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Chapter 23: Problem 6

Give three definitions of investment used in practice when computing ROI.

Short Answer

Expert verified
Three definitions of investment used in practice when computing ROI are: 1. Initial Investment: The amount of money initially spent to acquire an asset or start a project. ROI = \(\frac{Net Profit}{Initial Investment}\) 脳 100%. 2. Total Investment: Takes into account the initial investment and all other costs incurred over the life of the investment. ROI = \(\frac{Net Profit}{Total Investment}\) 脳 100%. 3. Average Investment: Averages the investment balances over the investment period to account for varying investments over time. ROI = \(\frac{Net Profit}{Average Investment}\) 脳 100%, where Average Investment = \(\frac{Beginning Investment Balance + Ending Investment Balance}{2}\).

Step by step solution

01

Definition 1: Initial Investment

The initial investment is the amount of money that is initially spent to acquire an asset or start a project. This could include the purchase price of a property, the cost of equipment, or the amount of money spent on research and development for a new product. When computing ROI, the initial investment is usually used as the baseline to compare with the returns generated by the investment. The formula for ROI in this case is: ROI = \(\frac{Net Profit}{Initial Investment}\) 脳 100% Where Net Profit = Total revenue generated - Total cost (including initial investment)
02

Definition 2: Total Investment

The total investment takes into account not only the initial investment but also other costs incurred over the life of the investment, such as maintenance costs, taxes, and fees. In the context of ROI, the total investment provides a more accurate representation of the true cost of the investment. The formula for ROI using total investment is: ROI = \(\frac{Net Profit}{Total Investment}\) 脳 100% Where Net Profit = Total revenue generated - Total cost (including all expenses related to the investment)
03

Definition 3: Average Investment

The average investment is an approach that takes into account the varying amount of money invested over time. This method is particularly useful for investments that require continuous or periodic investments, such as a business that requires ongoing investments in inventory or machinery. To calculate the average investment, one needs to average the investment balances over the investment period (usually the beginning and ending balances). The formula for ROI using average investment is: ROI = \(\frac{Net Profit}{Average Investment}\) 脳 100% Where Net Profit = Total revenue generated - Total cost (including all expenses related to the investment) Average Investment = \(\frac{Beginning Investment Balance + Ending Investment Balance}{2}\) By understanding these three definitions of investment and their respective formulas, one can adapt the way ROI is calculated to better suit the context of the investment and obtain a more accurate perspective on its performance.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Initial Investment
Understanding the initial investment is crucial when assessing potential returns on any project or asset acquisition. It represents the beginning of the financial journey and is the cornerstone for calculating Return on Investment (ROI).

The initial investment includes all the upfront costs required to launch a venture or buy an asset. Imagine you're opening a coffee shop; the initial investment would cover everything from purchasing coffee machines and furniture to the first batch of coffee beans. In real estate, it would be the purchase price of a property plus any immediate renovations needed.

To calculate the ROI based on the initial investment, you subtract the total cost from the total revenue generated by the investment, then divide this net profit by the initial investment. Lastly, multiply by 100 to get a percentage. This figure will tell you what percentage of your initial outlay you've earned back as profit.

Measuring ROI against the initial investment is excellent for getting a quick snapshot of investment performance, particularly soon after the investment is made.
Total Investment
The total investment entails a broader perspective than the initial investment. It includes all additional expenses that accrue over the lifespan of the investment. These could be ongoing maintenance, upgrades, taxes, and operational fees鈥攁 more comprehensive representation of what you've put in.

For instance, if your coffee shop needs a new espresso machine after the first one breaks down, that cost adds to the total investment. Similarly, if you're investing in real estate, expenses such as property taxes and maintenance are factored in.

To compute ROI using the total investment, you'll once again find the net profit by subtracting total costs from total revenue. Then, divide this by the total investment, taking into account all accumulated costs, and multiply by 100. This calculation affords a more accurate measure of profitability over the entire investment period. It helps investors understand the full scope of returns when every dollar spent is considered.
Average Investment
The concept of average investment comes into play when dealing with investments that require funding over time. This could include ongoing capital needs, such as a continually updated inventory for a retail store or periodic updates for property renovation.

To determine the average investment, you calculate the mean of the investment balances at different points, typically the start and end of the investment period. So if you opened your business with a \(50,000 investment and, after some time, invested an additional \)20,000 for expansion, your average investment would be the sum of those amounts divided by two.

When calculating ROI with average investment, you use the same net profit figure, but this time, divide by the average investment and multiply by 100 to convert it into a percentage. This approach provides insight into investments' ongoing performance, considering fluctuations in capital injection over time.

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Most popular questions from this chapter

During the current year, a strategic business unit (SBU) within Roke Inc. saw costs increase by \(\$ 2\) million, revenues increase by \(\$ 4\) million, and assets decrease by \(\$ 1\) million. SBUs are set up by Roke as follows I. cost SBU II. Revenue SBU III. Profit SBU IV. Investment SBU Given the numbers above, a SBU manager will receive a favorable performance review if she is responsible for a: a. I or IV only. b. II or III only. c. I, II, or IV only. d. II,III, or IV only.

What are the three steps in designing accounting-based performance measures?

Comfy Corporation manufactures furniture in several divisions, including the patio furniture division. The manager of the patio furniture division plans to retre in two years The manager receives a bonus based on the division's ROl, which is currently \(7 \%\) One of the machines that the patio furniture division uses to manufacture the furniture is rather old and the manager must decide whether to replace it. The new machine would cost \(\$ 35,000\) and would last 10 years. It would have no salvage value. The old machine is fully depreciated and has no trade-in value. Comfy uses straight-line depreciation for all assets. The new machine, being new and more efficient, would save the company \(\$ 5,000\) per year in cash operating costs. The only difference between cash flow and net income is depreciation. The internal rate of return of the project is approximately \(7 \%\). Comfy Corporation's's weighted-average cost of capital is 5\%. Comfy is not subject to any income taxes. 1\. Should Comfy Corporation replace the machine? Why or why not? 2\. Assume that "investment" is defined as average net long-term assets (that is, after depreciation) during the year. Compute the projects ROI for each of its first five years. . If the patio furniture manager is interested in maximizing his bonus, would he replace the machine before he retires? Why or why not? 3\. What can Comfy do to entice the manager to replace the machine before retiring?

Cora Manufacturing makes fashion products and competes on the basis of quality and leading-edge designs. The company has two divisions, clothing and cosmetics. Cora has \(\$ 5,000,000\) invested in assets in its clothing division. After-tax operating income from sales of clothing this year is \(\$ 1,000,000\). The cosmetics division has \(\$ 12,500,000\) invested in assets and an after-tax operating income this year of \(\$ 2,000,000\). The weighted- average cost of capital for Cora is \(6 \%\) The CEO of Cora has told the manager of each division that the division that "performs best" this year will get a bonus. 1\. Calculate the ROI and residual income for each division of Cora Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each measure? 2\. The CEO of Cora Manufacturing has recently heard of another measure similar to residual income called EVA. The CEO has the accountant calculate adjusted incomes for clothing and cosmetics and finds that the adjusted after- tax operating incomes are \(\$ 634,200\) and \(\$ 2,181,600,\) respectively. Also, the clothing division has \(\$ 470,000\) of current liabilities, while the cosmetics division has only \(\$ 380,000\) of current liabilities. Using the preceding information, calculate the EVA for each division and discuss which manager will get the bonus. 3\. What nonfinancial measures could Cora use to evaluate divisional performances?

Distinguish between measuring assets based on current cost and historical cost.
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