Alternative Investment Bases

Chapter 7 in the textbook discusses how differences in the amounts used to calculate ROI can impact performance evaluation. I found the reading very tedious and difficult to understand. This problem provides a simple example of how alternative investments bases affect the calculation of ROI (and therefore, affect performance evaluation).

Basic Information:

The T Division of A.T. Enterprises has depreciable assets costing $2 million. The cash flows from these assets for 3 years follow:

Year Cash Flow

$600,000

$700,000

$600,000

Depreciation of these assets is 10% per year; the assets have no salvage value.

Assumptions:

A.T. calculates Return on Investment as follows:

ROI = NOI / Investment

Required:

Compute ROI for each year by recreating the tables on the following pages assuming that investment is calculated using:

Net book value

Gross book value

Visually compare each method separately across the three years (i.e., dont compare Net Book Value to Gross Book Value). Based on your visual comparison, which method is better for evaluating performance? Why?

Alternative Investment Bases

NET BOOK VALUE

For Net Book Value:

NOI = Cash Flows Depreciation Expense

Investment Base = Depreciable Assets Accumulated Depreciation at year end

Year 1 has been completed as an example.

	Year 1	Year 2	Year 3
NOI (a)	$600,000 ($2,000,000 x 10%) $400,000
Investment Base (b)	$2,000,000 x 90%* $1,800,000
ROI (a)/(b)	$400,000 = 22.22% $1,800,000

* Alternatively, $2,000,000 ($2,000,000 x 10%)

Alternative Investment Bases

GROSS BOOK VALUE o For Net Book Value:

o NOI = Cash Flows Depreciation Expense o Investment Base = Depreciable Assets

Year 1 has been completed as an example.

	Year 1	Year 2	Year 3
NOI (a)	$600,000 ($2,000,000 x 10%) $400,000
Investment Base (b)	$2,000,000
ROI (a)/(b)	$400,000 = 20% $2,000,000

Note that this example only manipulates one variable Investment Base Net Book Value vs. Gross Book Value. Other Investment Base variations include: (1) Beginning of the Year vs. End of the Year vs. Average Book Balance and (2) Historical Cost vs. Current Cost. It can be quite complicated to ensure that the performance evaluation method being used is encouraging goal congruent behavior.