Question

Explain the merits and problems of using the return on investment, residual income and the economic value added methods (12 marks)

Answer 1

Return on Investment is one of the profitability ratios that measures the gain on investment. It is a ratio of the profit made on any investment to the cost of the investment.  

Merits of Roi

• ROI for is simple but effective and universally accepted as a financial ratio.
• Roi helps the investors and the financial professional to quickly check the prospect of an investment and thus saves on time.
• ROI helps in exploring and measuing the potential returns on different investment opportunities.

Problem of Roi 

• The calculation of return on investment completely ignores the time value of money.

Merits of residual income.

•  RI takes into account the opportunity cost of tying up assets in the division; The minimum rate of return varies depending on the riskiness of the division. Different assets can earn different returns.

Problem in RI 

• It is an absolute measure of return and thus it that it does not is difficult to directly compare divisonal performance.

Merits of economic added value.

•  EVA takes into consideration all the cost of equity and capital which is normally excluded costs including the cost of equity capital in the normal accounting.

Problem of EVA.

•  The problem main of economic value added is the practicability of the calculations.