Investments in Assets
Both A Strategic and a Control issue
Why long term investment is a
strategic issue
 Long term investment decisions are made after
long term strategy is decided (not the other way
around).
 Also, strategic leverage affects how much
investments in long term assets are necessary.
 Consequently, if decisions about long term
investments are made incorrectly, strategy and
strategic leverage are less likely to be
accomplished.
Why long term investments is a
control issue?
 Long term investments are generally huge in their
monetary and non-monetary impact.
 As such, if managers and others do not take all
precautions when investing and later, in
measuring the usefulness of the assets and their
contribution, it will have significant adverse
impact.
 Therefore, measuring long term assets is also a
control issue of great importance.
Before we discuss measurement of long-term
assets and alternative
measurement methods,
let us discuss why it is important to measure
long term assets and what specific factors
confound the valuation process.
Characteristics of long-term assets
 Long-term assets (Building, Plant, Machinery,
Information Technology)
 Short-term assets (Inventory, Accounts
Receivable, Cash)
 Long-term assets - an organization is committed
for a long period of time.
 The lack of investment could cause opportunity
losses or the investment could cause excess
capacity.
 The investment amount is usually large.
Regardless, when an organization makes
long term investment
The investment must:
– Lead to generation of adequate profits and
– the return (ratio of profits generated compared
to total investments) must be adequate.
– What is “adequate” return and which
investment is better than other alternatives are
the focus of this chapter.
Please remember that
Every investment competes with alternative
investments and,
No organization, however large it is, has
resource constraints; and therefore,
A company must choose its investment
strategy judiciously and such a strategy
Must be carried out within the overall
strategic framework – deciding priorities
and allocating resources.
Before choosing an evaluative
methodology, a manager must
determine the following:
 How to determine investment priorities (what
tangible and intangible benefits must be taken
into account)?
 How to assess the risk of each investment?
 How to establish a process for managing the
realization of expected benefits? This is a long
term issue, and
 How to justify the investments (how it fits
within the overall strategy)?
Perfoming investment analysis
Why relate profits to investments?
 Unless an organization is a 100% service
organization, profits are generated ONLY if you
have investments.
 Therefore, earning a satisfactory return on the
investments employed is necessary.
 The investors in stock compute such a return
routinely (e.g. Ford and G.M.).
 To compare two units, A and B, without
considering the investment made in each is
meaningless.
Why relate profits to investments?
The Manager’s Responsibility
First, a manager should invest in assets only
if the assets will produce adequate returns.
Second, when an asset is not providing
adequate return (the expected return could
change over the years), it is time to
“disinvest” or reduce further investments
into this asset.
Two ways to relate profits and
investments and to compare investment
alternatives
Return on Assets (ROA) and
Economic Value Added (EVA).
Return on Assets (ROA)
(let us use Exhibit 7.1 of your textbook)
ROA is a ratio of two numbers:
Income
ROI = -------------------------------------Average Assets (or Investment)
Note: Most times, average assets is - (the beginning of
the year equity + end of the year equity / 2). Equity for
this purpose would be defined as the stockholders’
equity + long term liabilities. From exhibit 7.1,
ROA = 100 (net income) / 500 (Equity) = 20%
(In exhibit 7.1, there are no long term liabilities).
Economic Value Added (EVA)
EVA=
Net income - (operating
assets)*cost of capital
EVA or Economic Value Added
EVA=
Net income - (operating
assets*cost of capital)
Note: Unlike ROA, EVA is not a ratio but a monetary
amount
Note: Operating Assets*Cost of Capital = Capital
charge.
Use exhibit 7.1 to compute EVA Net Income = 100
Capital charge – Equity * .10 = 50
EVA = 100 – 50 = 50
What is cost of capital?
 The minimum return an organization must earn
on its investments to meet investor expectations.
 Cost of capital is specific to each organization and
depends on several factors such as the type of
industry in which it operates, how risky the
organization is, the rate at which it can borrow
from outside and more (borrowing, in this context,
refers to both debt and equity).
 If an investment returns more than the cost of its
capital, the investment is positive and if not, it is
negative and as well not invested.
How asset values can distort
ROA and EVA Computations
ROA and EVA computations are simple.
However, depending on the asset based
used, they can give misleading signals.
Most long term assets are depreciated.
Everyone comfortable with depreciation
computations?
Depreciation reduces the book value of the
assets as they age.
Depreciation distorts ROA, EVA
Computations
 We will use the numbers from Exhibit 7.1, 7.3 and 7.4
 New Machine costs 100,000. Life 5 years
 Savings by using the new machine $27,000 per year or
on a Present Value basis for five years, $102,400 with
a net present value of $2,400 (102,400 - $100,000).
 Before this new asset is acquired, the annual
depreciation on fixed assets was $50,000 per year and
 After the new asset is purchased, the annual
depreciation will go up by $50,000 + 100,000 /5) =
$70,000.
See computations for before and after
purchase of asset - ROI and EVA are
overstated (See exhibit 7.1)
Before 1 year after
Profit before depreciation
Expenses (w/o Deprecn.)
Profit before depreciation
Depreciation
Profits after depreciation
Purchase
Purchase
of asset
of asset
$ 1,000,000 $ 1,000,000
( 850,000)
( 823,000)
150,000
177,000
(50,000)
(70,000)
$ 100,000 $
107,000
Equity
$
Capital charge at 10%
EVA (Profits – Cap. Charge)
ROA
500,000 $
50,000
50,000
20%
500,000
60,000
47,000
21.4%
Interpretation of the previous slide
 The profit before depreciation has remained constant at
$100,000 before and after purchase of the asset and yet
 The ROA went up from 20% to 21.4%. Why? Simply
because the depreciation expenses went up.
 In contrast, the EVA declined from 50,000 to 47,000
making it look like profits decline after purchase of the
asset (even though the income before taxes had actually
increased from $100,000 to $107,000).
 That is, a manager can make the wrong decision not to
purchase the asset based on these computations.
 In later years, the EVA will go up and so will the ROA
because of additional depreciation.
One more example of ROA increase just
by the passage of time and even without
acquiring a new asset.
Year 1
Year 2
Year 3
Profit before depreciation $ 110,000
Depreciation
$ 50,000
Profit after depreciation $ 60,000
$ 110,000
$ 50,000
$ 60,000
$110,000
$ 50,000
$ 60,000
Equity
ROI
$ 450,000
13.3%
$400,000
15%
$ 500,000
12.0%
ROI can lead to poor decisions
 Encourages division managers to retain assets
beyond their optimal life and not to invest in new
assets which would increase the denominator.
 Can cause corporate managers to over- allocate
resources to divisions with older assets because
they appear to be relatively more profitable.
 Capital may be allocated towards least profitable
divisions, at the expense of the most profitable
divisions.
ROI – the bad decisions
Can lead to different inventory policies and
decisions in different divisions, even for
identical items of inventory.
If corporate managers are not aware of
these distortions or do not adjust for them,
they can do a poor job of evaluating the
divisional managers and their
performances.
How to deal with this issue?
When computing ROA or EVA, don’t use
net book value of the asset but use gross
book value (original purchase price
ignoring depreciation).
See ROA computations from your exhibit
using gross value
Before
Profit before depreciation
Expenses (w/o Deprecn.)
Profit before depreciation
Equity
Capital charge at 10%
ROA
1 year after
Purchase
Purchase
of asset
of asset
$ 1,000,000 $ 1,000,000
( 850,000)
( 823,000)
150,000
177,000
$
500,000 $
50,000
150/500
=
30%
500,000
60,000
177/500
35.2%
Advantages of using EVA (residual
income)
 EVA ranks project on profits in excess of the
cost of capital (EVA increases).
 With EVA, all business units have the same
profit objective for comparable investments.
 EVA permits the use of different interest rates
for different investment projects.
 EVA has greater correlation with a firm’s
market value (it optimizes shareholder value).
ROA versus EVA
In practice, most businesses use ROA
because it is simpler to compute and
understand.
It is also comprehensive in the sense that it
considers the entire balance sheet and
income statement.
Unlike ROA – a percentage, EVA is a dollar
amount and does not allow for intra and
inter company comparisons.
Then, why use EVA? The Advantages
 EVA uses the same profit objectives; this
overcomes the problem of depreciation and
varying incentives to invest in assets.
 EVA, on the contrary, finds any investment that
returns over the cost of capital as worth investing.
 EVA permits use of different rates of interest to
each project (since some investments or more/less
risky than others.
 EVA (unlike ROA) is more positively correlated to
stock values.
What are intangible assets?
Not all benefits that accrue are so easy to
objectively measure and not all investments
are in tangible form (physical).
Intangible assets include items that lack of a
physical form but are nevertheless
important for a firm to measure and
understand. e.g. R& D, Marketing
promotions, investments in IT.
Why should a firm invest in intangible
assets?
Intangible assets signal a firm’s ability to:
Introduce new products
Develop customer relationships (marketing,
advertising, promotional schemes)
Approach new customer segments
Improve product quality and services
Manage cost, reduce lead times, and more.
Since the benefits from these efforts accrue
over a long time and into the future, these
investments could be capitalized.
How does an organization measure
intangible assets?
 Relative value. Measure progress, not a
quantitative target, that is the ultimate goal.
Example: have 80% of employees involved with
the customer in some meaningful way.
 Balanced scorecard: we will discuss these in the
performance measures chapter.
 Competency models. By observing and classifying
the behaviors of "successful" employees
("competency models") and calculating the
market value of their output.
Measuring Intangible Assets
4. Subsystem performance. Sometimes it's
relatively easy to quantify success or progress in
one intellectual capital component. For example,
Dow Chemical was able to measure an increase in
licensing revenues from better control of its patent
assets.
 5. Benchmarking. Involves identifying companies
that are recognized leaders in leveraging their
intellectual assets, determining how well they
score on relevant criteria, and then comparing
your own company's performance against that of
the leaders.
Measuring Intangible Assets
 6. Business worth. Ask 3 questions: What would
happen if the information we now use disappeared
altogether? What would happen if we doubled the
amount of key information available? How does
the value of this information change after a day, a
week, a year? Evaluation focuses on the cost of
missing or underutilizing a business opportunity,
avoiding or minimizing a threat.
Measuring Intangible Assets
7. Brand equity valuation. Methodology that
measures the economic impact of a brand
(or other intangible asset) on such things as
pricing power, distribution reach, ability to
launch new products as "line extensions."
8. "Calculated intangible value." Compares
a company's return on assets (ROA) with a
published average ROA for the industry.
Measuring Intangible Assets
9. "Colorized" reporting. Suggested by SEC
commissioner Steven Wallman, this method
supplements traditional financial statements
(which give a "black and white" picture)
with additional information (which add
"color"). Examples of "color" include
Brand values, customer satisfaction
measures, value of a trained work force.
Intangible assets and
investment analysis
 Calculate ROA/EVA ignoring intangible benefits.
If the return is less than what is acceptable, ask
whether the intangible benefits are worth at least
the amount of the difference between what is
acceptable and what the expected return is.
 Project rough, conservative estimates of the value
of the intangible benefits, and incorporate these
values into the investment calculation.