Different Methods To Evaluate The Performance Of An Investment Centre

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Mar 20, 2007
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What are the different methods to evaluate the performance of an investment centre? Discuss the merits and demerits of each? Which method would you recommend?
The following techniques are useful in evaluating the performance of an investment centre:

Return on investment (ROI)
The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit.

ROI = Profit / Invested capital * 100
ROI consists of two components viz.

a.Profit margin
b.Investment turnover

ROI = Net profit / Investment
= (Net profit / Sales) * (Sales / Investment in assets)​

It will be seen from the above formula that ROI can be improved by increasing one or both of its components viz. the profit margin and the investment turnover in any of the following ways:
•Increasing the profit margin
•Increasing the investment turnover
•Increasing both profit margin and investment turnover

Capital employed is taken to be the total of shareholders funds, loans etc

The profit figure used is in calculating ROI is usually taken from the profit and loss account, profit arising out of the normal activities of the company should only be taken.

Capital employed for the company as a whole can be arrived at as follows:



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Merits:
Return on investment analysis provides a strong incentive for optimum utilization of the assets of the company. This encourages managers to obtain assets that will provide a satisfactory return on investment and to dispose off assets that are not providing an acceptable return. In selecting among alternative long-term investment proposals, ROI provides a suitable measure for assessment of profitability of each proposal.

Demerits:
ROI analysis is not very suitable for short-term projects and performances. In the initial stages a new investment may yield a small ROI which may mislead the management. Most likely the rate would improve in course of time when the initial difficulties are overcome.

The book value of assets decline due to depreciation, the investment base will continuously decrease in value, causing the rate of return to increase.

Residual income
Residual income can be defined as the operating profit (or income) of the company less the imputed interest on the assets used by the company. In other words, interest on the capital invested in the company is treated as a cost and any surplus is the residual income.

Residual income is profit minus notional interest charge on capital employed. Residual income is affected by the size of the organization and therefore will not provide a basis for evaluation of organizational performance. This is probably the main reason why the management continues to make use of ROI which is relative measure.

Not all projects start off with positive or sufficiently large positive profits in the early years of a project to produce a positive increment to residual income.

It has been argued that a more suitable measure of performance for investment centres, which could encourage managers to be more willing to undertake marginally profitable projects, is residual income.

We recommend RI as a method of evaluating performance of an investment centre. Because when RI is adopted for evaluation purposes, emphasis is placed on marginal profit amount above the cost of capital rather than on the rate itself.
 
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