Net Present Value (NPV)
Definition:
1) The after-tax cash flow (before debt service) discounted at the weighted after-tax cost of capital, or
2) the free cash flow (after tax and debt service) discounted at the cost of equity
NPV =

Cash Flown
(1 + Discount Rate)n
Pros
Cons
• Fully aligned with value
- Single value incorporates string
of future values
• Works for all types of opportunities
and at all levels of the organization
• Not a sufficient measure on its own
- Opportunities with same NPV could
have different timing of cash flows
- Doesn’t compare the value of the
project vs. the size of the
investment
• Requires training to be used effectively
Conclusion
• Preferred primary measure for
decision making. Other measures
and tools must supplement,
especially at the company level.
Training is essential.
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Profitability Index Ratio (PI)
Definition:
PI =
Present Value of Cash Inflows
Present Value of Cash Outflows
Pros
Cons
• Aligned with value
• Single value that incorporates string
of future values
• Works for all opportunities at all
levels
• Not sufficient on its own:
- Opportunities with same PI could have
different timing of cash flows and capital
- Cannot determine project scale
- Ranking on PI breaks down when more
than one resource is rationed or when
resources are rationed for multiple yrs
• Requires education and experience to use
effectively
Conclusion
• A useful auxiliary measure for
prioritizing projects in a capital
constrained environment. Requires
that NPV be calculated.
2
Internal Rate of Return (IRR)
Definition:
Discount rate at which an investment’s NPV equals zero. If IRR exceeds the opportunity cost of capital
for a company, then an investment should be undertaken. Cash flows are assumed to be reinvested at
the rate of return.
Pros
Cons
• Doesn’t necessarily have a unique
solution
• Projects could have the same IRRs but
different timings of cash flow
• Doesn’t compare the value of the project
vs. the size of the investment
• Difficult to include risk
• Requires education and experience to
use effectively
• Aligned with value
• Single value incorporates string of
future values
• Works for all opportunities at all
levels
Conclusion
• Can be used for decision-making,
but NPV is a superior measure
because of the calculational issues
associated with IRR
3
Cash Flow Return on Investment (CFROI)
Definition:
Essentially a form of IRR. CFROI is an efficiency measure that compares cash flows with the total
assets employed to generation those flows.
CFROI = Cash Flow + Non-Depreciating Assets - Inflation Adjusted Gross Assets where
Cash Flow = Net Income + Depreciation/Amortization Expense + Interest Expense + Minority Interest + Rental Expense
+/- Holding Gains (Losses) - FIFO Profits
Non-Depreciating Assets = Cash + Land + Accounts Receivable + Inventory
Inflation Adjusted Gross Assets = Book Assets + Accumulated Depreciation + Gross Plant Inflation Adjustment + Inflation
Adjusted LIFO + Operating Leases - Non-Debt Monetary Liabilities
Pros
Cons
• Aligned with value
• Single value incorporates string of
future values
• Works for all opportunities at all
levels
• Doesn’t necessarily have a unique solution
• Projects could have the same CFROIs but
different timings of cash flow
• Doesn’t compare the value of the project vs.
the size of the investment
• Difficult to include risk
• Requires education and experience to use
effectively
Conclusion
• Can be used for decision-making,
but NPV is a superior measure
because of the calculational issues
associated with CFROI
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Economic Value Added (EVA)
Definition:
An approximation of value creation over a specified period. The NPV of EVA estimates is the same as
the NPV of cash flow.
EVA = NOPAT - After-tax Cost of Capital Employed to Produce NOPAT
= (Rate of Return - Cost of Capital) * Capital
= Operating Profit - (Cost of Capital * Capital)
Pros
Cons
• Not well aligned with long-term value:
- Single year measure
- Can lead to short-run focus
- Does not recognize value of
reserves
• Can be made complicated with
adjustments
• Not cash based
• PV of EVAs is equivalent to NPV
• Shows actual $$$ added to
company value (vs. % increase)
Conclusion
• Could be used as a short-term value
indicator. Would be a candidate as
a long-term value indicator if
measure were modified to include
reserves.
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Return on Assets (ROA)
Definition:
Rate of return earned on the total capital invested in the firm without regard to whether that capital is
called debt or equity. Reflects the fundamental earning power of the company before it is confounded
by differences in financing strategies. Measures profit as a percent of total assets.
EBIT * (1 - Tax Rate)
Total Assets
ROA =
Pros
Cons
• Can be tailored for company/
division/business unit levels with
some adjustments
• Useful for learning purposes
• Can be measured “real-time”
• Short-term focus only
• Does not recognize value of reserves
• Return measure, so doesn’t convey $
value of value delivered
• Not comparable across assets (different
assets will have different ROAs)
Conclusion
• Useful for learning on mature
assets, but not solely appropriate for
real-time monitoring of value
creation and delivery because it
lacks a long-term balance.
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Return on Equity (ROE)
Definition:
Estimate of the earnings per dollar of invested equity capital or, alternatively, the percentage return to
owners on their investment in the firm.
ROE =
Net Income - Preferred Dividends
Book Value of Shareholder’s Equity
Pros
Cons
• Easy to calculate
• Uses book rather than market value
of shareholder’s equity, thus is not
distorted due to market conditions
• Does not work below the corporate level
• Backwards looking measure that cannot
serve as an indicator of future value
creation
• Return measure, so doesn’t convey $
value of value delivered
• Ignores return on debt capital
Conclusion
• Not appropriate for decision-making
because measure does not work
below the corporate level
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Return on Net Assets (RONA)
Return on Capital Employed (ROCE)
Definition:
Measures the efficiency with which a company allocates and manages its resources.
RONA/ROCE =
EBIT * (1 - Tax Rate)
Total Assets - Current Liabilities
Pros
Cons
• Short-term focus only
• Does not recognize value of reserves
• Return measure, so doesn’t convey $
value of value delivered
• Not comparable across assets (different
assets will have different RONAs)
• Can be tailored for company/
division/business unit levels with
some adjustments
• Useful for learning purposes
• Can be measured “real-time”
Conclusion
• Useful for learning on mature
assets, but not solely appropriate
for real-time monitoring of value
creation and delivery because it
lacks a long-term balance.
8
Total Shareholder Return (TSR)
Definition:
Annual measure of stock appreciation
TSR =
Year-end Stock Price - Initial Stock Price + Dividends
Initial Stock Price
Pros
Cons
• Aligned with long-term value
creation
• Easy to measure on a real-time
basis if company is public
• Can be affected by market
conditions not attributable to a
company’s performance, particularly
in the short term
• Only allows for corporate level
measurement
Conclusion
• Not appropriate for business
monitoring because market effects
can dwarf company effects in the
short-term. Measure also does not
work below the company level.
9
Market Value Added (MVA)
Definition:
Measure of the company’s gross market value less the cumulative capital investment made to date.
Should be equivalent to NPV.
MVA = # Shares Outstanding * Current Share Price + Outstanding Debt - Historical Capital Invested
= PV of all Future EVAs (theoretically)
Pros
• Easy to calculate if company is
public
Cons
• Can be affected by market
conditions not attributable to a
company’s performance, particularly
in the short term
• Only allows for corporate level
measurement
Conclusion
• Not appropriate for business
monitoring because market effects
can cloud performance.
• Cannot be used below the company
level.
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