Week_12_Questions_Answers -...

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1. What are the strengths and weaknesses of ROI and EVA? ROI Strengths: Weaknesses : Used to supplement the intuition and  insight of managers, particularly in an  environment where companies began  to diversify. It   is   able   to   be   manipulated   by   division  managers   in   order   to   better   reflect   their  performance, and hence enable them to reap  the rewards. It may be used as a goal for division  managers to meet. Gives the illusion of insight and control when  managers are taking actions that increase ROI,  but decrease long run value of their business  units.   It   is   a   better   measure,   but   by   no  means great, of measuring divisions  of   different   sizes   –   see   EVA  disadvantages. Can   cause   problems   when   evaluating   short  term profit performance.  o actions that   the divisional ROI can   make the corp. worse off. As ROI is measured by a ratio or percentage, it  can   motivate   the   division   manager   to   refuse  investments,   because   it   can   be   incorrectly  calculated.  EVA Strengths: Weaknesses: builds upon developments in financial  economics – CAPM – to derive a cost  of capital based on industry and risk  characteristics of individual divisions. EVA tends to reject NPV projects where high  returns are not received in the early life of the  investment not a good idea for a high growth firms It   is   calculated   after   adjusting   for  distortions   introduced   by   generally  accepted   accounting   principles  (GAAP) required for external financial  reporting,   eg:   whether   or   not   to  expense   or   capitalise   intangible  EVA   while   having   certain   advantages   over  GAAP earnings in performance evaluation is still  an accounting based measure.  Therefore, EVA  will be negative in the early years of a start-up  firm.   While the discounted value of EVA is consistent  with  NPV  the  managers  may not plan  to  be  around long enough to see positive cash flows.  Thus   the   plan   might   encourage   them   not   to  invest.   Produces   goal   congruence   between  the   actions   of   the   division   and   the  actions  that  maximise   the  economic  wealth of the division and the firm.  Does not differentiate between large and small  divisions of the firm.  It just gives a figure.  ROI  is a better measure in this regard, because it  gives results as a ratio or percentage. It   pays   no   attention   to   the   decision   making 
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This note was uploaded on 07/31/2011 for the course MGMT 2027 taught by Professor Shak during the Three '07 term at Queensland.

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Week_12_Questions_Answers -...

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