Cost accounting

ACKNOWLEDGEMENT

It gives us a great pleasure while submitting this project on the topic

“Investment Centers.”

We thank Prof. Manish Sharma for guiding us throughout this project work and also for motivating us in different ways. He has been the tremendous helping hand in completing this difficult task, had an easy or any time access to such knowledgeable and guiding spirit.

We feel there is ample scope of improvement upon the work of this nature and shall be thankful if any suggestion is offered for its improvement.

We express our deep gratitude towards family members, who helped us in giving a final shape and structure to this project work.

We are also thankful to all those seen and unseen hands, which have been of direct or indirect help in completion of this project work

RESPONSIBILITY ACCOUNTING

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Responsibility Accounting collects and reports planned and actual accounting information about the inputs and outputs of responsibility centers.

Responsibility Accounting must be so designed as to suit the existing structure of the organization. Responsibility should be coupled with authority. A person is obliged to perform his duties only when he is conferred with adequate powers to do so. A sound organization structure, with clear-cut assignment of authorities and responsibilities should exist for the successful functioning of the responsibility accounting system. When the organization is not in order, it will miserably fail to work. Responsibility accounting system mainly depends on the assigned responsibilities and authorities such that the performance of each manager is evaluated in terms of such factors.

RESPONSIBILITY CENTER:

Responsibility center within an organization that has control over revenue, cost and investment funds. It is a profit center whose performance is evaluated on the basis of the return earned on invested capital. The corporate headquarters or division in a large decentralized organization would be an example of an investment center. Return on Investment and Residual Income are two key performance measures of an investment center

The main focus of responsibility accounting is on the responsibility centers. A responsibility centre is a sub-unit of an organization under the control of a manager who is held responsible for the activities of that centre. The responsibility centers, for control purposes, are generally classified into:

(1) Cost Centers (2) Profit Centers (3) Investment Centers (4) Revenue Centers

COST CENTERS:

When the manager is held accountable only for costs incurred in a responsibility centre, it is called a cost centre. More precisely, it is the inputs and not outputs that are measured in terms of money. In a cost centre of responsibility, the accounting system records only costs incurred by the centre/unit/division, but the revenues earned (output) are excluded from the purview. This only means that a cost centre is a segment whose financial performance is measured in terms of cost. The costs are the planning and control data in cost centers, since managers are not made responsible for profits and investments in assets. The performance of the managers is evaluated by comparing the costs incurred with the budgeted costs. The management focuses on the cost variances for ensuring proper control. The performance of a cost centre is measured by cost alone, without taking into consideration, its attainments in terms of “output”.

A cost centre does not serve the purpose of measuring the performance of the responsibility centre, since it ignores the output (revenues) measured in terms of money. A common feature of production departments is that they are usually multiple product units. There must be some common basis to aggregate the dissimilar products to arrive at the overall output of the responsibility centre. If this is not done, the efficiency and effectiveness of the responsibility centre cannot be measured.

PROFIT CENTERS:

When the manager is held responsible for both cost (inputs) and revenues (output) and thus, for profit of a responsibility centre, it is called a Profit Centre. In a Profit Centre, both inputs and outputs are measured in terms of money. The difference between revenues and costs represents profit where the former exceeds the latter and loss when it is vice versa. The term “revenue” with reference to responsibility accounting is used in a different sense altogether. According to generally accepted principles of accounting, revenues are recognized only when sales are made to external customers. For evaluating the performance of a profit centre, the revenue represents a monetary measure of output emanating from a profit centre during a given period, irrespective of whether the revenue is realized or not. The underlying principle is that a department has output representing goods and services which are capable of monetary measurement.

The relevant profit to facilitate the evaluation of performance measurement of a profit centre is the pre-tax profit of a responsibility centre. The profit of all the departments so calculated will not necessarily be equivalent to the profit of the entire organization. The variance will arise because costs which are not attributable to any single department are excluded from the computation of the department's profits and the same are adjusted while determining the profits of the whole organization. Hence, it is the divisional profit which is required for the purpose of managerial control.

As the profit provides more effective appraisal of the manager's performance, the manager of the profit centre is highly motivated in his decision-making relating to inputs and outputs so that profits can be maximized. In consonance with the above objective, by creating more profit centers in an organization, decentralization of activities can be easily effected.

The profit centre approach cannot be uniformly applied to all responsibility centers. The following are the criteria to be considered for making a responsibility centre into a profit centre. A profit centre must maintain additional record keeping to measure inputs and outputs in monetary terms. When a responsibility centre renders only services to other departments at the instance of the management, e.g., internal audit. It cannot be made a profit centre. A profit centre will gain more meaning and significance only when the divisional managers of responsibility centers have empowered adequately in their decision making relating to quality and quantity of outputs and also their relation to costs. If the output of a division is fairly homogeneous (e.g., cement), a profit centre will not prove to be more beneficial than a cost centre. Again, due to intense competition prevailing among different profit centers, there will be continuous friction among the centers arresting the growth and expansion of the whole organization. A profit centre will generate too much of interest in the short-run profit to the detriment of long-term results.

REVENUE CENTER:

A Revenue Center is responsible for selling an agreed amount of products or services. Usually its manager is responsible to maximize revenue given the selling price (or quantity) and given the budget for personnel and expenses. Generally, revenue centers work best if managers know customer demands well and are able to determine the optimum price/quantity combination and product mix. Care must be taken not to allow revenue centers to sacrifice profit for revenue too much.

INVESTMENT CENTERS:

When the manager is held responsibility for costs and revenues as well as for the investment in assets of a responsibility centre, it is called an Investment Centre. In an investment centre, the performance is measured not by profit alone, but it is related to investments effected, since the manager of an investment centre is always interested to earn a satisfactory return. The return on investment which is usually referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre. Viewed from this angle, investment centers may be considered as separate entities wherein the managers are entrusted with the overall of managing inputs, outputs and investment. This only represents an extension of the responsibility idea.

INVESTMENT

Investment or investing is a term with several closely-related meanings in business management, finance and economics, related to saving or deferring consumption.

Investment is the choice by the individual to risk his savings with the hope of gain. Rather than store the good produced, or its money equivalent, the investor chooses to use that good either to create a durable consumer or producer good, or to lend the original saved good to another in exchange for either interest or a share of the profits.

In the first case, the individual creates durable consumer goods, hoping the services from the good will make his life better. In the second, the individual becomes an entrepreneur using the resource to produce goods and services for others in the hope of a profitable sale. The third case describes a lender, and the fourth describes an investor in a share of the business.

In each case, the consumer obtains a durable asset or investment, and accounts for that asset by recording an equivalent liability. As time passes, and both prices and interest rates change, the value of the asset and liability also change.

An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a future return or interest from it. The word originates in the Latin "vestis", meaning garment, and refers to the act of putting things (money or other claims to resources) into others' pockets. See Invest. The basic meaning of the term being an asset held to have some recurring or capital gains. It is an asset that is expected to give returns without any work on the asset per se.

All investments are risky, as the investor parts with his money. An efficient investor with proper training can reduce the risk and maximize returns. He can avoid pitfalls and protect his interests.

Companies and govt. sell securities, either for equity capital or debt capital. These securities may be in the form of shares, debentures, bonds, etc. which are marketable. They have different degrees of risk and return, varying with the instrument. Some instruments of investment are non marketable and they are more risky and may become sometimes waste paper. The management of risk and return requires expertise. Investment is both art and science. The performance of companies and changes in share prices are all based on some fundamental principles, sentiment and psychological expectations. As such, investor has to use his discretion, which is an art to acquire by learning and experience. Principles of investment and the art of the management of investment are basic requirements for a successful investor.

Investors should be those who invest with the objective of receiving some income, share in the prosperity of the company and gain capital appreciation in a longer time span. Investors in the wider sense include speculators, institutions, companies and even banks.

CLASSIFICATION OF INVESTMENT

There are different methods of classifying the investment avenues.

A major classification is:

1. Physical investments

2. Financial investments.

They are physical, if savings are used to acquire physical assets, useful for consumption or production. Some physical assets like ploughs, tractors or harvesters are useful in agricultural production. A few physical assets like lorries, cars, jeeps, etc. are useful in business. Many items of physical assets are not useful for further production of goods or create income as in the case of consumer durables, gold, silver, etc. But most of the financial assets, barring cash are used for production or consumption, or further creation of assets, useful for production of goods and services.

Among different types of investments, some are marketable and transferable and others are not. Eg of marketable assets are shares and debentures of public limited companies, particularly the listed companies on stock exchanges, bonds of P.S.Us, govt. securities, etc. Non marketable securities or investments are bank deposits, provident and pension funds, insurance certificates, post office deposits, national savings certificates, company deposits, private limited companies, shares, etc.

I. FINANCIAL ASSETS II. PHYSICAL ASSETS

	SAVER

	CASH BANKS DEPOSITS P.F., L.I.C. SCHEMES PENSION SCHEME P.O. CERTIFICATES AND DEPOSITS

			INVESTOR

	SHARES, BONDS, GOVT. SECURITIES, ETC. M.F.SCHEMES, UTI UNITS, ETC.

III. MARKETABLE ASSETS

STOCK & CAPITAL MARKETS

NEW ISSUES STOCK MARKETS

OBJECTIVES OF INVESTOR

The investor has various alternative avenues of investment for his savings to flow in accordance with his preferences. Savings flow in to investment for a return, but savings kept as cash are barren and do not earn anything. Savings are invested in assets depending on their risk and return characteristics. But a minimum amount of cash is always kept in hand for transaction and contingencies. Any rational investor knows that money if loosing its value by the extent of the rise in prices. If money lent cannot earn as much as rise in prices or inflation, the real rate of return is negative. Thus, if inflation is at an average annual rate of 10%, then the return should be 10% or above to induce savings to flow in to investment. Thus, if an investment is made in short term deposits with banks or else securities of govt., then the rate of interest is around 8 to 10 %. As the risk of loss of money is almost negligible in such cases, this rate can be called as risk free returns. All investments involve some risk or uncertainty. The objective of investor is to minimize the risk involved in investment and maximize the return.

MODES OF INVESTMENT

There are different types of securities conferring different set of rights on the investors and different set of conditions under which these rights can be exercised. The various avenues for investment, ranging from riskless to high risk investment opportunities consist of both security and non- security forms of investment. All securitized forms given below are marketable.

1. Security forms of investment
1. corporate bonds/ debentures

a. convertible

b. non- convertible

2. public sector bonds

a. taxable

b. tax free

3. preference shares
4. equity shares

a. new issue

b. rights issue

c. bonus issue

2. Non- security forms of investment
1. national savings schemes
2. national savings certificates
3. provident fund

a. statutory provident fund

b. recognized provident fund

c. unrecognized provident fund

d. public provident fund

4. corporate fixed deposits

a. whole life policies

b. limited payment life policy

c. jeevan mitra

d. jeevan saathi

e. jeevan dhara

f. jeevan kishor

g. jeevan sarita

5. post office savings bank account

a. recurring deposits

b. time deposits

c. monthly income scheme

d. senior citizens saving scheme

6. others

a. RBI relief bonds phased out

b. Kisan vikas patra

c. Chit funds, nidhis, etc.

INVESTMENT AVENUES

Though investment opportunities abound all the time and in almost all situations, often they may not be very easy to identify. A shrewd and discerning investor will usually find opportunities for making money in places, and in situations, where a less discerning one will not. The best investment opportunities are often found in the most unlikely places and situations. For example, in the beginning of 1994 few could have predicted that the shares of the then relatively unknown company like Infosys Technologies, focusing primarily on Y2K software projects, would provide one of the best investment opportunities of the last decade.

VARIOUS INVESTMENT AVENUES:

There are a large number of investment instruments available today. To make our lives easier we would classify or group them under 4 main types of investment avenues. We shall name and briefly describe them.

1. FINANCIAL SECURITIES: These investment instruments are freely tradable and negotiable. These would include equity shares, preference shares, convertible debentures, non-convertible debentures, public sector bonds, savings certificates, gilt-edged securities and money market securities.

2. NON-SECURITIZED FINANCIAL SECURITIES: These investment instruments are not tradable, transferable nor negotiable. And would include bank deposits, post office deposits, company fixed deposits, provident fund schemes, national savings schemes and life insurance.

3. MUTUAL FUND SCHEMES: If an investor does not directly want to invest in the markets, he/she could buy units/shares in a mutual fund scheme. These schemes are mainly growth (or equity) oriented, income (or debt) oriented or balanced (i.e. both growth and debt) schemes.

4. REAL ASSETS: Real assets are physical investments, which would include real estate, gold & silver, precious stones, rare coins & stamps and art objects.

5. EMPLOYEES’ PROVIDENT FUND: This is one of the very safe investment avenues. The current interest rate of EPF is 8.5% per annum. However, this rate is not fixed and the government can modify the same from time to time. The best part of EPF is that the interest earned is exempt from tax under section 10 (12) of the Income Tax Act. That is the entire interest income earned by you goes into your pocket. The taxman gets nothing.

6. PUBLIC PROVIDENT FUND (PPF): PPF is considered yet another safe investment avenue. The current interest rate on PPF is 8% per annum. Again like EPF the rate of interest is not fixed. The government modifies the same from time to time.

7. LIFE INSURANCE POLICY (INCLUDING ULIP & PENSION PLAN): There are a variety of insurance products available. The traditional plans such as money back, cash back, endowment, whole life, children plans are considered relatively safe. However, the returns thereon vary between 4% per annum to 6% per annum. For most of these plans premium has to be paid monthly, quarterly, semi-annually or annually during the term of the policy.

8. NATIONAL SAVINGS CERTIFICATE (NSC): This is also a very safe investment avenue. The certificate has a maturity period of 6 years. The current interest rate is 8.16% per annum. The interest rate is fixed in a sense that subsequent changes to the interest rates do not affect you. That is, any increase/decrease in interest rates will not have any impact on your investment or interest earned.

The best part of PPF is that the interest thereon is exempt from tax under section 10(11) of the Income Tax Act. Tax deduction can be claimed on contribution made by an individual into his own PPF account or into the PPF account of his spouse or children

Before choosing the avenue for investment the investor would probably want to evaluate and compare them. This would also help him in creating a well diversified portfolio, which is both maintainable and manageable.

FEATURES OF INVESTMENT AVENUES

1. RISK: The risk depends on the following factors:

a. The longer the maturity period, the larger is the risk. Thus, deposits of two years carry a higher rate than one-year deposits.

b. The more the creditworthiness of the borrower or the agency issuing securities, the less is the risk. Thus, the risk of loss of interest and principal is less with the government or semi- government bodies than with the private corporate units.

c. The nature of instrument, namely, the debt instrument or fixed deposit or ownership instrument like equity or preference share, also determines risk. The risk of less in the case of debt instruments like debentures, as these are secured and fixed interest is payable on them. In the case of ownership instruments, the risk of loss is more due to their unsecured nature and variability of their return and ownership character which burdens them with all the risks connected with the enterprise.

2. RETURN: A major factor influencing the pattern of investment is its return, which is the yield plus capital appreciation, if any. The difference between the purchase price and the sale price is capital appreciation and the yield is the interest or dividend divided by its purchase price.

3. SAFETY: The safety of capital is the certainty of return on capital without loss of money or time involved. In the cases of money lent, some transaction costs and time are involved in getting the funds back. But leaving aside such general costs like stamp duty, postal charges, etc. the time involved is also an important factor. If money is returnable not on the same day but after a lapse of time, then the loss of liquidity is involved and if the time of return of funds is not certain and if cost of selling or realization of proceeds are involved, then the safety of funds is also not perfect. Thus, if safety of capital is to be assured then riskless return as in case of government bonds is to be chosen. If the return is higher as in case of private securities, then the degree of safety is less.

4. LIQUIDITY: If a capital asset is easily realizable, saleable or marketable, then it is said to be liquid. If an investment can be encashed with a time lag as in case of equity shares or with loss of money as in case of U.S.64 of UTI then they are less liquid. If, on the other hand there is a good market for the capital asset and no risk of loss of money or capital and no uncertainty of time involved, then the liquidity of asset is good. If liquidity is high, then the return may be low as in case of bank saving deposits.

An investor generally prefers liquidity for his investment, safety of his fund, a good return with a minimum risk or minimization of risk and maximization of return.

5. MARKETABILITY: This means easy and quick means of transferability of an asset.Thus asset of listed companies and shares of public limited companies are more easily transferable then those of non listed companies and private limited companies.

COMPARISON OF INVESTMENT AVENUES

	Rate of return	Rate of return
	Annual Income	Capital Appreciation	Risk	Marketability	Tax Benefit	Convenience
Financial Securities
Equity	Low	High	High	High	Yes	High
Non-convertible Debentures	High	Low	Low	Average	Nil	High
Financial Securities (Non-securitized)
Bank deposits	Low	Nil	Low	High	Yes	High
Provident fund	Nil	High	Nil	Average	Yes	High
Life insurance	Nil	High	Nil	Average	Yes	High
Mutual funds
Growth/equity	Low	High	High	High	Yes	High
Income/debt	High	Low	Low	High	Yes	High
Real assets
Real estate	Low	High	Low	Low	Limited	Average
Gold/silver	Nil	Average	Average	Average	Nil	Average

INVESTMENT CENTERS:

When the manager is held responsibility for costs and revenues as well as for the investment in assets of a responsibility centre, it is called an Investment Centre. In an investment centre, the performance is measured not by profit alone, but it is related to investments effected, since the manager of an investment centre is always interested to earn a satisfactory return. The return on investment which is usually referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre. Viewed from this angle, investment centers may be considered as separate entities wherein the managers are entrusted with the overall of managing inputs, outputs and investment. This only represents an extension of the responsibility idea.

An investment center is a classification used for business units within an enterprise. The essential element of an investment center is that it is treated as a unit which is measured against its use of capital, as opposed to a cost or profit center, which are measured against raw costs or profits.

The advantage of this form of measurement is that it tends to be more encompassing, since it accounts for all uses of capital. It is susceptible to manipulation by managers with a short term focus, or by manipulating the hurdle rate used to evaluate divisions

The purpose of this is to:

1) Discuss two common performance measurements for investment centers and the various relationships between these measurements,

2) Present some equations related to these measurements that can be used for planning purposes,

3) Discuss a number of issues related to how these measurements are calculated and

4) Discuss the transfer pricing problem that arises when investment centers sell products or services to each other.

Investment center is one of the breakdowns of responsibility centers in accounting. It is accountable for company's profit and also its assets. Both investment center and profit center are parallel each other hence they should not be regarded as separate category. The three measurements commonly used to evaluate investment centers are Return on Investment (ROI), Return on Equity (ROE) and Economic Value Added (EVA).The ROI measurement is discussed in the first section, followed by a discussion of ROE and finally the issues related to transfer pricing are discussed in the last section. An Appendix is also included related to the conflict between choosing investment projects and evaluating the subsequent results.

RETURN ON INVESTMENT

Return on investment – (ROI) - A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.
It is the rate of revenues received for every dollar invested in an item or activity. ROI is a traditional financial measure based on historic data. It is a backward-looking metric that yields no insights into how to improve business results in the future. In education organizations, ROI has been used primarily for self-justification rather than continuous improvement.

In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage rather than a fraction.

ROI does not indicate how long an investment is held. However, ROI is most often stated as an annual or annualized rate of return, and it is most often stated for a calendar or fiscal year. An investment that is held longer has an annualized ROI that is closer to zero. In this article, "ROI" indicates an annual or annualized rate of return, unless otherwise noted.

In a marketing sense, knowing the ROI of your advertising and marketing campaigns helps you to identify which techniques are most effective in generating income for your business.

Two Ways to Calculate Return On Investment

Return on investment or ROI = Net Income ÷ Investment. An alternative formulation of ROI based on Du Pont's formula is as follows:

ROI = (Capital Turnover Ratio) (Profit Margin on Sales)

= (Sales ÷ Investment) (Net Income ÷ Sales)

(TOTAL BENEFIT - TOTAL COSTS) X 100 = ROI
TOTAL COSTS

The Capital Turnover Ratio (CTR) reflects management's ability to generate sales from a given investment base. Note that the source of the investment (i.e., debt or stockholders equity) is usually considered irrelevant, but see alternatives below.

The Profit Margin is the Rate of Return on Sales (ROS) and measures management's ability to control the spread between prices and costs. Productivity and cost control are reflected in this measure as well as other factors such as the sales level.

A more detailed view of the Du Pont ROI formula appears in the graphic illustration below.

METHODS OF INCREASING ROI

ROI may be increased in various ways. Some possibilities include the following.

1. Increasing Capital Turnover (CTR).
a. Increase sales with the same the investment base.
b. Decrease the investment base with the same sales level.

2. Increasing Profit Margin or Return on Sales (ROS).
a. Increase prices with no unfavorable effects on sales.
b. Decrease cost with no unfavorable effects on quality or increase in assets.
c. Increase sales with no changes in prices or costs

The following diagram illustrates various combinations of turnover (CTR) and margin (ROS) required to provide three illustrative rates of return (ROI). For example, a 20% ROI can be obtained with a turnover of 2.5 and a margin of 8%, a turnover of 2 and a margin of 10%, or a turnover of 1 and a margin of 20%. A lower turnover requires a higher margin to produce the same ROI.

Rate of Return and Return on Investment indicate cash flow from an investment to the investor over a specified period of time, usually a year.

ROI is a measure of investment profitability, not a measure of investment size. While compound interest and dividend reinvestment can increase the size of the investment (thus potentially yielding a higher dollar return to the investor), Return on Investment is a percentage return based on capital invested.

In general, the higher the investment risk, the greater the potential investment return, and the greater the potential investment loss.

RETURN ON EQUITY

Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.

ROE = (Net income) / (Average total equity)

The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

Return on Equity (ROE) measures how well a company uses the capital provided by its equity investors. Since equity investors are entitled to what profits remain after interest is paid to debt holders and taxes are paid to the government, net income is the appropriate measure of profit.

Return on equity is a critical weapon in the investor's arsenal, as long as it's properly understood for what it is. ROE encompasses the three pillars of corporate management -- profitability, asset management, and financial leverage. By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can also assess management's ability to get the job done.

If return on equity is simply:

ROE = one year's earnings / shareholder equity

ROE = (one year's earnings / one year's sales) x (one year's sales / assets) x (assets / shareholder equity)

Earnings over sales are profit margin, sales over assets are asset turnover, and assets over equity are the amount of leverage the company has.

ROE is presumably irrelevant if the earnings are not reinvested.

• The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
• The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
• New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
• Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.

ROE encompasses the three pillars of corporate management -- profitability, asset management, and financial leverage. By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can also assess management's ability to get the job done.Return on equity is calculated by taking a year's worth of earnings and dividing them by the average shareholder equity for that year.

ECONOMIC VALUE ADDED

Economic value added (EVA) is the most misunderstood term among the practitioners of corporate finance. The proponents of EVA are presenting it as the wonder drug of the millennium in overcoming all corporate ills at one stroke and ultimately help in increasing the wealth of the shareholder, which is synonymous with the maximization of the firm value. The attractiveness of the EVA lies in its use of cash flow and cost of capital that are determinant of the value of the firm.

Technically speaking EVA is nothing but the residual income after factoring the cost of capital into net operating profit after tax.

EVA is the most misunderstood term among the practitioners of corporate finance. The

proponents of EVA are presenting it as the wonder drug of the millennium in overcoming

all corporate ills at one stroke and ultimately help in increasing the wealth of the

shareholder, which is synonymous with the maximization of the firm value. The

attractiveness of the EVA lies in its use of cash flow and cost of capital that are

determinant of the value of the firm.

In the process, EVA is being bandied about with utmost impunity by all and sundry,

which includes the popular press. The academic world in its turn has come up with

various empirical studies which either supports the superiority of EVA or questions the

claim of its proponents. Currently the empirical evidence is split almost half way.

EVA is nothing but a new version of the age-old residual income concept recognized by

economists since the 1770's. Both EVA and ‘residual income’ concepts are based on the

principle that a firm creates wealth for its owners only if it generates surplus over the cost

of the total invested capital. So what is new? Perhaps EVA could bring back the lost

focus on ‘economic surplus’ from the current emphasis on accounting profit. In a lighter

vein it can be said that in an era where commercial sponsorship is the ticket to the

popularity of even the concept of god, the concept of residual income has not found a

good sponsor until Stern Stewart and Company has adopted it and relaunched it with a

brand new name of EVA.

Examining EVA as a corporate philosophy we intend to look at the efficacy of EVA

when implemented at every level of managerial decision making process to encourage

managers to deploy resources only on value enhancing activities and to align the interests

of shareholders with managers. This involves two things, one is linking managerial

compensation package with EVA and second is to inculcate the culture of evaluating

every action from the viewpoint that it should generate EVA. The ultimate outcome

should be enhancement in the firm-value measured by the capital market. When EVA is

used as a management philosophy, it results in the enhancement of productivity by

continuously focusing on return vis-à-vis cost of capital. However as market discounts

expected long term performance of the firm, any compensation that motivates

enhancement of short term EVA, may not maximize the firm value.

However with EVA culture, the firm as a whole focuses on the economic surplus and that

definitely improves value enhancement process. Of course, this can be achieved even by

implementing the other practices but the simplicity of EVA in communicating the very

fundamental principle, that generation of surplus over cost of capital can only enhance

the firm value, makes it a management technique superior to other planning and control

techniques. We shall examine the appropriateness of this perception.

The basic formula is:

EVA = ( r - c ) * K = NOPAT – c * K

Where r = NOPAT / K

Return on Invested Capital (ROIC). is the firm's return on capital, NOPAT is the Net Operating Profit After Tax, c is the Weighted Average Cost of Capital (WACC) and K is capital employed.

Mathematically:

EVA= (adjusted NOPAT - cost of capital) x capital employed

Or

EVA = (Rate of return - cost of capital) x capital

Where;

Rate of Return = NOPAT/Capital

Capital = total assets minus non interest bearing debt, at the beginning of the year

Cost of capital = cost of equity x proportion of equity + cost of debt (1-tax rate) x

proportion of debt in the capital.

The above cost of capital is nothing but the weighted average cost of capital (WACC)

If we define ROI as NOPAT/capital then the above equation can be rewritten as

EVA= (ROI- WACC) x CAPITAL EMPLOYED-----(III)

Capital being used in EVA calculation is not the book capital, capital is defined as an

approximation of the economic book value of all cash invested in going-concern business

activities, capital is essentially a company’s net assets (total assets less non-interestbearing

current liabilities), but with three adjustments:

* Marketable securities and construction in progress are subtracted.

* The present value of noncapitalized leases is added to net property, plant, and

equipment.

* Certain equity equivalent reserves are added to assets:

* Bad debt reserve is added to receivables.

* LIFO reserve is added to inventories.

* The cumulative amortization of goodwill is added back to goodwill

* R&D expense is capitalized as a long-term asset and smoothly depreciated over 5

years (a period chosen to approximate the economic life typical of an investment in

R&D).

􀂾 Cumulative unusual losses (gains) after taxes are considered to be a long-term

investment.

A firm can motivate its managers to direct their effort towards maximizing the value of

the firm only by, first measuring the firm value correctly and secondly by providing

incentives to managers to create value. Both are interdependent and they complement

each other. Therefore this paper examines the EVA concept from two perspectives, EVA

as a performance measure and EVA as a corporate philosophy.

COMPANY

INVESTMENT AND SPECULATION

They are leading to claims on money, aim at maximization of return consistent with the risk taken. Motive is the determining factor, distinguishing between investment and speculation. In investment, the investor has long term and medium term objectives, takes delivery of securities and books profits as and when the returns are higher his target expectations. The speculation has a short term perspective and maximizes the returns through buying and selling and delivery of securities is least important in trade. Strakes of risk are higher and returns are higher in speculation than in investment. Both aim at capital gains or appreciation in share prices and maximization of returns. The difference is only in degree as between investment and speculation.

In the Indian stock markets, nearly, of trade is speculative in nature and do not involve deliveries of shares. Values of trade increase with increase in speculation, but the genuine investor takes the delivery and gets the securites transferred into his name in the companys registers, whether, it is an ownership or debt category. Speculation is increasing ingredient of the stock markets all over the world to impart liquidity and continuing trade and quotation.

SCOPE OF INVESTMENTS

The term "investment" is used differently in economics and in finance. Economists refer to a real investment (such as a machine or a house), while financial economists refer to a financial asset, such as money that is put into a bank or the market, which may then be used to buy a real asset.

BUSINESS MANAGEMENT

The investment decision (also known as capital budgeting) is one of the fundamental decisions of business management: Managers determine the investment value of the assets that a business enterprise has within its control or possession. These assets may be physical (such as buildings or machinery), intangible (such as patents, software, goodwill), or financial (see below). Assets are used to produce streams of revenue that often are associated with particular costs or outflows. All together, the manager must determine whether the net present value of the investment to the enterprise is positive using the marginal cost of capital that is associated with the particular area of business.

In terms of financial assets, these are often marketable securities such as a company stock (an equity investment) or bonds (a debt investment). At times the goal of the investment is for producing future cash flows, while at others it may be for purposes of gaining access to more assets by establishing control or influence over the operation of a second company (the investor).

ECONOMICS

In economics, investment is the production per unit time of goods which are not consumed but are to be used for future production. Examples include tangibles (such as building a railroad or factory) and intangibles (such as a year of schooling or on-the-job training). In measures of national income and output, gross investment (represented by the variable I) is also a component of Gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports. Thus investment is everything that remains of production after consumption, government spending, and exports are subtracted.

Both non-residential investment (such as factories) and residential investment (new houses) combine to make up I. Net investment deducts depreciation from gross investment. It is the value of the net increase in the capital stock per year.

Investment, as production over a period of time ("per year"), is not capital. The time dimension of investment makes it a flow. By contrast, capital is a stock, that is, an accumulation measurable at a point in time (say December 31st).

Investment is often modeled as a function of Income and Interest rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than loaning them out for interest.

FINANCE

In finance, investment is the buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.

Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.

Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.

Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.

PERSONAL FINANCE

Within personal finance, money used to purchase shares, put in a collective investment scheme or used to buy any asset where there is an element of capital risk is deemed an investment. Saving within personal finance refers to money put aside, normally on a regular basis. This distinction is important, as investment risk can cause a capital loss when an investment is realized, unlike saving(s) where the more limited risk is cash devaluing due to inflation.

In many instances the terms saving and investment are used interchangeably, which confuses this distinction. For example many deposit accounts are labeled as investment accounts by banks for marketing purposes. Whether an asset is a saving(s) or an investment depends on where the money is invested: if it is cash then it is savings, if its value can fluctuate then it is investment.

REAL ESTATE

In real estate, investment money is used to purchase property for the purpose of holding or leasing for income and there is an element of capital risk.

RESIDENTIAL REAL ESTATE

The most common form of real estate investment as it includes property purchased as a primary residence. In many cases the buyer does not have the full purchase price for a property and must engage a lender such as a bank, finance company or private lender. Different countries have their individual normal lending levels, but usually they will fall into the range of 70-90% of the purchase price. Against other types of real estate, residential real estate is the least risky.

COMMERCIAL REAL ESTATE

Commercial real estate consists of multifamily apartments, office buildings, retail space, hotels and motels, warehouses, and other commercial properties. Due to the higher risk of commercial real estate, loan-to-value ratios allowed by banks and other lenders are lower and often fall in the range of 50-70%.

http://en.wikipedia.org/wiki/Return_on_equity