI (%) 10 10 12 8 5 0
Cost of Capital (%) 14 14 14 14 14 14
– Depreciation - Rs. 5m pa
– Market value of short-term investments is Rs.10m
– Market value of debt is Rs.15m
– Operating Capital Rs.3m
– Value the business using SVA
Note: IFCI & IWCI are given as percentages of the moment in sales from the period of the next
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 Solution
Rs. In Million 1 2 3 4 5 6
onwards

Sales 10.80 11.34 12.13 12.86 13.50 13.50

Operating Profit 2.16 2.27 2.06 1.93 1.62 1.35
Tax (0.65) (0.68) (0.62) (0.58) (0.49) (0.41)
Profit after tax 1.51 1.59 1.44 1.35 1.13 0.94
Depreciation 5 5 5 5 5 5
Operating cash flow 6.5 1 6.59 6.44 6.35 6.13 5.94
RFCI (Note) (5) (5) (5) (5) (5) (5)
IFCI (0.02) (0.02) (0.04) (0.03) (0.01) 0
IWCI (0.08) (0.05) (0.09) (0.06) (0.03) 0
Free Cash flows 1.41 1.52 1.31 1.26 1.09 0.94
Discount factor 14% 0.877 0.769 0.675 0.592 0.519 3.707
PV 1.24 1.17 0.88 0.75 0.57 3.48

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PV of free CFs Within the Competitive 4.61 million
advantage period
PV of residual value 3.60 million
Plus: MV of non trade investments 10.00 million
Corporate Value 18.21 million
Less MV of Debt 15.00 million
MV of equity 3.21 million

(W) DF = 0.519 X 1/0.14 = 3.707

Note: Without further details, RFCI is often equated to
the annual depreciation charge.

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 Economic Value Added
• Alternate Approach 3: Economic Value Added (EVATM)
EVATM is the residual income that remains after net operating profit
after tax (NOPAT) has been reduced by additional charge, this
charge is based on the return investors can be expected to require,
given the amount of the capital they have tied up in the business.
Note that interest charges are not deducted to arrive at NOPAT, as
financing costs are incorporated into the capital charge. Therefore
we have:
EVATM = NOPAT – Capital Charge
= NOPAT – (Capital Charge x Cost of Capital)
It is therefore =very clear if profits are sufficient to cover the cost of
capital. This link can be made more explicit by rewriting EVATM ,
using the ‘spread method’ as:
EVATM = (ROI – Cost of Capital) x Capital, where ROI = NOPAT/capital 19
• Example 2: Using the same information as in Example 1,
calculate the EVATM for each year.
• Solution: In this example, a more complex calculation must be
made to obtain the capital figure as depreciation must be
deducted from the running total, and any further investment
(IWCL, RFCI, IFCI) added:

Rs. In Million 1 2 3 4 5 6 onwards

Capital b/f 3 3 3.17 3.3 3.39 3.43
RFCI 5 5 5 5 5 5
Depreciation (5) (5) (5) (5) (5) (5)
IFCI 0.02 0.02 0.04 0.03 0.01 0
IWCI 0.08 0.05 0.09 0.06 0.03 0
Capital c/f 3 3.17 3.3 3.39 3.43 3.43

The profit after tax figures obtained in Example 1 can then be

used to calculate the EVATM .
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 Profit after Tax 1.51 1.59 1.44 1.35 1.13 0.97
Cost of Capital (0.42) (0.43) (0.44) (0.46) (0.47) (0.48)
EVATM 1.09 1.16 1.00 0.89 0.66 0.49
• NOTE: Cost of Capital has been calculated using the capital B/F
figures making the cost of capital so visible to managers should result
in being more careful when choosing to invest further funds, and
exercising greater control over working capital investment.
• Proponents of EVATM argue that it also supports the NPV approach
investment appraisal .
• To see this , the Present Value of future EVATM figures can be
calculated , given the market value added ( MVA) to the business .
• To calculate the value of Equity , this needs to be added to the
opening capital and then adjustments made for non –trade assets
and debt , as for SVA.

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• Example 2: Using the EVATM figures calculated in Example 2,
calculate the market value of equity for the acquisition:
• Solution:

EVATM 1.09 1.16 1.00 0.89 0.66 0.49

Discount Factor (at 14%) 0.877 0.769 0.675 0.592 0.519 3.707
PV 0.96 0.89 0.68 0.53 0.34 1.82

Rs. m
MVA 5.22
Plus: Operating Capital 3.00
Plus: MV of investments 10.00
Less: MV of debt (15.00)
MV of Equity 3.22 (same as SVA
approach, subject
to rounding)

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 Economic Value Added
• The main problem with EVATM, however, is danger that
managers with short-term horizon will reject activities that
have negative EVATM in the first year, even though these
activities will deliver positive MVA over the longer term.
• The adjustments to capital described below, such as
capitalizing research expenditure, should reduce such
behavior cannot not eliminate it completely.

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 Economic Value Added
• The most common adjustments include:
– Replacing conventional depreciation with an estimate of the
‘economic depreciation’.
– Economic depreciation measures true fall in the value of the assets
each year through wear & tear obsolescence.
– Although depreciation would not normally be charged in calculating
discounted cash-flow, in this case economic depreciation must be
recovered from a company’s cash flow.
– Reversing out advertising costs from NOPAT and adding them to the
capital figure instead.
– This is seen because advertising is seen as market-building investment.
A small charge of advertising may remain in the profit & loss account
to reflect the economic depreciation of the capitalized value.
– In a similar way, research & development costs may be transferred
from being expenses to becoming part of capital.
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– Adjusting the tax charge to exclude the tax relief on interest payments
 Economic Value Added
• Alternate Approach 4: Cash-flow Return on Investment
(CFROI).
Cash-flow return on investment (CFROI) is a product of Boston
Consulting Group (BCG) and HOLT Value Associated.
CFROI is the long-term internal rate of return of the firm,
defined in a similar way to the more familiar IRR. The matter
has the following steps:
1. Convert profitability data into inflation-adjusted gross cash-flows
available to all capital owners of the firm. The approach works with
real cash-flow rather than nominal flows, hence the need for
inflation adjustments.
2. Calculate the implied investment based on real gross assets, again
inflation-adjusted where necessary. Intangibles, such as goodwill,
are normally excluded here. 25
 Economic Value Added
3. Calculate the finite economic life of depreciating assets and the
residual value of non-depreciating assets, such as land and
working capital.
4. BCG then calculates CFROI as the internal rate of return that
equates the present value of the future cash-flows with the
estimate of the current value of gross investment.

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 Conclusions

Shareholders value is a constant priority in many board

rooms.
The need for a wealth metric and a performance metric has
generated a range of solutions, but with mixed success.
Ultimately users choose the method best suit to their
solution.
CFROI is growing in use by potential investors, SVA is often
chosen for corporate planning decision, but EVATM appears to
offer the simplest and most consistent overall solution.

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 Transfer Pricing

The amount charged when one division

sells goods or services to another division.

Batteries

Battery Division Auto Division

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 Transfer Pricing

The transfer price affects the profit measure for

both the selling division and the buying division.

A higher transfer
price for batteries
means . . .

Battery Division Auto Division

Greater profits for Lower profits for
the battery division. the auto division.
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 Transfer Pricing

The ideal transfer price allows

each division manager to make
decisions that maximize the
company’s profit, while
attempting to maximize the
division’s profit.

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 Setting Transfer Prices
Market-based transfer prices are
preferred because they promote efficiency
and fairness.

When market prices are not available,

companies may use:
 Cost-based prices
 Negotiated prices

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 Negotiated Transfer Price
A system where transfer prices are arrived at
through negotiation between managers of buying
and selling divisions.

Excessive management
time may be used in the
negotiation process. May not be in the
best interest of
the company.
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 Cost-Based Transfer Prices
Cost-based transfer prices are the
least desirable because the incentive
to control cost is diminished.

When used, cost-based transfer prices . . .

– Are either variable cost or full cost.
– Should use standard rather than actual costs.

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 Setting Transfer Prices
Conflicts may arise between the company’s
interests and an individual manager’s interests
when transfer-price-based performance
measures are used.

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