Measuring and Controlling Assets Employed

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Presentation transcript:

Measuring and Controlling Assets Employed Management Control Systems Chapter 7 August 2014 Iwan Pudjanegara, SE., MM.

Purpose To provide information that is useful in making sound decisions about assets employed and to motivate managers to make these sound decisions that are in the best interests of the company. To measure the performance of the business unit as an economic entity. August 2014 Iwan Pudjanegara, SE., MM.

The Investment Base The Investment Base : the sum of the principal types of assets that may be employed in an investment center. An Investment Center : a special type of profit center. 2 methods of Investment Base : ROI & EVA (Economic Value Added) August 2014 Iwan Pudjanegara, SE., MM.

Methods of Investment Base Return On Investment (ROI) Income ROI = ----------------- x 100 Investment August 2014 Iwan Pudjanegara, SE., MM.

Methods of Investment Base Economic Value Added (EVA) EVA = Net Profit – Capital Charge Capital Charge = Cost of Capital x Capital employed = Required rate of return x Capital employed EVA = Capital employed (ROI – Cost of Capital) August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI Example: PT. APN has a property business in Indonesia. As of Dec 31, 2013 its financial statement include of: Current Assets = Rp 100 Billion Fixed assets = Rp 400 Billion Net Profit = Rp 50 Billion August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI Required Rate of Return for investing in: Current Assets = 5% Fixed Assets = 7,5% Question: Calculate ROI & EVA for PT. APN’s property business!!! (see also Exhibit 7.12 page 286) August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI Answer : Total Investment = CA + FA = Rp 100 bio + Rp 400 bio = Rp 500 billion. ROI = (Net Income : Investment) x 100% ROI = (Rp 50 bio : Rp 500 bio) x 100% = 10% Capital Charge = (5% x Rp 100 bio) + (7,5% x Rp 400 bio) = Rp 35 billion EVA = Net Profit – Capital Charge = Rp 50 bio – Rp 35 bio = Rp 15 billion. August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI 3 Benefits of an ROI measure : It is a comprehensive measure in that anything that affects financial statements Simple to calculate, easy to understand and meaningful in an absolute sense. It is a common denominator that may be applied to any organizational unit responsible for profitability. August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI Advantages to use EVA over ROI : With EVA all business units have the same profit objective for comparable investments. The ROI approach provides different incentives for investments across BUs. August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI Decisions that increase a center’s ROI may decrease its overall profits. If an investment center’s performance is measured by EVA, investments that produce a profit in excess of the cost of capital will increase EVA and therefore be economically attractive to the manager. August 2014 Iwan Pudjanegara, SE., MM.

EVA vs ROI Different interest rates may be used for different types of assets, to take into account different degrees of risk. EVA has a stronger positive correlation with changes in a company’s market value. August 2014 Iwan Pudjanegara, SE., MM.

Shareholder Value Creation Why shareholder value creation is critical for the firm? Reduces the risk of takeover Creates currency for aggressiveness in mergers and acquitisions Reduces cost of capital, which allow faster investments for future growth. August 2014 Iwan Pudjanegara, SE., MM.