ROI, Residual Income and EVA: Investment, Disposal and Accounting Adjustment Bias
Sundaram Polymers evaluates its division heads on return on investment, and the manager of the Moulding Division is paid a bonus that rises sharply once divisional ROI exceeds 15%. The division's invested capital is ₹48 crore and its operating profit is ₹7.2 crore; the corporate cost of capital is 12%. Two proposals are on the table. The first is a ₹12 crore compounding line expected to earn ₹1.62 crore of operating profit a year for ten years. The second is the sale of the packaging unit for ₹5.5 crore; its book value is ₹6 crore and it currently earns ₹0.72 crore a year. Two accounting facts matter: ₹3 crore of the reported capital is capital work-in-progress on a plant that will not earn anything for eighteen months, and ₹1.2 crore of development expenditure was written off this year although it will generate benefits for the next three years. The CEO has heard of EVA and wants to know whether it would change the decisions the divisional manager is likely to take.
1. Evaluate both proposals under ROI and under residual income, and state what the divisional manager will do versus what the company should do.
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Current position: ROI = 7.2 ÷ 48 = 15.0%. RI = 7.2 − (0.12 × 48) = 7.2 − 5.76 = ₹1.44 crore.
Proposal 1 - new line (13.5% return on ₹12 crore).
- Company test: 13.5% > 12%, so accept; NPV is positive.
- ROI after: 8.82 ÷ 60 = 14.70%, below the 15% bonus trigger - the manager rejects.
- RI after: 8.82 − (0.12 × 60) = 8.82 − 7.20 = ₹1.62 crore, up ₹0.18 crore - an RI-manager accepts.
Proposal 2 - sale of the packaging unit.
- Company test: the unit earns 0.72 ÷ 6 = 12%, exactly the cost of capital, so its earnings are neutral; but the proceeds of ₹5.5 crore are below book value of ₹6 crore, so selling crystallises a ₹0.5 crore loss and the company is worse off by about ₹0.5 crore (perpetuity value at 12% = ₹6 crore versus ₹5.5 crore received).
- ROI after: 6.48 ÷ 42 = 15.43% - the manager sells and earns a bigger bonus.
- RI after: 6.48 − (0.12 × 42) = 6.48 − 5.04 = ₹1.44 crore, unchanged - an RI-manager is indifferent, which is closer to correct but still not a signal to sell.
Verdict: ROI systematically produces both errors - rejecting profitable growth and dumping adequately earning assets. It measures a ratio, and a ratio can be improved by shrinking the denominator.
2. Compute EVA after the stated accounting adjustments and show how EVA would treat the two proposals.
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Adjustments, with assumptions stated:
- Capital work-in-progress. ₹3 crore is excluded from capital because it is not yet earning; charging 12% on it would penalise the manager for an investment the company wants.
- Development expenditure. ₹1.2 crore was written off in full but benefits three years. Capitalise it, amortise ₹0.4 crore this year, and add back the remaining ₹0.8 crore to both profit and capital.
Adjusted NOPAT = 7.2 + 0.8 = ₹8.0 crore. Adjusted capital = 48 − 3 + 0.8 = ₹45.8 crore. Capital charge = 0.12 × 45.8 = ₹5.496 crore. EVA = 8.0 − 5.496 = ₹2.504 crore.
Proposal 1 under EVA: incremental EVA = 1.62 − (0.12 × 12) = 1.62 − 1.44 = +₹0.18 crore a year, so accept - the same conclusion as residual income.
Proposal 2 under EVA: the packaging unit currently earns EVA of 0.72 − 0.72 = 0. Selling it removes a zero-EVA asset but crystallises a ₹0.5 crore loss in NOPAT while the capital charge avoided is only 0.72, so year-one EVA falls by about ₹0.5 crore and returns to zero thereafter. EVA therefore discourages a value-destroying disposal, which ROI encourages - but note it does so through the one-off loss, and a manager judged on a single year's EVA could still be tempted to time disposals to suit the bonus.
3. Recommend a performance-measurement package for Sundaram Polymers, addressing the weaknesses you have identified and the risk of gaming the measure.
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Replace ROI with a residual measure. Use EVA (or RI) for bonus, with the capital charge at 12% on average capital employed. This makes the rule automatic: any investment earning above 12% adds to the score, any earning below it subtracts, so the manager's interest coincides with the group's on both the new line and the disposal.
Embed the accounting adjustments in the policy, not in the discretion of the CFO:
- Exclude CWIP from capital until commissioning, then phase the capital charge in over, say, twelve months, so that a manager is not deterred by a two-year gestation.
- Capitalise development expenditure and amortise it over its benefit period, so that investment in intangibles is not punished as a cost in year one.
- Deduct trade payables from capital and add back non-cash provisions, and disclose all adjustments in a standing note.
Guard against gaming. A single residual measure invites manipulation of the capital base: managers can lease rather than buy assets to shrink invested capital (and hide debt), sell assets shortly before the measurement date, or defer maintenance to protect NOPAT. Counter with a bonus bank spreading the reward over three years, a rolling three-year capital employed, a check on major leases and disposals above a threshold, and a review of the disposal price against an independent valuation.
Supplement, do not substitute. Add throughput, on-time delivery, quality, safety and customer retention. A division can improve EVA for a year by cutting the very spending that sustains its franchise; the non-financial scorecard is the check on that, not a decoration.