ACCA P5 Advance Performance Management
Annuity Depreciation: In the article “Here’s mud in RIs” we
see the use of ROI and RI does not always result in best decisions because RIs’
over initial period of project are lower
compared to the later period because of depreciated value of assets which
decreases over life of project. Annuity depreciation resolves this problem by
smoothing depreciation over project’s life.
Steps in Calculating RI and ROI using annuity depreciation
method:
Step 1
Equivalent Annual Cost = Initial Investment/ Cumulative
discount factor at company’s cost of capital
Step 2
Equivalent Annual Cost = Interest on Opening Book Value +
Annual Depreciation
(or, Annual Depreciation = Equivalent Annual Cost
– Interest on Opening Book Value)
Step 3
Annuity adjusted Operating Profit (PBIT)= PBITD – Annual Depreciation (From step 2)
Residual Income = Net Cash Inflow – Equivalent Annual Cost
Return on Investment = Annuity adjusted Operating Profit / Opening Book Value
Economic Value Added (EVA) – relate to NPV check drawbacks
of NPV and review drawbacks of EVA
EVA = Net Operating Profit After Tax (NOPAT) – WACC * Economic
Value of Capital Employed
In simple term, EVA is recalculation of residual income RI
replacing all economic adjusted values.
It is directly linked to creation of shareholder wealth. It
is an absolute measure. EVA is consistent with NPV. In a way it is economically
adjusted NPV of investment over a period of one year.
Comparing EVA and RI
RI
|
PBIT – Imputed interest (Capital employed * cost of
capital)
|
In Profit term
|
EVA
|
NOPAT – (Economic Value of Capital employed * WACC)
|
In Economic Cash flow term
|
Disadvantage of EVA:
Absolute measure therefore presents difficulty in comparison
Provide historic information
Requires lots of adjustments
ACCA
Article: Economic Value Added
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