Investment Center Performance - Residual Income and Economic Value Added

Summary

This video explores key performance metrics used to evaluate investment centers, which are responsibility centers tasked with making money through allocated resources. The three primary metrics covered are Return on Investment (ROI), Residual Income, and Economic Value Added (EVA). ROI measures the return relative to operating assets, while Residual Income calculates the income exceeding expected returns. EVA assesses an organization's profitability after factoring in the cost of capital, including both debt and equity. These metrics provide valuable insights into the effectiveness of an investment center’s financial performance.

Takeaways

• 😀 An investment center is a responsibility center focused on making money by allocating resources to profitable projects or investments.
• 😀 Return on Investment (ROI) is the key metric for assessing an investment center's performance, measuring income relative to operating assets.
• 😀 ROI is calculated by dividing operating income by the value of operating assets in the investment center.
• 😀 Residual Income measures the income above the expected return, calculated by subtracting actual income from the expected operating income.
• 😀 Expected operating income is derived by multiplying the operating assets by the expected rate of return.
• 😀 Residual income represents the amount of income that exceeds the target or expectation, showing how well the center has performed beyond the minimum expected return.
• 😀 Economic Value Added (EVA) is a broader organizational metric that looks at net operating profit minus the cost of operating assets.
• 😀 To calculate EVA, multiply the value of operating assets by the weighted average cost of capital (WACC), which includes both debt and equity investment costs.
• 😀 WACC is a blend of the return on equity (based on risk) and the return on debt (based on interest rates), reflecting the overall cost of capital for the investment center.
• 😀 EVA shows the value added by the investment center above the expected return on the combined debt and equity investment.
• 😀 The three primary performance metrics for investment centers are ROI, Residual Income, and EVA, each providing a different perspective on profitability and investment success.

Q & A

What is an investment center?

An investment center is a responsibility center within an organization that is tasked with making money by allocating resources towards profitable projects or investments.

What is the primary function of an investment center?

The primary function of an investment center is to allocate money towards investments and projects with the goal of generating a return on that money.

How do you assess the effectiveness of an investment center?

The effectiveness of an investment center is typically assessed by measuring the return on the allocated resources. This is commonly done using metrics like return on investment (ROI), residual income, and economic value added (EVA).

What is the formula for calculating return on investment (ROI) in an investment center?

The ROI for an investment center is calculated by dividing the operating income (the income generated) by the operating assets (the value of assets allocated to the center).

What is residual income and how is it calculated?

Residual income is the income generated above the expected or target level. It is calculated by subtracting the expected operating income (operating assets multiplied by the expected rate of return) from the actual operating income.

What does residual income indicate about an investment center?

Residual income indicates how much the investment center has exceeded its target or expected income. A positive residual income suggests the center has outperformed its expected return.

How is economic value added (EVA) calculated?

EVA is calculated by subtracting the cost of capital (weighted average cost of capital, or WACC) from the net operating profit after taxes (NOPAT). The cost of capital is calculated by multiplying the operating assets by the WACC, which combines the expected return on both debt and equity investments.

What does economic value added (EVA) measure?

EVA measures the value an investment center has added beyond its cost of capital. It provides a more comprehensive view of whether the investment center has created value for the organization.

What is the weighted average cost of capital (WACC) and how is it used in the context of EVA?

WACC is the combined rate of return expected by both debt and equity investors in an organization. It is used to calculate the cost of capital for an investment center by multiplying the value of operating assets by the WACC, which is then subtracted from the net operating profit to calculate EVA.

What are the three main methods used to assess the performance of an investment center?

The three main methods used to assess the performance of an investment center are return on investment (ROI), residual income, and economic value added (EVA).