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Introduction

Definition of 'Return On Investment - ROI'

A performance measure used to evaluate the efficiency of an investment or tocompare the efficiency of a number of different investments. To calculate ROI, the

benefit (return) of an investment is divided by the cost of the investment; the result

is expressed as a percentage or a ratio.

The return on investment formula:

In the above formula "gains from investment", refers to the proceeds obtained from

selling the investment of interest. Return on investment is a very popular metric

because of its versatility and simplicity. That is, if an investment does not have a

positive ROI, or if there are other opportunities with a higher ROI, then the

investment should be not be undertaken.

Investopedia explains 'Return On Investment - ROI'

Keep in mind that the calculation for return on investment and, therefore the

definition, can be modified to suit the situation -it all depends on what you include

as returns and costs. The definition of the term in the broadest sense just attempts to

measure the profitability of an investment and, as such, there is no one "right"

calculation.

For example, a marketer may compare two different products by dividing the gross

profit that each product has generated by its respective marketing expenses. A

financial analyst, however, may compare the same two products using an entirely

different ROI calculation, perhaps by dividing the net income of an investment

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by the total value of all resources that have been employed to make and sell the

product.

This flexibility has a downside, as ROI calculations can be easily manipulated to

suit the user's purposes, and the result can be expressed in many different ways.

When using this metric, make sure you understand what inputs are being used.

A performance measure used to evaluate the efficiency of an investment or compare the

efficiency of a number of different investments. To calculate ROI, the return on an investment is

divided by the cost of the investment, as shown here; the result is expressed as a percentage or a

ratio. Return on investment is a popular metric because it is versatile and simple to use. If an

investment does not have a positive ROI or if there are alternative investment opportunities with

a higher ROI, the investment should not be undertaken.

Return on investment is a method of calculating profits from an investment. The gain is

converted to a percentage to facilitate uniform comparison. The usual formula is 100 X gain/cost.

The number is useful for comparing the performance of investments and resembles the yield paid

onfixed income investmentslike CDs.

The time period used for the calculation can vary, but the most common one is for the calendar

year or thefiscal year.

When stock investments are compared it is common to calculate the gain as the difference

between the closing value for a recent date and the closing value for one year earlier. When

dividendshave been paid ordistributionsfrom amutual fund, they are added to the gain.

In some cases cost is adjusted by subtractingdepreciationor other allowances likedepletion.

A negative value is reported when the result is a loss.
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When the time period exceeds one year, thecompound interest formulacan be used to calculate

the compounded rate of return for the investment.

When calculations are based on single stock prices, the number can vary wildly depending on the

particular times chosen to select stock prices. More reliable estimates can be obtained by

averaging prices over a specified period or by usingcurvefittingtechniques such asleast squares

(regression analysis) to fit a calculated line to a collection of stock prices. Then theslopeof the

calculated line approximates return on investment.

For example, if you invested $5,000 and the investment was worth $7,500 after two years, your

annual return on investment would be 25%. To get that result, you divide the $2,500 gain by

your $5,000 investment, and then divide the 50% gain by 2.

Return on investment includes all the income you earn on the investment as well as any profit

that results from selling the investment. It can be negative as well as positive if the sale price

plus any income is lower than the purchase price.

Purpose

The purpose of the "return on investment" metric is to measure per-period rates of return on

dollars invested in an economic entity. ROI and related metrics (ROA,ROC,RONAandROIC)

provide a snapshot of profitability adjusted for the size of the investment assets tied up in the

enterprise. Marketing decisions have obvious potential connection to the numerator of ROI

(profits), but these same decisions often influence assets usage and capital requirements (for

example, receivables and inventories). Marketers should understand the position of their

company and the returns expected. ROI is often compared to expected (or required) rates of

returnon dollars invested.
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Construction

For a single-period review just divide the return (net profit) by the resources that were committed

(investment):

Return on investment (%) = Net profit ($) / Investment ($) * 100 %

Calculation

The initial value of an investment, Vi, does not always have a clearly definedmonetary value, but

for purposes of measuring ROI, the expected value must be clearly stated along with the

rationale for this initial value. Similarly, the final value of an investment, Vf, also does not

always have a clearly defined monetary value, but for purposes of measuring ROI, the final value

must be clearly statedalong with the rationale for this final value.

The rate of return can be calculated over a single period, or expressed as an average over

multiple periods of time.

Single-period

Arithmetic return

The arithmetic return is:

rarith is sometimes referred to as theyield.

Logarithmic or continuously compounded return

The logarithmic return orcontinuously compounded return, also known asforce of interest,

is defined as:
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or R = P*e^{-rt} where: R = Return P = Principal amount r = rate t = time period It is the

reciprocal of thee-foldingtime.

Multiperiod average returns

Arithmetic average rate of return

The arithmetic average rate of return over n periods is defined as:

Geometric average rate of return

The geometric average rate of return, also known as the True Time-Weighted Rate of

Return, over n periods is defined as:

The geometric average rate of return calculated over n years is also known as the annualized

return.

Time-weighted rates of return (TWRR) are important because they eliminate the impact of cash

flows. This is helpful when assessing the job that a money manager did for his/her clients, wheretypically the clients control these cash flows.
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Internal rate of return

The internal rate of return (IRR), also known as the dollar-weighted rate of return or the

money-weighted rate of return (MWRR), is defined as the value(s) of that satisfies the

following equation:

where:

NPV =net present valueof the investment

Ct=cashflowat time t

When the cost of capital ris smaller than the IRR rate , the investment is profitable, i.e.,NPV>

0. Otherwise, the investment is not profitable.

MWRR are helpful in that they take cash flows into consideration. This is especially helpful

when evaluating cases where the money manager controls cash flows (for private equity

investments, for example, as well as sub-portfolio rates of return) as well as to provide the

investor with their return. Contrast with TWRR.

Comparisons between various rates of return

Arithmetic and logarithmic return

The value of an investment is doubled over a year if the annual ROR rarith = +100%, that is, ifrlog

= ln($200 / $100) = ln(2) = 69.3%. The value falls to zero when rarith = -100%, that is, ifrlog = -

.

Arithmetic and logarithmic returns are not equal, but are approximately equal for small returns.

The difference between them is large only when percent changes are high. For example, an

arithmetic return of +50% is equivalent to a logarithmic return of 40.55%, while an arithmetic

return of -50% is equivalent to a logarithmic return of -69.31%.
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Logarithmic returns are often used by academics in their research. The main advantage is that the

continuously compounded return is symmetric, while the arithmetic return is not: positive and

negative percent arithmetic returns are not equal. This means that an investment of $100 that

yields an arithmetic return of 50% followed by an arithmetic return of -50% will result in $75,

while an investment of $100 that yields a logarithmic return of 50% followed by a logarithmic

return of -50% it will remain $100.

Comparison of arithmetic and logarithmic returns for initial investment of $100

Initial investment, Vi $100 $100 $100 $100 $100

Final investment, Vf $0 $50 $100 $150 $200

Profit/loss, Vf Vi $100 $50 $0 $50 $100

Arithmetic return,rarith 100% 50% 0% 50% 100%

Logarithmic return,rlog 69.31% 0% 40.55% 69.31%

Arithmetic average and geometric average rates of return

Both arithmetic and geometric average rates of returns are averages of periodic percentage

returns. Neither will accurately translate to the actual dollar amounts gained or lost if percent

gains are averaged with percent losses. A 10% loss on a $100 investment is a $10 loss, and a

10% gain on a $100 investment is a $10 gain. When percentage returns on investments are

calculated, they are calculated for a period of timenot based on original investment dollars, but

based on the dollars in the investment at the beginning and end of the period. So if an investment

of $100 loses 10% in the first period, the investment amount is then $90. If the investment then

gains 10% in the next period, the investment amount is $99.

A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss and gain occurs

does not affect the result. A 50% gain and a 50% loss is a 25% loss. An 80% gain plus an 80%

loss is a 64% loss. To recover from a 50% loss, a 100% gain is required. The mathematics of this

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are beyond the scope of this article, but since investment returns are often published as "average

returns", it is important to note that average returns do not always translate into dollar returns.

Example #1 Level Rates of Return

Year 1 Year 2 Year 3 Year 4

Rate of Return 5% 5% 5% 5%

Geometric Average at End of Year 5% 5% 5% 5%

Capital at End of Year $105.00 $110.25 $115.76 $121.55

Dollar Profit/(Loss) $5.00 $10.25 $15.76 $21.55

Compound Yield 5% 5.4%

Example #2 Volatile Rates of Return, including losses


Rate of Return 50% -20% 30% -40%

Geometric Average at End of Year 50% 9.5% 16% -1.6%


Dollar Profit/(Loss) ($6.40)

Compound Yield -1.6%

Example #3 Highly Volatile Rates of Return, including losses

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Rate of Return -95% 0% 0% 115%

Geometric Average at End of Year -95% -77.6% -63.2% -42.7%


Dollar Profit/(Loss) ($89.25)

Compound Yield -22.3%

Annual returns and annualized returns

Care must be taken not to confuse annual and annualized returns. An annual rate of return is a

single-period return, while an annualized rate of return is a multi-period, arithmetic average

return.

An annual rate of return is the return on an investment over a one-year period, such as January 1

through December 31, or June 3, 2006 through June 2, 2007. Each ROI in the cash flow exampleabove is an annual rate of return.

An annualized rate of return is the return on an investment over a period other than one year

(such as a month, or two years) multiplied or divided to give a comparable one-year return. For

instance, a one-month ROI of 1% could be stated as an annualized rate of return of 12%. Or a

two-year ROI of 10% could be stated as an annualized rate of return of 5%.

In the cash flow example below, the dollar returns for the four years add up to $265. Theannualized rate of return for the four years is: $265 ($1,000 x 4 years) = 6.625%.

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Uses

ROI is a measure of cashgenerated by or lost due to the investment. It measures the cashflow or income stream from the investment to the investor, relative to the amount

invested. Cash flow to the investor can be in the form of profit, interest, dividends, or

capital gain/loss. Capital gain/loss occurs when the market value or resale value of the

investment increases or decreases. Cash flow here does not include the return of invested

capital.

Cash Flow Example on $1,000 Investment


Dollar Return $100 $55 $60 $50

ROI 10% 5.5% 6% 5%

ROI values typically used for personal financial decisions include Annual Rate of Returnand Annualized Rate of Return. For nominal risk investments such as savings accounts or

Certificates of Deposit, the personal investor considers the effects of

reinvesting/compounding on increasing savings balances over time. For investments in

which capital is at risk, such as stock shares, mutual fund shares and home purchases, the

personal investor considers the effects of price volatility and capital gain/loss on returns.

Profitability ratios typically used by financial analysts to compare a companysprofitability over time or compare profitability between companies include Gross Profit

Margin, Operating Profit Margin, ROI ratio,Dividend yield,Net profit margin,Return on

equity, andReturn on assets.

Duringcapital budgeting, companies compare the rates of return of different projects toselect which projects to pursue in order to generate maximum return or wealth for the

company's stockholders. Companies do so by considering the average rate of return,
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payback period, net present value, profitability index, and internal rate of return for

various projects.

A return may be adjusted for taxes to give the after-tax rate of return. This is done ingeographical areas or historical times in which taxes consumed or consume a significant

portion of profits or income. The after-tax rate of return is calculated by multiplying the

rate of return by the tax rate, then subtracting that percentage from the rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25%

0.05 x 0.15 = 0.0075

0.05 - 0.0075 = 0.0425 = 4.25%

A return of 10% taxed at 25% gives an after-tax return of 7.5%0.10 x 0.25 = 0.025

0.10 - 0.025 = 0.075 = 7.5%

Investors usually seek a higher rate of return on taxable investment returns than on non-taxable

investment returns.

A return may be adjusted for inflation to better indicate its true value in purchasingpower. Any investment with a nominal rate of return less than the annual inflation rate

represents a loss of value, even though the nominal rate of return might well be greater

than 0%. When ROI is adjusted for inflation, the resulting return is considered an

increase or decrease inpurchasing power. If an ROI value is adjusted for inflation, it is

stated explicitly, such as The return, adjusted for inflation, was 2%.

Many online poker tools include ROI in a player's tracked statistics, assisting users inevaluating an opponent's profitability.
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Cash or potential cash returns

Time value of money

Investments generate cash flow to the investor to compensate the investor for thetime value of

money.

Except for rare periods of significant deflation where the opposite may be true, a dollar in cash is

worth less today than it was yesterday, and worth more today than it will be worth tomorrow.

The main factors that are used by investors to determine the rate of return at which they are

willing to invest money include:

estimates of future inflation rates estimates regarding the risk of the investment (e.g. how likely it is that investors will

receive regular interest/dividend payments and the return of their full capital)

whether or not the investors want the money available (liquid) for other uses.

The time value of money is reflected in theinterest ratesthatbanksoffer fordeposits, and also in

the interest rates that banks charge for loans such as home mortgages. The risk-free rate is the

rate onU.S. Treasury Bills, because this is the highest rate available without risking capital.

The rate of return which an investor expects from an investment is called the Discount Rate.

Each investment has a different discount rate, based on the cash flow expected in future from the

investment. The higher the risk, the higher the discount rate (rate of return) the investor will

demand from the investment.

Compounding or reinvesting

Compound interestor other reinvestment of cash returns (such as interest and dividends) does

not affect the discount rate of an investment, but it does affect the Annual Percentage Yield,

because compounding/reinvestment increases the capital invested.
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For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD) that paid an annual

interest rate of 4%, compounded quarterly, the CD would earn 1% interest per quarter on the

account balance. The account balance includes interest previously credited to the account.

Compound Interest Example

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Capital at the beginning of the period $1,000 $1,010 $1,020.10 $1,030.30

Dollar return for the period $10 $10.10 $10.20 $10.30

Account Balance at end of the period $1,010.00 $1,020.10 $1,030.30 $1,040.60

Quarterly ROI 1% 1% 1% 1%

The concept of 'income stream' may express this more clearly. At the beginning of the year, the

investor took $1,000 out of his pocket (or checking account) to invest in a CD at the bank. The

money was still his, but it was no longer available for buying groceries. The investment provided

a cash flow of $10.00, $10.10, $10.20 and $10.30. At the end of the year, the investor got

$1,040.60 back from the bank. $1,000 was return of capital.

Once interest is earned by an investor it becomes capital. Compound interest involves

reinvestment of capital; the interest earned during each quarter is reinvested. At the end of the

first quarter the investor had capital of $1,010.00, which then earned $10.10 during the second

quarter. The extra dime was interest on his additional $10 investment. The Annual Percentage

YieldorFuture valuefor compound interest is higher than for simple interest because the interest

is reinvested as capital and earns interest. The yield on the above investment was 4.06%.

Bank accounts offer contractually guaranteed returns, so investors cannot lose their capital.

Investors/Depositors lend money to the bank, and the bank is obligated to give investors back
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their capital plus all earned interest. Because investors are not risking losing their capital on a

bad investment, they earn a quite low rate of return. But their capital steadily increases.

Returns when capital is at risk

Capital gainsand losses

Many investments carry significant risk that the investor will lose some or all of the invested

capital. For example, investments in company stock shares put capital at risk. The value of a

stock share depends on what someone is willing to pay for it at a certain point in time. Unlike

capital invested in a savings account, the capital value (price) of a stock share constantly

changes. If the price is relatively stable, the stock is said to have low volatility. If the price

often changes a great deal, the stock has high volatility. All stock shares have some volatility,and the change in price directly affects ROI for stock investments.

Stock returns are usually calculated for holding periods such as a month, a quarter or a year.

Reinvestment when capital is at risk: rate of return and yield

Example: Stock with low volatility and a regular quarterly dividend, reinvested

End of: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Dividend $1 $1.01 $1.02 $1.03

Stock Price $98 $101 $102 $99

Shares Purchased 0.010204 0.01 0.01 0.010404

Total Shares Held 1.010204 1.020204 1.030204 1.040608

Investment Value $99 $103.04 $105.08 $103.02

Quarterly ROI -1% 4.08% 1.98% -1.96%
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Yield is the compound rate of return that includes the effect of reinvesting interest or dividends.

To the right is an example of a stock investment of one share purchased at the beginning ofthe year for $100.

The quarterly dividend is reinvested at the quarter-end stock price. The number of shares purchased each quarter = ($ Dividend)/($ Stock Price). The final investment value of $103.02 is a 3.02% Yield on the initial investment of $100.

This is the compound yield, and this return can be considered to be the return on the

investment of $100.

To calculate the rate of return, the investor includes the reinvested dividends in the total

investment. The investor received a total of $4.06 in dividends over the year, all of which were

reinvested, so the investment amount increased by $4.06.

Total Investment = Cost Basis = $100 + $4.06 = $104.06. Capital gain/loss = $103.02 - $104.06 = -$1.04 (a capital loss) ($4.06 dividends - $1.04 capital loss ) / $104.06 total investment = 2.9% ROI

The disadvantage of this ROI calculation is that it does not take into account the fact that not all

the money was invested during the entire year (the dividend reinvestments occurred throughout

the year). The advantages are: (1) it uses the cost basis of the investment, (2) it clearly shows

which gains are due to dividends and which gains/losses are due to capital gains/losses, and (3)

the actual dollar return of $3.02 is compared to the actual dollar investment of $104.06.

For U.S. income tax purposes, if the shares were sold at the end of the year, dividends would be

$4.06, cost basis of the investment would be $104.06, sale price would be $103.02, and the

capital loss would be $1.04.

Since all returns were reinvested, the ROI might also be calculated as a continuously

compounded return or logarithmic return. The effective continuously compounded rate of

return is the natural log of the final investment value divided by the initial investment value:

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Vi is the initial investment ($100) Vfis the final value ($103.02)

.

Total returns

This section addresses only total returns without the impact of U.S. federal individual income

and capital gains taxes.

Mutual funds report total returns assuming reinvestment of dividend and capital gain

distributions. That is, the dollar amounts distributed are used to purchase additional shares of the

funds as of the reinvestment/ex-dividend date. Reinvestment rates or factors are based on total

distributions (dividends plus capital gains) during each period.

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Average annual total return (geometric)

US mutual funds are to compute average annual total return as prescribed by the U.S. Securities

and Exchange Commission (SEC) in instructions to form N-1A (the fund prospectus) as the

average annual compounded rates of return for 1-year, 5-year and 10-year periods (or inception

of the fund if shorter) as the "average annual total return" for each fund. The following formula

is used.

Where:

P = a hypothetical initial payment of $1,000.

T = average annual total return.

n = number of years.

ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the

1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).

Solving for T gives

Example

Example: Balanced mutual fund during boom times with regular annual dividends, reinvested at

time of distribution, initial investment $1,000 at end of year 0, share price $14.21
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Year 1 Year 2 Year 3 Year 4 Year 5

Dividend per share $0.26 $0.29 $0.30 $0.50 $0.53

Capital gain distribution pershare

$0.06 $0.39 $0.47 $1.86 $1.12

Total Distribution Per Share $0.32 $0.68 $0.77 $2.36 $1.65

Share Price At End Of Year $17.50 $19.49 $20.06 $20.62 $19.90

Reinvestment factor 1.01829 1.03553 1.03975 1.11900 1.09278

Shares owned before distribution 70.373 71.676 74.125 76.859 84.752

Total distribution $22.52 $48.73 $57.10 $181.73 $141.60

Share price at distribution $17.28 $19.90 $20.88 $22.98 $21.31

Shares purchased 1.303 2.449 2.734 7.893 6.562

Shares owned after distribution 71.676 74.125 76.859 84.752 91.314

Total return = (($19.90 1.09278) / $14.21) - 1 = 53.04% Average annual total return (geometric) = ((($19.90 91.314) / $1,000) ^ (1 / 5)) - 1 =

12.69%

Using a Holding Period Returncalculation, after five years, an investor who reinvested owned

91.314 shares valued at $19.90 per share. ((($19.90 91.314) / $1,000) - 1) / 5 = 16.34% return.

An investor who did not reinvest received total cash payments of $5.78 per share. ((($19.90 +

$5.78) / $14.21) - 1) / 5 = 16.14% return.

Mutual funds include capital gains as well as dividends in their return calculations. Since the

market price of a mutual fund share is based on net asset value, a capital gain distribution is
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offset by an equal decrease in mutual fund share value/price. From the shareholder's perspective,

a capital gain distribution is not a net gain in assets, but it is a realized capital gain.

Rate of Return and Return on Investment indicate cash flow from an investment to the

investor over a specified period of time, usually a year.

ROI is a measure of investment profitability, not a measure of investment size. While compound

interest and dividend reinvestment can increase the size of the investment (thus potentially

yielding a higher dollar return to the investor), Return on Investment is a percentage return

based on capital invested.

In general, the higher the investment risk, the greater the potential investment return, and the

greater the potential investment loss.

USES OF ROI

The general formula for computing ROI is income / invested capital. ROI can be computed on a

company-wide basis by dividing net income by owners' equity. This measure indicates how well

the overall company is utilizing its equity investment. Calculated in this way, ROI provides agood indicator of profitability that can be compared against competitors or an industry average.

Experts suggest that companies usually need at least 10-14 percent ROI in order to fund future

growth. If this ratio is too low, it can indicate poor management performance or a highly

conservative business approach. On the other hand, a high ROI can either mean that management

is doing a good job, or that the firm is undercapitalized.

ROI can also be computed for various divisions, product lines, or profit centers within a small

business. In this way, it gives management a basis for comparing the performance of different

areas. One large division may generate much higher profits than another, smaller division, for

example, which might encourage management to consider investing further in that division. But

an ROI analysis might reveal that a great deal more capital investment was required by the large

division than by the smaller one. The smaller division may have generated a lower dollar amount

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of profit, but a greater percentage of profit on every dollar of investment. As Ronald W. Hilton

wrote in his bookManagerial Accounting, "The important question is not how much profit each

division earned, but rather how effectively each division used its invested capital to earn a

profit."

ROI can also be used to evaluate a proposed investment in new equipment by dividing the

increase in profit attributable to the new equipment by the increase in invested capital needed to

acquire it. For example, a small business may be able to save $5,000 in operating expenses (and

thus raise profit by the same amount) by spending $25,000 on a piece of new equipment. This

yields an ROI of $5,000 / $25,000 or 20 percent. If this figure is higher than the company's cost

of capital (the interest paid on debt and the dividends paid to investors) prior to the investment,

and no better investment opportunities exist for those funds, it may make sense to purchase theequipment.

In addition to the various uses ROI holds for a small business managers, it can also be a useful

measure for investors. For example, a stockholder might calculate the return of investing in a

company by the following formula: dividends stock price change / stock price paid. This

calculation of ROI measures the gain (or loss) achieved by placing an investment over a period

of time.

ROI and ROE Performance Measure

Worksheet model used to calculate Return on Investment (ROI) and Return on Equity (ROE)

that also provides easy methods of changing input values and seeking a final ROE.

You can develop a model of your business with an Excel workbook. This model calculates ROE,

ROI, profit margin and asset turnover. Once the model is developed, you can try various what if

scenarios. You can use Goal Seek functions to solve the model for a desired output (ROE). By

adjusting different inputs to the ROE calculation, you can better understand the financial

structure and opportunities facing the business. Notes like those inserted in cells N13, N15, Q14

and X18 describe methods of increasing ROE.
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Enter starting values in column B. Click the reset buttons to show ROE for the input values.

Click on the spinner buttons to change assumptions and use the reset buttons to return to the

original values. Enter a desired ROE in cell M4 and click on the Seek button -- choose which

input variable you want to change to solve for the desired ROE.

Decentralisation and the need for performance measurement

Decentralisation is the delegation of decision-making responsibility. All organisations

decentralise to some degree, some do it more than others. Decentralisation is a necessary

response to the increasing complexity of the environment that organisations face and the

increasing size of most organisations. Nowadays it would be impossible for one person to make

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all the decisions involved in the operation of even a small company, hence senior managers

delegate decision-making responsibility to subordinates.

One danger of decentralisation is that managers may use their decision-making freedom to make

decisions that are not in the best interests of the overall company (so called dysfunctional

decisions). To redress this problem, senior managers generally introduce systems of performance

measurement to ensure - among other things - that decisions made by junior managers are in the

best interests of the company as a whole. Example 1 details different degrees of decentralisation

and typical financial performance measures employed.

Example 1

Responsibility

structureManager's area of responsibility

Typical financial performance

measure

Cost centre Decisions over costs Standard costing variances

Profit centre* Decisions over costs and revenues Controllable profit

Investment centre*Decisions over costs, revenues, and

assets

Return on investment and residual

income

* These two structures are often referred to as divisions - divisionalisation refers to the

delegation of profit-making responsibility.

What makes a good performance measure?

A good performance measure should:

provide incentive to the divisional manager to make decisions which are in the bestinterests of the overall company (goal congruence)

only include factors for which the manager (division) can be held accountable recognise the long-term objectives as well as short-term objectives of the organisation.

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Traditional performance indicators

Cost centres

Standard costing variance analysis is commonly used in the measurement of cost centre

performance. It gives a detailed explanation of why costs may have departed from standard.

Although commonly used, it is not without its problems. It focuses almost entirely on short-term

cost minimisation which may be at odds with other objectives, for example, quality or delivery

time. Also, it is important to be clear about who is responsible for which variance - is the

production manager or the purchasing manager (or both) responsible for raw material price

variances? There is also the problem with setting standards in the first place - variances can only

be as good as the standards on which they are based.

Profit centres

Controllable profit statements are commonly used in profit centres. A proforma statement is

given in Example 2.

Example 2: Controllable profit statement

$ $

Sales (external) XXX

(internal) XXX

XXX

Controllable divisional variable costs (XXX)

Controllable divisional fixed costs (XXX)

Controllable divisional profit XXX

Other traceable divisional variable costs (X)

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Other traceable divisional fixed costs (XXX)

Traceable divisional profit XXX

Apportioned head office cost (XXX)

Net profit XXX

The major issue with such statements is the difficulty in deciding what is controllable or

traceable. When assessing the performance of a manager we should only consider costs and

revenues under the control of that manager, and hence judge the manager on controllable profit.

In assessing the success of the division, our focus should be on costs and revenues that are

traceable to the division and hence judge the division on traceable profit. For example,

depreciation on divisional machinery would not be included as a controllable cost in a profit

centre. This is because the manager has no control over investment in fixed assets. It would,

however, be included as a traceable fixed cost in assessing the performance of the division.

Investment centres

In an investment centre, managers have the responsibilities of a profit centre plus responsibility

for capital investment. Two measures of divisional performance are commonly used:

1 Return on investment (ROI) =

controllable (traceable) profit %

controllable (traceable) investment

2 Residual income = controllable (traceable) profit - an imputed interest charge on controllable

(traceable) investment.

Example 3 demonstrates their calculation and some of the drawbacks of return on investment.

Example 3

Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a profit of

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$2.2m per annum. Division X's cost of capital is 10% per annum. The division is considering two

proposals.

Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of $0.15m.

Proposal 2 involves the disposal of assets at their net book value of $2.3m. This would lead to a

reduction in profits of $0.3m.

Proceeds from the disposal of assets would be credited to head office not Division X.

Required: calculate the current ROI and residual income for Division X and show how they

would change under each of the two proposals.

Current situation

Return on investment

ROI = $2.2m = 22%

$10.0m

Residual income

Profit $2.2m

Imputed interest charge

$10.0m x 10% $1.0m

Residual income $1.2m

Comment: ROI exceeds the cost of capital and residual income is positive. The division is

performing well.

Proposal 1


ROI = $2.35m = 21.4% $11.0m

Residual income

Profit $2.35m

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$11.0m x 10% $1.1m


Comment: In simple terms the project is acceptable to the company. It offers a rate of return of

15% ($0.15m/$1m) which is greater than the cost of capital. However, divisional ROI falls and

this could lead to the divisional manager rejecting proposal 1. This would be a dysfunctional

decision. Residual income increases if proposal 1 is adopted and this performance measure

should lead to goal congruent decisions.

Proposal 2


ROI = $1.9m = 24.7% $7.7m

Residual income

Profit $1.90m


$7.7m x 10% $0.77m


Comment: In simple terms the disposal is not acceptable to the company. The existing assets

have a rate of return of 13.0% ($0.3m/$2.3m) which is greater than the cost of capital and hence

should not be disposed of. However, divisional ROI rises and this could lead to the divisional

manager accepting proposal 2. This would be a dysfunctional decision. Residual income

decreases if proposal 2 is adopted and once again this performance measure should lead to goal

congruent decisions .

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Criticism/Disadvantages or Limitations of Return on Investment (ROI) Method of

Performance Evaluation:

Learning Objectives:

1. What are the limitations of return on investment method of performance evaluation?Although the return on investment is widely used in evaluating performance, it is not a perfect

tool. The method is subject to the following criticism:

1. Just telling managers to increase ROI may not be enough. Managers may not know how to

increase ROI; they may increase ROI in a way that is inconsistent with the company's strategy;

or they may take actions that increase ROI in the short run but harm company the long run (suchas cutting back on the research and development). This is why ROI is best used as part of a

balanced scorecard. A balanced scorecard can provide concrete guidance to managers, making it

more likely that action taken are consistent with the company's strategy and reducing the

likelihood that short-run performance will be enhanced at the expense of long-term performance.

2. A manager who takes over a business segment typically inherent many committed costs over

which the manager has no control. These committed costs may be relevant in assessing the

performance of the business segment as an investment but make it difficult to fairly assess the

performance of the manager relative to other managers.

3. A manager who is evaluated based on return on investment (ROI) may reject investment

opportunities that are profitable for the whole company but that would have a negative impact on

the manager's performance evaluation.

Methods of Controlling and Improving the Rate of Return on Investment (ROI):

Return on investment is normally used to judge the managerial performance in an investment

center.

Managers therefore try to control and improve the ROI of their investment center. Here we shall

discuss the methods of improving rate of return on investment.

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The following formula is usually used for computing return on investment.

Return on investment (ROI) = Net operating income / Average operating income

This formula is also discussed atrate of return for measuring managerial performancepage. Wecan modify this formula slightly by introducing sales as follows:

ROI = (Net operating income / Sales) (Sales / Average operating assets)

These two equations are equivalent because the sales terms cancel out in the second equation.

The first term on the right hand side of the equation is margin, which is defined as follows:

Margin = Net operating income / Sales

Margin is a measure of management's ability to control operating expenses in relation to sales.

The lower the operating expenses per dollar of sales, the higher the margin earned.

The second term on the right hand side of the equation is turnover, which is defined as follows:

Turnover = Sales / Average operating assets

Turnover is a measure of the sales that are generated for each dollar invested in operating assets.

The following alternative form of the ROI formula, which we will use here, combines margin

and turnover.

ROI = Margin Turnover

Both the formulas give same answer. However margin and turnover formulation provides some

additional insights. Some managers tend to focus too much on margin and ignore turnover. To

some degree the margin can be a valuable indicator of a manager's responsibility. Standing

alone, however, it overlooks one very crucial area of manager's responsibility--the investment in

operating assets. Excessive funds tied up in operating assets, which depresses turnover, can be

just as much of a drag on profitability as excessive operating expenses, which depresses margin.

One of the advantages of return on investment (ROI) as a performance measure is that it forces
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the manager to control the investment in operating assets as well as to control expenses and the

margin.

To illustrate how an investment center manager can improve ROI by making the use of three

methods mentioned above consider the following example:

Example:

The following data represents the results of an investment center of the operations of a company

for the most recent month.

Net operating incomeSales

Average operating assets

$10,000

100,000

50,000

The rate of return generated by the company for this investment center is as follows:

ROI = Margin Turnover

(Net operating income / Sales) (Sales / Average operating assets)

($10,000 / $100,000) ($100,000 / $50,000)

10% 2

= 20%

As we stated above that manager can increase sales, reduce expenses, or reduce the operating

assets to improve the ROI figure.

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Approach 1: Increase sales:

Assume that the manager is able to increase sales from $100,000 to $110,000. Assume further

that either because of good cost control or because some costs in the company are fixed, the net

operating income increases even more rapidly, going from $10,000 to $12,000 per period.

Assume that operating assets remain constant. The new ROI will be:

ROI = ($12,000 / $110,000) ($110,000 / $50,000)

10.91% 2.2

24%

Approach 1: Reduce expenses:

Assume that manager is able to reduce expenses by $1,000 so that net operating income

increases from $10,000 to $11,000. Assume that both sales and operating assets remain constant.

The new ROI would be:

ROI = ($11,000 / $100,000) ($100,000 / $50,000)

11% 2.2

22%

Approach 3: Reduce operating assets:

Assume that the manager of the company is able to reduce operating assets from $50,000 to

$40,000, but that sales and operating income remain unchanged. Then the new ROI would be:

ROI = ($10,000 / $100,000) ($100,000 / $40,000)

11% 2.2

22%

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The use of the return on investment formula, if properly used, can be to have a fair estimate and

comparisons of different investments decisions. In fact, the simplicity of the ROI formula

enables homeowners and small enterprises to use the formula along with the corporate big

names. The return on investment formula is especially a very efficient tool of a personal budget

worksheet as the general investor can clearly make a decision about what to do and what not to

do. The ROI formula can also be used to have a fair comparison of different investment

strategies and to calculate the percentage of increment (or decrement) on an investment.

Finally, an important factor to be kept in consideration in the ROI calculations is that the time

factor is not included in the formula. The time factor should be kept in mind while you are

evaluating the return on investment formula percentages presented to you.

Residual Income

When most hear the term residual income, they think of excess cash or disposable income.

Although that definition is correct in the scope of personal finance, in terms of equity valuation

residual income is the income generated by a firm after accounting for the true cost of its capital.

You might be asking, "But don't companies already account for their cost of capital in their

interest expense?" Yes and no. Interest expense on the income statement only accounts for a

firm's cost of its debt, ignoring its cost of equity, such as dividends payouts and other equity

costs. Looking at the cost of equity another way, think of it as the shareholders' opportunity cost,

or the required rate of return. The residual income model attempts to adjust a firm's future

earnings estimates, to compensate for the equity cost and place a more accurate value to a firm.

Although the return to equity holders is not a legal requirement like the return to bondholders, inorder to attract investors firms must compensate them for the investment risk exposure.

Residual income is a performance measure that consists of some measure of operating income

minus some charge for the capital used by the manager (or unit) being evaluated. The concept

appeared as early as the 1920s (e.g., in DuPont's bonus plan calculation of its "Executive Trust
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Fund"), and has been frequently discussed in management accounting texts since General

Electric adopted it in the 1950s. Despite its merits, residual income was not widely used in

practice until recently. The business community's greater attention to this type of performance

measure in recent years is due largely to the stimulus from Stern Stewart & Co.'s touting of their

version of residual income, which they call Economic Value Added or EVA.

As a performance measure, residual income is designed to influence management's investment in

capital assets, ideally inducing managers to undertake investments for which the net present

value is positive and to reject those for which the net present value is negative. The rate used in

calculating the capital charge, often called the "cost of capital," is clearly the riskless interest rate

in a world of certainty or risk neutrality with no private pre-contract management information.

However, we show that determining the appropriate measure of the cost of capital underuncertainty and risk aversion is complex, even if management does not have private pre-contract

information.

Definition of 'Residual Income'

The amount of income that an individual has after all personal debts, including the mortgage,

have been paid. This calculation is usually made on a monthly basis, after the monthly bills and

debts are paid. Also, when a mortgage has been paid off in its entirety, the income that individual

had been putting toward the mortgage becomes residual income.

Actually Residual Income is-

1. Net income that an investment can earn over the minimum rate ofreturn.

2. Royalty income that accrues to the owner of an intellectual property, such as art, books, lyrics,

music, patents, etc.

Barron's Accounting Dictionary:

Operating income that an investment center is able to earn above some minimum return on its

assets. It is a popular alternative performance measure to return on investment (ROI). RI is

computed as:
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Residual income, unlike ROI, is an absolute amount of income rather than a rate of return. When

RI is used to evaluate divisional performance, the objective is to maximize the total amount of

residual income, not to maximize the overall ROI percentage figure. For example, assume that

operating assets are $100,000, net operating income is $18,000, and the minimum return on

assets is 13%.

Residual income is $18,000 - (13% X $100,000) = $18,000 - $13,000 = $5,000. RI is sometimes

preferred over ROI as a performance measure because it encourages managers to accept

investment opportunities that have rates of return greater than the charge for invested capital.

Managers being evaluated using ROI may be reluctant to accept new investments that lower their

current ROI, although the investments would be desirable for the entire company. Advantages of

using residual income in evaluating divisional performance include:

(1) It takes into account the opportunity cost of tying up assets in the division;

(2) The minimum rate of return can vary depending on the riskiness of the division;

(3) Different assets can be required to earn different returns depending on their risk;

(4) The same asset may be required to earn the same return regardless of the division it is in; and

(5) The effect of maximizing dollars rather than a percentage leads to goal congruence.

Investopedia Financial Dictionary:

Residual Income is the amount of income that an individual has after all personal debts,

including the mortgage, have been paid. This calculation is usually made on a monthly basis,

after the monthly bills and debts are paid. Also, when a mortgage has been paid off in its

entirety, the income that individual had been putting toward the mortgage becomes residual

income.
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Investopedia explains 'Residual Income' is often an important component of securing a loan. The

loaning institution usually assesses the amount of residual income an individual has left after

paying off other debts each month. If the individual requesting the loan has sufficient residual

income to take on additional debt, the loaning institution will be more likely to grant the loan

because having an adequate amount of residual income will ensure that the borrower has

sufficient funds to make the loan payment each month.

For Example:

In calculating a firm's residual income the key calculation is to determine its equity charge.

Equity charge is simply a firm's total equity capital multiplied by the required rate of return of

that equity, can be estimated using the capital asset pricing model. The formula below shows the

equity charge equation.

Equity Charge = Equity Capital x Cost of Equity

Once we have calculated the equity charge, we only have to subtract it from the firm's net

income to come up its residual income. For example, if Company X reported earnings of

$100,000 last year and financed its capital structure with $950,000 worth of equity at a required

rate of return of 11%, its residual income would be:

Equity Charge $950,000 x 0.11 = $104,500

Net Income $100,000

Equity Charge -$104,500

Residual Income -$4,500

So as you can see from the above example, using the concept of residual income, although

Company X is reporting a profit on its income statement (which it should), once its cost of equity

is included in relation to its return to shareholders, it is actually economically unprofitable based

on the given level of risk. This finding is the primary driver behind the use of the residual
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income method. A scenario where a company is profitable on an accounting basis, it may still not

be a profitable venture from a shareholder's perspective if it cannot generate residual income.

Passive Income vs. Residual Income

Often we come across terms in regards to doing business online that we are not 100% familiar

with. Sometimes even several terms that are mistakenly interchanged to the point that the true

meaning of each gets lost altogether.

According to a recent survey, two such terms are "passive income" and "residual income". Both

are often associated with Network Marketing opportunities... but today we're going to explore

their true meaning, as well as other online opportunities to earn one or both types of income.

- Residual Income

Recurring payments that you receive long after the initial sale is made, usually in specific

amounts and at regular intervals.

- Passive Income

"Income derived from business investments in which the individual is not actively involved"

Passive basically means "inactive" or "submissive", so Passive Income could be viewed as

money that you make that doesn't require an effort from you.

From those definitions, it's obvious that Residual Income is also considered Passive Income.

Once you make the initial sale, your residual income can be considered passive. In most cases,

you do not have to "work", or make additional sales, in order to continue to reap the profits.

Examples of residual income options might include:

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Network Marketing, where you enroll customers or recruit representatives that you earn amonthly commission from.

Affiliate programs for recurring payment type services or products, such as: hosting,membership sites, dating sites, etc. In these programs, you are paid a commission each

time the recurring payment is billed to the customer you referred.

Selling anything that is automatically renewable or consumables where the re-ordering isautomated.

There are also OTHER ways to earn Passive Income, outside of these traditional 'ResidualIncome' options. Again, a great definition of Passive Income is:

"Income derived from business investments in which the individual is not actively involved".

Residual income model

A residual income model values securities using a combination of book value of the company

(i.e. its NAV), and a present value based on accounting profits. The value of a company is thesum of:

the NAV at the time of valuation, and, the present value of the residual income: the amounts by which profits are expected to

exceed the required rate of return on equity.

The latter, like most present value calculations, ends with a terminal value which is calculated on

a different basis to the other future amounts.

The residual return is:

(R - r) B
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Where;

B is the NAV

R is the return based on accounting profits and owners equity (net profit B), and

r is the required rate of return on equity.

This can also be expressed as net profit - (r B)

The terminal value is somewhat different from that used in an NPV. Rather than being the actual

value of the company at that time, it is the actual value minus the NAV at that time.

The significance of the extra profit over the required rate of return is that it is a measure of the

wealth the company creates for shareholders. This is what the company adds to the value of is

assets, and what justifies a company being worth more than the value of its assets. Therefore, the

value of a company should be the sum of this and its assets.

The NAV will vary from year to year, which affects the calculation of the returns. The change is

the net profit, fewer dividends and other returns to shareholders, plus capital rose.

Basing valuation on wealth creation is conceptually similar to EVA. Residual income models are

better suited to securities valuation (whereas EVA is primarily useful to management).

The advantage of the residual income model is that it is entirely based on accounting measures of

profit and value of assets.

The most obvious objection to the residual income model is that it is based on accounting

numbers that often fail to reflect the true economic value of assets and cash flows.
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The Residual Income Valuation Model

When used to value stocks, the residual income model separates value as the sum of two

components:

The current book value of equity (BV) The present value of expected future residual income [sum from time t=1 to

infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a

share, using book value and residual income per share.

Unlike models that discount dividends or free cash flow, in which a significant portion of theestimated value is the terminal value, a residual income model tends to be front-end loaded by

the reliance on book value. This can be an advantage since forecasting errors tend to magnify

over time. Using only the residual income is likely to result in smaller errors and even if the error

is not reduced, the future income is less significant to the overall value calculation.

Valuing a Company Using the Residual Income Method

There are many different methods to valuing a company or its stock. One could opt to use a

relative valuation approach, comparing multiples and metrics of a firm in relation to other

companies within its industry or sector. Another alternative would be value a firm based upon an

absolute estimate, such as implementing discounted cash flow modeling or the dividend discount

method, in an attempt to place an intrinsic value to said firm. One absolute valuation methodwhich may not be so familiar to most, but is widely used by analysts is the residual income

method. In this article we will introduce you to the underlying basics behind the residual income

model and how it can be used to place an absolute value on a firm. (The Dividend Discount

Mode (DDM) is one of the most foundational of financial theories, but it's only as good as its

assumptions.)
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Intrinsic Value with Residual Income

Now that we've found how to compute residual income, we must now use this information to

formulate a true value estimate for a firm. Like other absolute valuation approaches, the concept

of discounting future earnings is put to use in residual income modeling as well. The intrinsic, or

fair value, of a company's stock using a the residual income approach can be broken down into

its book value and the present values of its expected future residual incomes, as illustrated in the

formula below.

As you may have noticed, the residual income valuation formula is very similar to a multistage

dividend discount model, substituting future dividend payments for future residual earnings.

Using the same basic principles as a dividend discount model to calculate future residual

earnings, we can derive an intrinsic value for a firm's stock. In contrast to the DCF approach

which uses the weighted average cost of capital for the discount rate, the appropriate rate for the

residual income strategy is the cost of equity.

"Cost of capital" in residual income for performance evaluation.

BASIC PRODUCTION MODEL

The model has two factors of production: the effort supplied by the manager, denoted by its cost

a, and the capital supplied by the principal, denoted by its cost q, with a [member of] A = [0,

[infinity]) and q [member of] Q = [0, [infinity]). The outcome (e.g., net revenue) x generated by

these two factors also depends on a random productivity factor [delta]. In particular, we assume:

x = h(a) + [delta]g(q),
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Where h(a) and g(q) are increasing, concave production functions with h(0) = g(0) = 0 and

infinite marginal productivities at a = 0 and q = 0. The additive separability between the two

factors of production, a and q, simplifies the analysis, whereas the multiplicative relation fig(q) is

a simple means of having the investment choice q influence the riskiness of the outcome. (5) We

let [delta] = [bar][delta] + [[epsilon].sub.[delta]], where [delta] is the prior mean and

[[epsilon].sub.[delta]] ~ N(0, [[tau].sub.[delta].sup.2]) is the random component.

No Pre-decision Information

We now consider the setting in which the manager does not receive any pre-decision information

about [delta]. In that case, there is a unique optimal investment level q (as well as a unique

optimal effort level a). From Remarks 1 and 2 we know that for any effort level a there is a

unique incentive rate [nu] that will induce a, and for any investment level q (given the incentive

rate [new]) there is unique capital charge [GAMMA] that will induce q. Since q is contractible

information, the desired investment level could be induced by specifying the amount that will be

provided by the principal (essentially a penalty contract). However, it is instructive to identify

the capital charge that will induce the desired investment choice if it is delegated to the manager,

since we view this setting as the limiting case in which little of the manager's uncertainty isresolved before he makes his production decision. That is, post-decision risk is a central feature

of this setting, and we are interested in identifying the impact of firm-specific post-decision risk

on the optimal capital charge in the manager's incentive contract

MARKET RISK

As discussed in the introduction, the management accounting literature has generally held that

the appropriate "cost of capital" in measuring residual income is the "weighted average cost of

capital." This implies that firm-specific (i.e., diversifiable) risk is irrelevant and that the focus is

on the relation of the firm's outcome to the market return. In Section IV, we demonstrated that, in

the absence of market risk, firm-specific risk affects the optimal capital charge if a principal uses

residual income as a performance measure in a setting in which capital investment affects the

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amount of firm-specific risk. Interestingly, in that setting, firm-specific risk does not affect the

first-best investment level, but it does affect the second-best level.

We now introduce market risk into the no-pre-decision-information setting. As we demonstrate,

market risk influences both the first- and second-best investment levels, but it does not directly

affect the optimal capital charge in the manager's performance measure. This result depends

crucially on the assumption that either the manager can invest (go long or short) in the market

portfolio or the principal can vary the manager's compensation with the return on the market

portfolio. The effects of firm-specific risk are essentially the same as in Section IV, in which

there was no market risk.

Net income

Net income is the residual income of a firm after adding total revenue and gains and subtracting

all expenses and losses for the reporting period. Net income can be distributed among holders of

common stock as a dividend or held by the firm as an addition to retained earnings. As profit and

earnings are used synonymously for income (also depending on UK and US usage), net earnings

and net profit are commonly found as synonyms for net income. Often, the term income is

substituted for net income, yet this is not preferred due to the possible ambiguity. Net income is

informally called the bottom line because it is typically found on the last line of a company's

income statement (a related term is top line, meaning revenue, which forms the first line of the

account statement).

The items deducted will typically include tax expense, financing expense (interest expense), and

minority interest. Likewise, preferred stockdividends will be subtracted too, though they are not

an expense. For a merchandising company, subtracted costs may be the cost of goods sold, sales

discounts, and sales returns and allowances. For a product company advertising, manufacturing,

and design and development costs are included.

An equation for net income

Net sales (revenue)
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Cost of goods sold

= Gross profit

SG&A expenses (combined costs of operating the company)

= EBITDA

Depreciation & amortization

= EBIT

Interest expense (cost of borrowing money)

= EBT

Tax expense

= Net income (EAT)

Economic Value Added

In corporate finance, Economic Value Added or EVA, a registered trademark ofStern Stewart &Co., is an estimate of a firm's economic profitbeing the value created in excess of the required

return of the company's investors (being shareholders and debt holders). Quite simply, EVA is

the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is

created when the return on the firm's economic capital employed is greater than the cost of that

capital; see Corporate finance: working capital management. This amount can be determined by

making adjustments to GAAP accounting. There are potentially over 160 adjustments that could

be made but in practice only five or seven key ones are made, depending on the company and the

industry it competes in.
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Calculating EVA

EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the

product of the cost of capital and the economic capital. The basic formula is:

Where:

, is the Return on Invested Capital (ROIC); is the weighted average cost of capital (WACC); is the economic capital employed; NOPAT is the net operating profit after tax, with adjustments and translations, generally

for the amortization of goodwill, the capitalization of brand advertising and others non-

cash items.

EVA Calculation:

EVA = net operating profit after taxesa capital charge [the residual income method]

Therefore EVA = NOPAT(c capital), or alternatively

EVA = (r x capital)(c capital) so that

EVA = (r-c) capital [the spread method, or excess return method]

Where:

r = rate of return, and

c = cost of capital, or the Weighted Average Cost of Capital (WACC).
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NOPAT is profits derived from a companys operations after cash taxes but before financing

costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash

return to those who provide capital to the firm.

Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as

the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing

current liabilities (NIBCLs).

The capital charge is the cash flow required to compensate investors for the riskiness of the

business given the amount of economic capital invested.The cost of capital is the minimum rate

of return on capital required to compensate investors (debt and equity) for bearing risk, their

opportunity cost.

Another perspective on EVA can be gained by looking at a firms return on net assets (RONA).

RONA is a ratio that is calculated by dividing a firms NOPAT by the amount of capital it

employs (RONA = NOPAT/Capital) after making the necessary a

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