Hanyang University Business School

Managerial Accounting
Fall 2022

Professor Taeho Ko
[email protected]

Week 9. Financial performance measures and

their effects
Week 9-11
• Performance Measurement Issues and Their Effects
• Financial performance measures and their effects
(Week 9)
• Financial performance measures
• Market
• Accounting
• Investment performance
• Return on investment
• Residual income and EVA

• Remedies to the myopia problem (Week 10)

• Using financial results controls in the presence of
uncontrollable factors (Week 11)
2
Summary measures
• Summary, single-number, aggregate, bottom-line
financial measures of performance
• Reflect aggregate, or bottom-line, impacts of multiple
performance areas
• e.g., accounting profits: aggregate effects of both revenue and
cost decisions
• Largely two types
• Market measures: changes in stock prices, total shareholder
returns
• Accounting measures
• Residual terms (e.g., net income, operating profit, residual
income, Economic Value Added)
• Ratio terms (e.g., return on investment, return on equity, return
on net assets)
3
Market measures: benefits
• Timely: measured in short time period
• Precise: in well-functioning capital market
• Objective: not (easily) manipulable by managers
whose performance is being evaluated
• Congruent: most direct manifestation of and closest
proxy for theoretical notion of firm value
• Cost effective: do not require measurement expenses
• Understandable: measures represent changes in
market value of firm

4
Market measures: limitations
• Controllability
• All but top employees have infinitesimally small
influences on stock prices
• Even for top management, market measures are
affected by many uncontrollable factors
• “Noise” → Reason for (complementary/substitutive)
use of accounting measures

5
Market measures: limitations
• Risks
• Market measures are shaped by future expectations,
but these may not be realized
• In either direction (positive or negative)
• e.g., Microsoft’s Steve Ballmer was “surprised” when stock
price was hammered after announcing “win-win” deal with
Yahoo → Who was right – he or market?
• Proprietary information is kept within company
• Market (in)efficiency
• Markets are not always fully informed and efficient about
firm’s prospects, future cash flows, and risks
• “Anomalies” (e.g. “Friday effect”, “under-reaction to news”)

6
Market measures: limitations
• Feasibility
• Market measures are not available for privately held
firms, wholly owned subsidiaries or divisions, and
not-for-profit organizations

• These limitations cause firms to look for surrogate

measures of performance
• Accounting measures are most important surrogates
• Particularly at management levels below very top
• Although they are widely used at all levels

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Accounting measures: benefits
• Timely: measured in short time period
• Precise: subject to extensive accounting rules
• “Reliability principle”: different people assigned to measure
profit will arrive at approximately same number
• Objective: audited by independent auditors;
examined by regulators and tax authorities; analyzed
by investing public (e.g., institutional and retail
investors, analysts)

8
Accounting measures: benefits
• Congruent:
• Congruent with true firm goal of maximizing shareholder
value, esp. in long run
• Positive correlations between accounting profits and stock
returns
• Cost effective: already required for financial reporting
• Understandable (by market participants)

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Accounting measures: limitations
• Accounting incomes do not reflect “economic income”
perfectly, because accounting measures are ...
• transaction-oriented
• e.g., patents granted → no immediate accounting effect, but
likely change in firm’s economic value
• dependent on choice of measurement methods
• e.g., depreciation, write-off, reserves

“Economic income”: Change in firm’s

economic value, where “economic value”
is obtained by NPV of all future CFs

10
Accounting measures: limitations
• Accounting incomes do not reflect “economic income”
perfectly, because accounting measures ...
• are conservatively biased
• exclude some intangibles and working capital
• e.g., research in progress, human capital, customer goodwill
• ignore cost of “equity” capital
• ignore risks
“Economic income”: Change in firm’s
• focus on past economic value, where “economic value”
is obtained by NPV of all future CFs

• Caution: can we estimate “economic income” or “firm

value” without relying on accounting information?
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Myopia
• These limitations can create perverse effects
• Managers who are motivated to inflate accounting
profits or returns (in short term) can do so by:
• (1) not making investments, even worthwhile ones
(“Investment myopia”)
• (2) making operational decisions to shift income across
periods (“Operational myopia”)
• e.g., “channel stuffing”: boosting current sales by extending
lower prices to distributors, hurting profitability and future
sales

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Investment performance measures
• Return on investment (ROI)
• Ratio of accounting profit earned by the unit divided
by investment assigned to it
• ROI = profits ÷ investment base

• Residual income (RI)

• Dollar amount obtained by accounting profit less
capital charge to generate the profit
• RI = profit − capital charge

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Return on Investment (ROI)

EBIT

Net operating income

ROI =
Average operating assets

Cash, A/R, inventory, PP&E,

and other productive assets

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Net Book Value

Most firms use net book value of depreciable assets to

calculate average operating assets

Acquisition cost
Less: Accumulated depreciation
Net book value

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Net Book Value
• Firm bought equipment worth $10m on Jan 1, 2022
• Good for 4 years, with salvage value = $2m; Straight
line depreciation
• Net book value, December 31, 2022 = $8m
• Net book value, December 31, 2023 = $6m ...

16
Alternative asset measurements
• Current cost: cost of purchasing similar asset today
(“fair value”, “market value”)
• Relevant: current economic returns
• Less reliable: requires active market, information, and
assumptions

• Historical cost – gross value and net value; which?

• Comparing division ROIs: Gross value more accurate
• e.g., ROI based on net value automatically increases over time
• e.g., inflated ROI for old plant vs. deflated ROI for new plant
• W.r.t. financial reporting: Net value more consistent
• e.g., B/S assets measurement, I/S profits measurement

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ROI problems
• Numerator = Accounting profits
• Contains limitations associated with profit measures

• Denominator = Investment base

• How to measure investment base (i.e., operating assets)?

• Suboptimization (in addition to above measurement

issues)
• ROI can incentivize division managers to make decisions that
improve division ROI but are not in firm’s best interest
• Divisions are focused on their current ROI as implicit hurdle
rate when making investment decisions

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ROI suboptimization example 1

• Firm: accept
• Division A: accept
• Division B: reject → under-investment
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ROI suboptimization example 2

• Firm: reject
• Division A: accept → over-investment
• Division B: reject
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 Residual Income (RI)

Residual
income
=
Net
operating -
income
(Average
operating
assets

Minimum
required rate of
return
)
ROI, ROE, RI:
ROI: net operating income earned relative to investment
in average operating assets
ROE: net operating income earned relative to equity
investment
RI: net operating income earned less minimum required
return on equity and debt investment in average
operating assets
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Residual Income: remedy for suboptimization
• Suboptimization does not occur with RI measures
• Set corporate capital charge at or above cost of capital
• All division managers must earn income above capital
charge → No suboptimization incentives

22
Misleading performance signals
• If use net book value as measure of capital (1/2)
• Both ROI and RI get better merely through time
• Both ROI and RI are overstated if division has many
old assets
• e.g., Invest $100; Depreciation $20/year for 5 years;
Incremental income $7/year; Capital charge 10%

Incremental Capital
Yr NBV Income Charge RI ROI
1 100 7 10 −3 7%
2 80 7 8 −1 9%
3 60 7 6 1 12%
4 40 7 4 3 18%
5 20 7 2 5 35%

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Misleading performance signals
• If use net book value as measure of capital (2/2)
• Division managers are encouraged to retain assets
beyond optimal life and not invest in new assets
• Corporate managers may be induced to over-allocate
resources to divisions with older assets
• Combined with suboptimization issue, managers of
older assets (hence with higher ROI) are more
reluctant to invest in desirable projects with IRR
higher than COC

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Quick Check 1

A division has net operating income of $60,000

and average operating assets of $300,000.
Required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%

25
Quick Check 1a

A division has net operating income of $60,000

and average operating assets of $300,000.
Required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20% ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%

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Quick Check 2

A division has net operating income of $60,000

and average operating assets of $300,000. If the
manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No

27
Quick Check 2a

A division has net operating income of $60,000

and average operating assets of $300,000. If the
manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No ROI = $78,000/$400,000 = 19.5%
This lowers the division’s ROI from
20.0% down to 19.5%.

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Quick Check 3

The company’s required rate of return is 15%.

Would the company want the division manager
to make an investment of $100,000 that would
generate additional net operating income of
$18,000 per year?
a. Yes
b. No

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Quick Check 3a

The company’s required rate of return is 15%.

Would the company want the division manager
to make an investment of $100,000 that would
generate additional net operating income of
$18,000 per year?
a. Yes
ROI = $18,000/$100,000 = 18%
b. No
The return on investment exceeds the
minimum required rate of return.

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Quick Check 4

A division has net operating income of $60,000

and average operating assets of $300,000.
Required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000

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Quick Check 4a

A division has net operating income of $60,000

and average operating assets of $300,000.
Required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000 Net operating income $60,000
d. $ 51,000 Required return (15% of $300,000) (45,000)
Residual income $15,000

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Quick Check 5

A division has net operating income of $60,000

and average operating assets of $300,000. If the
division manager is evaluated based on residual
income, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No

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Quick Check 5a

A division has net operating income of $60,000

and average operating assets of $300,000. If the
division manager is evaluated based on residual
income, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
Net operating income $78,000
b. No Required return (15% of $400,000) (60,000)
Residual income $18,000

$3,000 increase in RI

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Learning-by-Doing

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 Learning-by-Doing

Company A Company B Company C

Sales (a) $9,000,000 * $7,000,000 * $4,500,000 *
Net operating income (b) $540,000 $280,000 * $360,000
Average operating assets (c) $3,000,000 * $2,000,000 $1,800,000 *
Return on investment (ROI) (b) ÷ (c) 18%* 14%* 20%
Minimum required rate of return:
Percentage (d) 16%* 16% 15%*
Dollar amount (c) × (d) $480,000 $320,000 * $270,000
Residual income (b) – [(c) × (d)] $60,000 $(40,000) $90,000 *

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Economic Value Added (EVA™)
• Modified/adjusted residual income
• EVA = Adj income – Cost of capital × Adj investment
= NOPAT – WACC × (Total assets – Current liabilities)
• NOPAT = Net operating profit after tax
• WACC = Weighted average cost of capital (after tax)
• Many other adjustments possible
• 164 in total, as suggested by Stern Stewart & Co (EVA creator)
• e.g., capitalize and amortize R&D, advertising, employee
training

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Net income vs EVA

EBIT EBIT
NOPAT
– I – T
– T – Capital Charges (CC)
= Net Income = EVA

Debt  i rate Debt

I= IC CC = IC × COC
Equity Equity

IC = invested capital

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Example

HY Corp. evaluates performance of stand-alone divisions

using ROI and RI. The CFO received following
performance information of property division:

Sales revenues $900,000

Operating income 225,000
Total assets 1,500,000
Current liabilities 300,000
Debt (interest rate: 5%) 400,000
Common equity (book value) 500,000

HY defines investment as total assets and income as

operating income (i.e., income before interest and taxes).
The firm pays a flat rate of 25% for income taxes.
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Example

1. The division’s net income after interests and taxes?

Operating income $225,000

Less interest expense 20,000
Income after interests and before taxes $205,000
Income taxes 51,250
Net income after taxes $153,750

2. The division’s ROI?

Investment = $1,500,000
Income = $225,000
ROI = 15%

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Example

3. Based on HY’s required rate of return of 8%, what is the

division’s residual income?

Income = $225,000
Cost of investment = $1,500,000 × 8% = $120,000
Residual income = $105,000

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Example

4. HY’s four divisions have similar risk attributes. HY’s debt

trades at book value while its equity has a market value
approximately 150% that of its book value.

The company’s cost of equity capital is 10%. Calculate each

of the following components of EVA for property division,
as well as the final EVA figure:

a. Net operating profit after taxes

b. Weighted average cost of capital
c. Investment, as measured for EVA calculations
d. EVA

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Example

a. Net operating profit after taxes = $225,000 × (1 – 0.25) =

$168,750

b. Market value of debt = $400,000

After-tax cost of debt = 5% × (1 – Tax rate) = 3.75%
Market value of equity = $500,000 × 150% = $750,000
Cost of equity capital = 10%
Weighted average cost of capital = (3.75% × 400,000 + 10% ×
750,000) / (400,000 + 750,000) = 7.83%

c. Investment = Total Assets – Current Liabilities =

$1,500,000 – $300,000 = $1,200,000

d. EVA = $168,750 – 7.83% × $1,200,000 = $74,790

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Case discussion: Over to Shireen (시렌)!
• Las Ferreterías de México, S.A. de C.V.
• 1. Evaluate the proposed bonus plan that Mr.
Gonzalez is considering.
• 2. How, if at all, would you modify the proposed plan?

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Week 9-11
• Performance Measurement Issues and Their Effects
• Financial performance measures and their effects
(Week 9)
• Financial performance measures
• Market
• Accounting
• Investment performance
• Return on investment
• Residual income and EVA

• Remedies to the myopia problem (Week 10)

• Using financial results controls in the presence of
uncontrollable factors (Week 11)
45
Hanyang University Business School

Managerial Accounting
Fall 2022

Professor Taeho Ko
[email protected]

Week 9. Financial performance measures and

their effects