Performance Management: Part 2

What are the limitations of ROI?

- Short-term focus - Disincentive to invest

What is the equation for the DuPont ROE?

Dupont ROE = Net profit margin * Asset turnover * Financial leverage where: - Net profit margin = Net income/Sales - Asset turnover = Sales/Average total assets - Financial leverage = Average total assets/Equity

Define economic value added (EVA). How does EVA differ from residual income?

EVA measures the excess of income after taxes earned by an investment over the rate of return defined by the company's WACC. EVA differs from residual income in the following ways: - WACC must be used to calculated EVA. - The income and investment numbers used to calculate EVA are generally adjusted to produce a more accurate analysis of economic profit.

What is the equation for the extended DuPont ROE?

Extended DuPont ROE = Tax burden * Interest burden * Operating income margin * Asset turnover * Financial leverage where: - Tax burden = Net income/Pretax income - Interest burden = Pretax income/EBIT - Operating income margin = EBIT/Sales - Asset turnover = Sales/Average total assets - Financial leverage = Average total assets/Equity

Define return on equity (ROE)

ROE is a measure of the rate of return earned by a company on the equity component of its capital structure. It shows how well a company is using its funds to generate earnings.

What is the formula for residual income?

Residual income = Net income - Requires return Where the required return is equal to: Net book value * Hurdle rate = Required return If the amount of the income from the investment exceeds the computed required return, performance objectives have been met.

Define return on investment (ROI).

Return on investment is used to assess the percentage return relative to capital investment risk. ROI can be calculated as income divided by invest capital or as a product of profit margin (income/sales) and investment turnover (sales/assets).

Define the steps and formula for economic value added.

Step 1: Calculate the required amount of return and income after taxes. Investment * Cost of capital = Required return Step 2: Compare income to the required return. Income after taxes - Required return = Economic value added

Define residual income.

The residual income method measures the excess of actual income earned by an investment over the hurdle rate.