Project on Return on Investment

Submitted by: Subarna Chatterjee Swati Karwa Laveena Pinto Re ha Sani! 7305 7319 7327 7331

"# $art o% the interna! a##e##ment

Return on &nve#tment ' Con(e$t

The two complementary approaches to return on investment are:
Return on total assets (ROTA) Return on equity (ROE)

The two separate measures are necessary because they throw light on different aspects of the business, both of which are important. Return on total assets loo s at the operating efficiency of the total enterprise, while return on equity considers how that operating efficiency is translated into benefit to the owners. RET!R" O" E#!$T% (ROE) This ratio is arguably the most important in business finance. $t measures the absolute return deli&ered to the shareholders. A good figure brings success to the business ' it results in a high share price and ma es it easy to attract new funds. These will enable the company to grow, gi&en suitable mar et conditions, and this in turn leads to greater profits and so on. All this leads to high &alue and continued growth in the wealth of its owners. ROE ( )AT * +,, Owner-s funds At the le&el of indi&idual business, a good return on equity will eep in lace the financial framewor for a thri&ing, growing enterprise. At the le&el of the total economy, return on equity dri&es industrial in&estment, growth in gross national product, employment, go&ernment ta* receipts and so on. $t is, therefore, a critical feature of the o&erall modern mar et economy as well as of indi&idual companies. RET!R" O" TOTA. A//ET/ (ROTA) Return on total assets pro&ides the foundation necessary for a company to deli&er a good return on equity. A company without a good ROTA finds it almost impossible to generate a satisfactory ROE.

ROTA (

)0$T

+,,

Total Assets )0$T is the amount remaining when total operating cost is deducted from total re&enue, but before either interest or ta* ha&e been paid. Total operating cost direct factory cost, plus administration, selling and distribution o&erheads. This operating profit figure is set against the total assets figure in the balance sheet. The percentage relationship between the two &alues gi&es the rate of return being earned by the total assets. Therefore this ratio measures how well management uses all the assets in the business to generate an operating surplus. Return on total assets uses the three main operating &ariables of the business. Total re&enue Total cost Assets employed

$t is therefore the most comprehensi&e measure of total management performance. Con(e$t te#tin) 1

1. ROI Composition:
RO$ consists of two components &i2. )rofit margin, and $n&estment turno&er

As shown below3 RO$ ( "et profit $n&estment OR RO$ ( "et profit /ales )ont 5hart. * /ales $n&estment in Assets

The basic elements of the return on in&estment ratio can be shown in the form of a 4u

6.

Two ways of improving return on investment

The earning power or the return on in&estment ratio is a central measure of the o&er all profitability and operational efficiency of the firm. $t shows the interaction of the profitability and acti&ity ratios. $t implies that the performance of a firm can be impro&ed either by generating more sales &olume per rupee of in&estment or by increasing the profit margin per rupee of sales. E*ample ' Earning power (RO$) ( "et profit after ta*es Total assets. Earning power (RO$) ( "et profit after ta*es* /ales /ales Total assets i.e.

Assume

This ratio can be impro&ed by either impro&ing a or b. a can be impro&ed by increasing the net profit for the same amount of sales i.e. increase the profit margin. b can be impro&ed by increasing the sales &olume for the same amount of in&estment.

3. Tax shelter
Return on in&estment i.e. the earning power of a firm is the ratio of net profit to total assets. "et profit is the residual income after pro&iding for all the e*penses. These e*penses include, 5ost of direct material, labour and &ariable e*penses

Operating costs li e salaries, wages etc. 7i*ed costs li e interest and ta*es.

Return on in&estment can be impro&ed by increasing the profit margin for the same &olume of sales. )rofit can be further impro&ed by reducing costs. One of the elements of cost is interest payment. One way of eeping the costs under control is by maintaining a proper balance between equity and debt. 4ebt carries a fi*ed charge nown as interest, which has to be paid irrespecti&e of the amount of profits. Equity does not carry a fi*ed charge and can be paid from the net profits after allowing for all the e*penses. The return to the equity holders i.e. payment of di&idend is not a legal binding on the firm. The interest on debt is ta* deductible but the equity di&idends are not ta*1deductible payments. 8ence a proper proportion of debt and equity can be used to impro&e return on in&estment.

4. 28%debt = 14% preference shares, tax rate=50%

The abo&e statement can be e*plained as follows3 $nterest on debt is ta*1deductible. Therefore, a 69: interest on debt would mean an interest payment of 69(+1.;,)( +<: i.e. same as +<:interest on preference shares.

;.

Social wealth

The shareholders of a company form a part of the society. Their in&estments in the company form a large part of social wealth. As the society pro&ides finance to a company, the goal of 7inancial =anagement is to ma*imise the present wealth of the owners i.e. equity shareholders in a company. $t is defined as &alue ma*imisation. The wealth of the shareholders is represented in the mar et &alue of equity shares. The mar et price of a share ser&es as an inde* of the performance of the company. $t indicates how well management is doing on behalf of stoc holders. The factors that bear upon the

mar et price of stoc are the present and prospecti&e future earnings per share, the timing and the ris of these earnings, the di&idend and retention policies of the firm and many others. /hareholder-s wealth and in effect social wealth is ma*imised only when the mar et &alue of the share is ma*imised.

6. Du pont Chart
Return on $n&estment Earnings as : of sales multiplied Turno&er

Earnings /ales

divided by

/ales

/ales

divided by

Total $n&estment

minus 5ost of sales )ermanent plus >or ing in&estment capital

5ost of sales

plus

/elling plus e*penses

Administrati&e e*penses $n&entories

plus

Accounts plus recei&ables

5ash

4u )ont control chart3 *R&+&, '

A system for management control has been designed which is popularly nown as the -u Pont Chart system of control. This system utili2es the ratio inter1relationships to pro&ide an important series of charts and indicators calling management-s attention to desirable and undesirable trends of corporate performance. Once a company has de&eloped standards of performance regarding the &arious ratios, it becomes easy to ?udge performance changes with such a system. *./0C1&20 1 An important ob?ecti&e of the 4u )ont system is to isolate the elements entering into the final figure in order to appraise the individual factors affecting performance.

30",&,+ ' $t may be noted that the analytical chain in this chart is de&eloped along two tiers ' 1he %ir#t #e4uen(e starts with turno&er, determined by di&iding sales by total in&estment@ total in&estment represents current assets plus net fi*ed assets. 5urrent assets include in&entories, accounts recei&ables and cash. $n the #e(ond tier, the sequence starts with earnings as a percentage of sales, calculated by di&iding earnings by sales@ earnings equal sales less cost of sales, and cost of sales includes cost of goods sold, selling e*penses, administrati&e and general e*penses. 5S0 1 The chart pro&ides management with an o&erall perspecti&e of the financial relationships leading to the earnings rate on in&estment. 5hanges in any important segment of this structure will influence the final in&estment returns. The two1tier approach concentrates attention on the separate forces contributing to profits. $mpro&ement can be accomplished either through more effecti&e use of a&ailable capital, measured by the turno&er sequence or through a better relationship between sales and costs, measured by the profit margin sequence. The same rate of return is achie&ed by either a low profit margin and high turno&er or a high margin and low turno&er. 7or pro&iding standards of e&aluation, calculations are made of the ratios of return on in&estment, assets turno&er and profit margins for comparable companies. Appropriate brea downs can also be established for indi&idual units within the same organi2ation for internal comparisons. The return on in&estment has been used as a measure of performance and a means of e&aluating alternati&e in&estment opportunities. 8owe&er, the approach is rearward and the data from which the ratio is calculated are applicable to specific past periods. To be consistent, it is necessary that the earnings in the numerator of the ratio should flow from

the in&estment base used in the denominator. 0ut, in practice, this consistency is not usually obser&ed.

1heory 4ue#tion#

+.

Evaluate different Financial Management objectives6

5lear ob?ecti&es are required for wise decision1ma ing. Ob?ecti&es pro&ide a framewor for optimum financial decision1ma ing. $n other words they are concerned with designing a method of operating the internal in&estment and financing of a firm. There are alternati&e approaches in financial literature regarding ob?ecti&es. Two of the most widely discussed approaches are3 +. )rofit ma*imi2ation approach 6. >ealth ma*imi2ation approach +.)rofit ma*imi2ation decision criteria3 !nder this approach, actions that increase profits should be underta en and those that decrease profits are to be a&oided. $n specific operational terms, the profit ma*imi2ation criterion implies that the in&estment, financing and di&idend policy decisions of a firm should be oriented towards the ma*imi2ation of profits. The rationale behind profit ma*imi2ation as a guide to financial decision ma ing, is due to the following reasons3 +. )rofit is a test of economic efficiency. $t pro&ides the yardstic economic performance can be ?udged. 6. $t leads to efficient allocation of resources as resources tend to be directed to uses, which in terms of profitability are the most desirable. A. $t ensures ma*imum social welfare. This is so because the quest fro &alue dri&es scarce resources to their most producti&e uses and their most efficient users. The more effecti&ely resources are deployed@ the more robust will be the economic growth and the rate of impro&ement in the standard of li&ing. by which

The profit ma*imi2ation criterion howe&er has been questioned and critici2ed on se&eral grounds. $t suffers from the following limitations3 +. )rofit in absolute terms is not a proper guide to decision ma ing. $t has no precise connotation. $t should be e*pressed either on a per share basis or in relation to in&estment. Also, profit can be long term or short term, before ta* or after ta*, it may be the return on total capital employed or total assets or shareholders equity and so on. $f profit ma*imi2ation is ta en to be the ob?ecti&e, which of these &ariants of profit should a firm try to ma*imi2eB Therefore, a loose term li e profit cannot form the basis of operational criterion for financial management. 6. $t lea&es considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations. A. $t glosses o&er the ris factor. $t cannot, for e*ample, discriminate between an in&estment pro?ect, which generates a certain profit of Rs. ;,,,,,, and an in&estment pro?ect, which has a &ariable profit outcome with an e*pected &alue of Rs. ;,,,,,. 6.>ealth ma*imi2ation decision criterion3 This is also nown as &alue ma*imi2ation or net present worth ma*imi2ation. The focus of financial management is on the &alue to the owners or suppliers of equity capital. The wealth of the owners is reflected in the mar et &alue of the shares. /o wealth ma*imisation implies the ma*imisation of the mar et price of shares. $t has been uni&ersally accepted as an appropriate operational decision criterion for financial management decisions as it remo&es the technical limitations, which characterise the earlier profit ma*imisation criterion. $ts operational features satisfy all the three requirements of a suitable operational ob?ecti&e of financial courses of action, namely e*actness, quality of benefits and the time &alue of money. 4espite the forceful arguments in fa&our of the goal of ma*imising shareholder &alue its supremacy has been challenged by many. They are as follows3

=a*imisation of the wealth of shareholders (as reflected in the mar et &alue of equity) appears to be the most appropriate goal for financial decision1ma ing.

2. Explain the role of finance head as conflict manager

5onflict of goal between management an downers3 Agency problem A characteristic feature of corporate enterprise is the separation between ownership and management as a corollary of which the latter en?oys substantial autonomy in regard to the affairs of the firm. >ith widely diffused ownership, scattered and ill1organised shareholders hardly e*ercise any controlCinfluence on management, which may be inclined to act in its own interests rather than those of the owners. 8owe&er shareholders as owners of the enterprise ha&e the right to change the management. 4ue to the threat of being dislodged for poor performance, the management would ha&e a natural inclination to achie&e a minimum acceptable le&el of performance to satisfy the shareholders requirementsC goals, while focussing primarily on their own personal goals. Thus in furtherance of their ob?ecti&e of sur&i&al, management would aim at satisfying instead of maximising shareholders- wealth. 8owe&er, the conflicting goals of management ob?ecti&e of sur&i&al and ma*imising owners &alueCwealth can be harmonised. The shareholders delegate the decision1ma ing authority to professional management on the premise that the latter will wor in the best interest of the former, that is, management is an agent of the owners. $n order to ensure that management would ta e optimal decisions compatible with the shareholders- interest of &alue ma*imisation and minimise agency problems in terms of conflicts of interest, two remedial measures commend themsel&es3 +. )ro&ision of appropriate incenti&es and 6. =onitoring of agentsCmanagers +. &n(entive# to mana)ement3 the incenti&e gi&en to management is of &arious types. /ome of them are as follows i) ii) iii) /toc options3 confer on management the right to acquire shares of the enterprise at a specialCconcessional price )erformance shares are gi&en based on the performance of the management as reflected in rates of return. 5ash bonus1 lin ed to specified performance targets

i&)

)erquisites1 such as company car, e*pensi&e offices and fringe benefits

These incenti&es are closely related to the sta e of management in the ownership of the company. They promote congruence between the personal goals of management and the interests of the owners. 26 3onitorin) o% mana)er#: /ince management accounts for a small portion of the ownership of the enterprise, they would not be oriented to the ma*imisation of the &alue of the shareholders. =onitoring of the acti&ities of management can be done by3 i) ii) 0onding the agent Auditing financial statements and limiting decision ma ing by the management $n case of bonding, the enterprise obtains a fidelity bond from a bonding company to the effect that the latter will compensate the former up to a certain specified amount of losses caused by dishonest acts of managers. The audit and control procedures and limiting managerial decisions are intended to ensure that the actions of management sub ser&e the interests of shareholders.

A.

Analysis of Dupont Chart (Problem7

"bra#ive# !td6 ha# the %o!!owin) turnover ratio# $re#ented a!on) with the (orre#$ondin) indu#try avera)e#: Ratio de#(ri$tion Sa!e#9&nventory Sa!e#9Re(eivab!e# Sa!e#9<i=ed a##et# Sa!e#91ota! a##et# "bra#ive8# ratio 5309101: 5 time# 5309;;:12 time# 53099>: 56; time# 5309300: 1677 time# &ndu#try avera)e 10 time# 15 time# ? time# 3 time#

<inan(ia! ana!y#i# o% the (om$any i# $re#ented be!ow in the %orm o% a -u Pont Chart6 Study the (hart@ a!on) with the %our turnover ratio# and indu#try avera)e#@ and (omment on the major wea ne##e# o% the (om$any where mana)eria! attention mu#t be %o(u#ed %or %uture (ontro!6 Return on $n&estment Earnings as : of sales (6.9: multiplied Turno&er (+.DD

Earnings ( Rs.+; /ales (Rs.;A,

divided by

/ales Rs.;A,

(Rs.

/ales ;A,

divided by

Total $n&estment (Rs.A,,

minus 5ost of sales (Rs.;+;

)ermanent plus >or ing in&estment capital

(Rs.E9

(Rs.6,6

5ost of sales (Rs.<<,

plus

/elling plus e*penses (Rs.6F

Administrati&e e*penses (Rs.<E

$n&entories (Rs.+,F

plus

Accounts plus 5ash recei&ables (Rs.<< (Rs.;6

So!ution: a7 Pro%it mar)in not too badA a##et# turnover 4uite !ow6 "(tion re4uired6 b7 &nventory $er unit o% #a!e# hi)her than other %irm#6 "(tion re4uired6 &m$!i(ation# and im$a(t o% #u))e#ted a(tion B!i e %und# re!ea#ed in the wa e o% inventory uti!iCed in !i4uidatin) debt and redu(in) intere#t burden with im$roved $ro%it $ro#$e(t#7 #hou!d be hi)h!i)hted6 (7 0=(e## (a$a(ity #ituation may e=i#t@ thou)h not with de%initivene##

4. ROI is not the end of financial objectives. Explain.

$t must be noted that return on in&estment is a ratio. The term ratio refers to the numerical or quantitati&e relationship between two items C &ariables. The rationale of ratio analysis is that it ma es related information comparable. 8owe&er ratios by themsel&es mean nothing. Thus, the return on in&estment must be compared with3 A norm or a target )re&ious RO$ achie&ed in order to assess trends, and The RO$ achie&ed in other comparable companies

RO$ cannot be considered as the end of financial ob?ecti&es because of the following reasons. RO$ is calculated from financial statements which are affected by the financial bases and policies adopted on such matters as depreciation and the &aluation of stoc s. 7inancial statements do not represent a complete picture of the business, but merely a collection of facts, which can be e*pressed in monetary terms. These may not refer to other factors, which affect performance. O&er use of RO$ as control on managers could be dangerous, in that management might concentrate more on simply impro&ing the ratio than on dealing with the significant issues. E.g. the return on total assets can be impro&ed by reducing assets rather than increasing sales. RO$ is a comparison of two figures, a numerator and a denominator. $n comparing RO$, it may be difficult to determine whether differences are due to change in the numerator, or in the denominator or in both. Thus, RO$ should be considered only as a tool for analysis rather than as the end of financial ob?ecti&es.

5. How can ROI concept be used in profit planning & control. Explain with the help of Du Pont chart
(4upont chart is gi&en in the earlier question) Return on in&estment ratio assesses the o&erall operating efficiency of a firm. The earning power of a firm i.e. the return on in&estment is the o&erall profitability of the enterprise. This ratio has two elements3 o profitability on sales reflected in the net profit margin and "et profit margin ( "et profit after ta*es /ales The operating efficiency of a firm in terms of the efficient utilisation of the resources is reflected in the net profit margin. o the profitability of in&estments which is re&ealed by the in&estments C assets turno&er. $n&estment turno&er ( /ales A&erage total in&estment This ratio measures the efficiency of a firm in managing and utilising the assets. "et profit margin can be impro&ed by increasing the profit margin for the same &olume of sales or by increasing the &olume of sales eeping the profit margin at the same le&el. Geeping a chec on e*penses such as selling, administrati&e, financial, etc can impro&e profit margin. $nterest is also one of the fi*ed charges against net profit, which can be minimised by maintaining a balance between equity and debt. As mentioned abo&e, $n&estment turno&er ratio indicates the efficiency of the firm in utilising its assets C capital employed. Total in&estment comprises the permanent in&estment (fi*ed assets) and wor ing capital. >or ing capital includes in&entories, accounts recei&ables, cash etc.

This ratio can be impro&ed by increasing the sales for the same amount of capital employed. This means effecti&e use of the resources employed. )roper management of in&entories, effecti&e credit policies, maintaining only the required cash balance can help to increase the turno&er of assets. Another way to impro&e on in&estment turno&er is by in?ecting additional capital into the firm so as to increase the sales. The firm can e*pand its acti&ity le&el and thereby ma*imise the return on in&estment. RO$ shown by way of a 4upont chart is thus an important tool to measure the o&erall profitability of the firm. Thus, RO$ ratio can be used for profit planning and control and management can thus be alerted about the desirable and undesirable trends of corporate performance.

6. What are the different profit concepts employed for profit planning with budgeting
The different profit concepts employed for profit planning with budgeting are as follows3 +ro## $ro%it ' this is the amount of profit earned on purchases, manufacture and sales of goods and ser&ices only. Hross profit is arri&ed at by deducting cost of sales from the amount of net sales. Adequate amount od gross profit is necessary for meeting other e*penses of business. *$eratin) $ro%it ' the amount of gross profit left after meeting all other indirect e*penses is termed as operating profit. This amount is arri&ed at by deducting &arious administrati&e, selling and distribution and finance e*penses. This amount is also nown as earnings before interest, depreciation and ta* (E0$4T) 0arnin)# be%ore intere#t and ta= B0.&17 ' this is the amount of profit less depreciation. 0arnin)# be%ore ta= B0.17 ' this is the amount of profit after interest is deducted.

0arnin)# a%ter ta= B0"17 ' this is the final profit amount left after payment o ta*es.