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. 1.
First, it is, a comprehensive measure in that anything that affects financial statements is reflected in this ratio. 2.
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. 3.
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: 1.
First, with EVA all business units have the same profit objective for com¬parable 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. 2.
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...
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