Investment and Net Operating Profit

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Chapter 7
Measuring and Controlling Assets Employed

Case 7-7
Marden Company

There are many methods to evaluate the performance of each division. We can use profitability ratios, liquidity ratio and debt ratio and so on to do the measurement. Just like many big company in the world, ROI, the indicator of money gained or lost on an investment relative to the amount of money invested, is the most popular way to do the measurement. However, in my opinion, EVA or RI should be a better method to evaluate the performance of each division separately. Let use EVA to explain the reason of EVA being a better approach.

EVA is net operating profit after taxes less the money cost of capital. If the company uses ROI to measure the performance, it cannot maximize the shareholder’s value. When there is a project which will increase the value of the company but will decrease the ROI result, the manager will cancel it. But if we use EVA method, we just need to calculate the capital cost rate. In addition, each investment has different capital cost. EVA method can use different interest rate for each investment. The most important reason is it can encourage division managers to do their best to add value for the whole company.

After all, when the top manager measures the performance for each division, he should consider not only the value added for each department because of the different size, but also the trend of weight for total value added.

Interest on debt, kd = 9%

Interest on equity would be more than that on debt. Let, Interest on equity, ke = 12%

The applicable corporate tax rate in Bangladesh is 27.5%. Hence we use the same in Marden Company’s case.

Equity (E) = $ 1300, Debt (D) = $ 700So, E+D = $ 2000
 
EVA = NOPAT ± (WACC* Capital employed)
 
Where,EVA = Economic value added 
NOPAT = Net operating profit after tax
WACC = Weighted avg. cost of capital
 
NOPAT = Profit Before Tax * (1 - Tax rate) = 600 * (1 – 27.5%) = $ 435  
WACC=...
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