Measuring of Assets

							Measuring And Controlling
   Assets Employed
 Why long term investment is
      a strategic issue?
Long term investment decisions are made
 after long term strategy is decided (not the
 other way around).
Also, strategic leverage affects how much
 investments in long term assets are
 necessary.
Consequently, if decisions about long term
 investments are made incorrectly, strategy
 and strategic leverage are less likely to be
 accomplished.
Why long term investments is
      a control issue?
Long term investments are generally huge
 in their monetary and non-monetary
 impact.
As such, if managers and others do not take
 all precautions when investing and later, in
 measuring the usefulness of the assets and
 their contribution, it will have significant
 adverse impact.
Therefore, measuring long term assets is
 also a control issue of great importance.
Before we discuss measurement of long-term
assets and alternative measurement methods,
let us discuss why it is important to measure
long term assets and what specific factors
confound the valuation process.
 Characteristics of long-term
           assets
Long-term assets (Building, Plant,
 Machinery, Information Technology)
Short-term assets (Inventory, Accounts
 Receivable, Cash)
Long-term assets - an organization is
 committed for a long period of time.
The lack of investment could cause
 opportunity losses or the investment could
 cause excess capacity.
The investment amount is usually large.
    Regardless, when an
organization makes long term
         investment
The investment must:
  – Lead to generation of adequate profits
    and
  – the return (ratio of profits generated
    compared to total investments) must be
    adequate.
  – What is “adequate” return and which
    investment is better than other
    alternatives are the focus of this chapter.
      Please remember that
Every investment competes with alternative
 investments and,
No organization, however large it is, has
 resource constraints; and therefore,
A company must choose its investment
 strategy judiciously and such a strategy
Must be carried out within the overall
 strategic framework – deciding priorities
 and allocating resources.
     Before choosing an evaluative
     methodology, a manager must
         determine the following:
How to determine investment priorities
 (what tangible and intangible benefits
 must be taken into account)?
How to assess the risk of each
 investment?
How to establish a process for managing
 the realization of expected benefits? This
 is a long term issue, and
How to justify the investments (how it
 fits within the overall strategy)?
Performing investment analysis
 Why relate profits to investments?

Unless an organization is a 100% service
 organization, profits are generated ONLY if
 you have investments.
Therefore, earning a satisfactory return on
 the investments employed is necessary.
The investors in stock compute such a
 return routinely (e.g. Ford and G.M.).
To compare two units, A and B, without
 considering the investment made in each is
 meaningless.
    Why relate profits to investments?
     The Manager’s Responsibility

First, a manager should invest in assets only
 if the assets will produce adequate returns.
Second, when an asset is not providing
 adequate return (the expected return could
 change over the years), it is time to
 “disinvest” or reduce further investments
 into this asset.
     Two ways to relate profits and
investments and to compare investment
             alternatives

Return on Assets (ROA) and




Economic Value Added (EVA).
          Return on Assets (ROA)
  (let us use Exhibit 7.1 of our textbook)
ROA is a ratio of two numbers:
                     Income
  ROI = --------------------------------------
             Average Assets (or Investment)
   Note: Most times, average assets is - (the beginning of
   the year equity + end of the year equity / 2). Equity for
   this purpose would be defined as the stockholders’
   equity + long term liabilities. From exhibit 7.1,
   ROA = 100 (net income) / 500 (Equity) = 20%
   (In exhibit 7.1, there are no long term liabilities).
  Economic Value Added (EVA)

EVA= Net income - (operating
     assets)*cost of capital

Capital Charge = (operating
        assets)*cost of capital

 EVA = Net Income – Capital Charge
                 Exhibit 7.1
Current Assets:          Current Liab.
Cash………….50            Accounts Payable…..90
Receivables….150       Other Current……...110
Inventory…….200
Total C.A…….400        Total C.L…………..200
Fixed Assets:
Cost………….600            Corporate equity…500
Depreciation…(300)
Book Value…..300
Total Assets…..700     Total Equities…….700
            Exhibit 7.1 contd.
Income Statement
Revenue…………………………………..1000
Expenses except depreciation……………..850
Depreciation………………………………….50
                                     (900)
Income before taxes……………………….. 100
Capital charge(500*10%)…………………..50

So, Economic Value Added (EVA)…………50
ROA or ROI……………………100/500 = 20%
 EVA or Economic Value Added
EVA= Net income - (operating
        assets*cost of capital)
Note: Unlike ROA, EVA is not a ratio but a
 monetary amount
Note: Operating Assets*Cost of Capital =
 Capital charge.
Use exhibit 7.1 to compute EVA -
Net Income = 100
Capital charge – Equity * .10 = 50
EVA = 100 – 50 = 50
The minimum return an organization must
 earn on its investments to meet investor
 expectations.

Cost of capital is specific to each
  organization and depends on several factors
  such as the type of industry in which it
  operates, how risky the organization is, the
  rate at which it can borrow from outside
  and more (borrowing, in this context, refers
  to both debt and equity).
 If an investment returns more than the cost of its
  capital, the investment is positive and if not, it is
  negative and as well not invested.
      How asset values can distort
      ROA and EVA Computations
ROA and EVA computations are simple.
However, depending on the asset based
 used, they can give misleading signals.
Most long term assets are depreciated.
Everyone comfortable with depreciation
 computations?
Depreciation reduces the book value of the
 assets as they age.
     Depreciation distorts ROA, EVA
                Computations
We will use the numbers from Exhibit 7.1
New Machine costs 100. Life 5 years
Savings by using the new machine $27 per
 year or on a Present Value basis for five
 years, $102.4 with a net present value of
 $2.4 (102.4 - $100).
Before this new asset is acquired, the annual
 depreciation on fixed assets was $50 per
 year and
After the new asset is purchased, the annual
 depreciation will go up by 50 + (100 /5) = 70
      See computations for before and after
       purchase of asset - ROI and EVA are
           overstated (See exhibit 7.1)
                       Before 1 year after
                                 Purchase   Purchase
                                 of asset   of asset
Profit before depreciation…..... 1,000      1,000
Expenses (w/o Deprecn.)……… ( 850)           ( 823)
Profit before depreciation……..150           177
Depreciation ……………………(50)                   (70)
Profits after depreciation……… 100           107

Equity……………....... ………... 500                500
Capital charge at 10%................ 50     60
EVA (Profits – Cap. Charge)…..50             47

ROA                                20%      21.4%
  Interpretation of the previous slide

 The profit before depreciation has remained constant at
  $100 before and after purchase of the asset and yet
 The ROA went up from 20% to 21.4%. Why? Simply
  because the depreciation expenses went up.
 In contrast, the EVA declined from 50 to 47 making it look
  like profits decline after purchase of the asset (even though
  the income before taxes had actually increased from $100
  to 107).
 That is, a manager can make the wrong decision not to
  purchase the asset based on these computations.
 In later years, the EVA will go up and so will the ROA
  because of additional depreciation.
One more example of ROA increase just
by the passage of time and even without
         acquiring a new asset.


                          Year 1   Year 2    Year 3

Profit before depreciation….110        110        110
Depreciation…………………50                  50         50
Profit after depreciation…….60          60         60

Equity ………………………..500                  450       400
ROI……………………………12.0%                    13.3%     15%
   ROI can lead to poor decisions
Encourages division managers to retain
 assets beyond their optimal life and not to
 invest in new assets which would increase
 the denominator.
Can cause corporate managers to over-
 allocate resources to divisions with older
 assets because they appear to be relatively
 more profitable.
Capital may be allocated towards least
 profitable divisions, at the expense of the
 most profitable divisions.
        ROI – the bad decisions

Can lead to different inventory policies and
 decisions in different divisions, even for
 identical items of inventory.
If corporate managers are not aware of
 these distortions or do not adjust for them,
 they can do a poor job of evaluating the
 divisional managers and their
 performances.
     How to deal with this issue?




When computing ROA or EVA, don’t use
 net book value of the asset but use gross
 book value (original purchase price
 ignoring depreciation).
See ROA computations from your exhibit
          using gross value

                           Before   1 year after
                           Purchase Purchase
                           of asset   of asset
Profit before depreciation…..1,000     1,000
Expenses (w/o Deprecn.)…….( 850)       ( 823)
Profit before depreciation……150         177

Equity………………………… 500                      500
Capital charge at 10%............. 50     60
ROA …………………………..50/500                   177/500
                           =       30%    35.2%
   Advantages of using EVA (residual
               income)
EVA ranks project on profits in excess of
 the cost of capital (EVA increases).
With EVA, all business units have the
 same profit objective for comparable
 investments.
EVA permits the use of different interest
 rates for different investment projects.
EVA has greater correlation with a
 firm’s market value (it optimizes
 shareholder value).
            ROA versus EVA

In practice, most businesses use ROA
 because it is simpler to compute and
 understand.
It is also comprehensive in the sense that it
 considers the entire balance sheet and
 income statement.
Unlike ROA – a percentage, EVA is a dollar
 amount and does not allow for intra and
 inter company comparisons.
  Then, why use EVA? The Advantages
EVA uses the same profit objectives; this
 overcomes the problem of depreciation and
 varying incentives to invest in assets.
EVA, on the contrary, finds any investment
 that returns over the cost of capital as worth
 investing.
EVA permits use of different rates of
 interest to each project (since some
 investments or more/less risky than others.
EVA (unlike ROA) is more positively
 correlated to stock values.
     What are intangible assets?

Not all benefits that accrue are so easy to
 objectively measure and not all investments
 are in tangible form (physical).
Intangible assets include items that lack of a
 physical form but are nevertheless
 important for a firm to measure and
 understand. e.g. R& D, Marketing
 promotions, investments in IT.
Why should a firm invest in intangible
              assets?
 Intangible assets signal a firm’s ability
 to:
Introduce new products
Develop customer relationships
 (marketing, advertising, promotional
 schemes)
Approach new customer segments
Improve product quality and services
Manage cost, reduce lead times, and
 more. Benefits from these efforts accrue
 over a long time and into the future,
 these investments could be capitalized.
 How does an organization measure
        intangible assets?
 Relative value. Measure progress, not a
 quantitative target, that is the ultimate goal.
 Example: have 80% of employees involved
 with the customer in some meaningful way.
Balanced scorecard: we will discuss these in
 the performance measures chapter.
Competency models. By observing and
 classifying the behaviors of "successful"
 employees ("competency models") and
 calculating the market value of their output.
      Measuring Intangible Assets
4. Subsystem performance. Sometimes it's
 relatively easy to quantify success or
 progress in one intellectual capital
 component. For example, Dow Chemical
 was able to measure an increase in licensing
 revenues from better control of its patent
 assets.
5. Benchmarking. Involves identifying
 companies that are recognized leaders in
 leveraging their intellectual assets,
 determining how well they score on relevant
 criteria, and then comparing your own company's
     Measuring Intangible Assets

6. Business worth. Ask 3 questions: What
 would happen if the information we now use
 disappeared altogether? What would
 happen if we doubled the amount of key
 information available? How does the value
 of this information change after a day, a
 week, a year? Evaluation focuses on the cost
 of missing or underutilizing a business
 opportunity, avoiding or minimizing a
 threat.
    Measuring Intangible Assets

7. Brand equity valuation. Methodology
 that measures the economic impact of a
 brand (or other intangible asset) on such
 things as pricing power, distribution reach,
 ability to launch new products as "line
 extensions."
8. "Calculated intangible value." Compares
 a company's return on assets (ROA) with a
 published average ROA for the industry.
     Measuring Intangible Assets

9. "Colorized" reporting. Suggested by SEC
 commissioner Steven Wallman, this method
 supplements traditional financial statements
 (which give a "black and white" picture)
 with additional information (which add
 "color"). Examples of "color" include
 Brand values, customer satisfaction
 measures, value of a trained work force.
           Intangible assets and
            investment analysis
Calculate ROA/EVA ignoring intangible
 benefits. If the return is less than what is
 acceptable, ask whether the intangible
 benefits are worth at least the amount of the
 difference between what is acceptable and
 what the expected return is.
Project rough, conservative estimates of the
 value of the intangible benefits, and
 incorporate these values into the investment
 calculation.
Thanks



Presented By: Dalbir Singh
University Business School
Semester - 3