Most of the companies employing investment centers evaluate business units on the basis of Return on Investment (ROI) rather than Economic Value Added (EVA). There are three apparent benefits of an ROI measure.
- First, it is, a comprehensive measure in that anything that affects financial statements is reflected in this ratio.
- Second, Return on Investment (ROI) is simple to calculate, easy to understand, and meaningful in an absolute sense. For example, an ROI of less than 5 percent is considered low on an absolute scale, and an ROI of over 25 percent is considered high.
- Finally, it is a common denominator that may be applied to any organizational unit responsible for profitability, regardless of size or type of business. The performance of different units may be compared directly to one another. Also, ROI data are available for competitors and can be used as a basis for comparison.
The collar amount of Economic Value Added (EVA) does not provide such a basis for comparison. Nevertheless the EVA approach has some inherent advantages. There are four competing reasons to use EVA over ROI:
- First, with EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other hand, provide, different incentive; for investments across business units. For example, a business unit that currently is achieving an ROI of 30 percent would be reluctant to expand unless it is able to earn on ROI of 30 percent or more on additional assets: a lesser return would decrease its overall ROI below its current 30 percent level. Thus, this business unit might forgo investment an opportunity that’s ROI is above the cost of capital but below 30 percent.
- The use of ROI as a measure deals with both these problems. They relate to asset investment whose ROI falls between the cost of capital and the center’s current ROI. If investment center’s performance is measured by EVA, investments that practice a profit in excess of the cost of capital will increase EVA and therefore economically attractive to the manager.
- A third advantage of EVA is that different interest rates may be used for different types of assets. For example, a low rate may be used for inventories while a relatively higher rate may be used for investments in fixed assets. Furthermore, different rates may be used for different types of fixed assets to take into account different degrees of risk. In short, management control systems can be made considered with the framework used for decisions about capital investments and resources allocation. It follows that the same type of asset may be required to earn the same return throughout the company, regardless of the particular business nits profitability. Thus, business unit managers should act consistently when a deciding to invest in new assets.
- A fourth advantage is that EVA, in contrast to ROI, has a stronger positive correction with changes in a company’s market value. There are several reasons why shareholder value creation is critical for the firm: It (a) reduces the risk of takeover, (b) creates currency for aggressiveness in mergers and acquisitions, and (c) reduces cost of capital, which allows faster investment for future growth, Thus, optimizing shareholder value is an important goal of an enterprise. However, since shareholder value measures the worth of the consolidated enterprise as whole n is nearly impossible to use it as a performance criterion for an organization individual responsibility centers. The best proxy for shareholder value at the business unit level is to ask business unit managers to create and grow EVA. It indicates that companies with high EVA tend to show high market value added (MVA) or high gains for shareholders. When used as a performance metric, EVA motivates managers to increase EVA by taking actions consistent with increasing stockholder value.
Credit: Business Finance-CU