Thursday, July 9, 2009

(71)---RETURN ON INVESTMENT (ROI) AND DECISION MAKING.



Return On Investment(ROI) and decision making.


New investment.


If investment centre performance is judged by ROI, should expect that the managers of investment centre will probably decide to undertake new capital investment only if these new investment are likely to increase the ROI of their centre.

The target returns for a group of companies.



If a group of companies sets a target return for the group as a whole, it might be group policy that investment projects should only go ahead if the promises to earn at least the target return.


Discounted Cash Flows(DCF) Vs ROI.


In spite of the superiority of DGF yield over accounting ROI as a means of evaluating investment, and in spite of the wisdom of taking a longer term view rather than a short term view with investment, it is nevertheless an uncomfortable fact that the consideration of short-run accounting ROI does influence investment decisions.
A similarly misguided decision would occur where a divisional manager is worried about the low ROI of his decision, and decides to reduce his investment by scrapping some machinery which is not currently in use. The reduction in both depreciation charge and assets would immediately improve the ROI. When the machinery is eventually required the manager would then be obliged to buy new equipment. Such a situation may seem bizarre, but does occur in real life.
ROI should not be used to guide management decisions but there is a difficult motivational problem. If management performance is measured in term of ROI, any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager’s reported performance. In other words, good investment decisions would make a manager’s performance seem worse than if the wrong investment decision were taken instead.


Residual Income (RI)


An alternate way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre’s profits after deducting or imputed interest cost.

  • The centre’s profit is after deducting depreciation on capital equipment.
  • The imputed cost of capital might be the organization’s cost of borrowing or its weighted average cost of capital.
Residual income (RI) is “pretax profits less an imputed interest change for invested capital” Used to assess divisional performance.

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