An investment center is a segment or area of responsibility in which a manager controls revenues, costs, and the assets invested in that segment. The manager's performance is assessed based on how well the manager controls these components, typically using an evaluation that includes an assessment of profit and a return on the invested assets. A group of investment centers are typically housed under a corporate structure which top executives that provide strategic guidance.


Managers of investment centers are given responsibility to fully operating their respective segments. Evaluation of these managers is based on the three components for which these managers are responsible---revenues, expenses, and the segment's assets. Evaluation using return on investment is based on a percentage rate of return relative to a benchmark rate of return. The benchmark is the discount rate established by top management as the minimum acceptable rate it is willing to accept. You know this amount as the required rate of return, or the hurdle rate. When residual income is used for evaluation of investment centers, it focuses on the dollar amount that a segment contributes to the shareholder value of the parent company. 


Return on Investment

Return on investment, known in the financial world as ROI, is an important gauge of the performance of investment centers and their managers. It  focuses the attention of a manager on both income and the assets invested in the segment, making it a better measure of performance than simply income. The calculation parallels that of return on assets (ROA) from a financial accounting perspective. Return on assets is calculated for a company as a whole, and its components are taken straight from a company's financial statements. Net income is divided by average total assets to arrive at a percentage return. ROA indicates the portion of each dollar of assets that a company generates as profit. The ROI is compared to the required rate of return to assess the viability of the investment. Only investments which generate at least the required rate of return should be accepted.


ROI is used to calculate the return of an investment center of a company using the profit of that segment and the assets invested in the segment. It enables top executives to compare multiple segments to determine the better candidate for expansion. In most cases, an investment with a higher ROI is deemed to be a better investment than those with lower ROIs. Return on investment is calculated as "profit" divided by the total assets of the investment center.


ROI =  "Profit" = NOPAT
"Assets" Invested Capital


However, because ROI is computed on a single segment, the profit amount on the numerator and the asset amount on the denominator to be modified to reflect only the amounts applicable for the segment being evaluated. The amount used as profit is NOPAT, and the denominator is replaced by invested capital.


ROI is reported as a percentage with two decimal places displayed. It indicates the percent of profit earned for each dollar of invested assets. In other words, it measures the ability of an investment center to generate profit using the assets invested in the division. For example, if ROI is calculated to be 13.14%, it would indicate that for each dollar of assets invested on average, the segment is generating about 13 cents of profit. A division with a higher ROI is a better candidate for expansion than a division with a lower ROI because it can generate more profit out of each dollar of  invested assets. 


How Profit is Measured

As you have already experienced, “profit” can be expressed by different measurements. Net income, a common expression, is net earnings after deducting all expenses from revenues including income taxes. Profit can also be expressed as net operating income after taxes (NOPAT), earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA) , or the more generic name---profit.


The income statements of the segments will likely contain some allocated costs for which managers of those segments have no control. This is due to the allocation of costs to segments, in a manner similar to how costs are allocated to products. A key concern is to insure that a segment manager is evaluated only on the costs, revenues, and assets for which the  manager is able to control. Most of the costs that segment managers are unable control are expenses. Managers believe it is unfair to be evaluated on amounts for which they have no control.....and rightfully so. To remedy this issue, the profit amount must be modified by adjusting net income to remove the uncontrollable amounts prior to evaluating performance.



NOPAT is a commonly used 'profit' concept utilized by a number of companies. This pneumonic stands for 'net operating profit after taxes.' Net operating profit includes all revenues minus the costs that are within the segment manager's control.


Segment managers find a number of expenses listed on their segment's income statement. For purposes of this course, this text will simplify the adjustment to income by limiting the examples to removing only interest expense.


The answer to why interest is considered to be uncontrollable lies in how a company is financed. Recall the discussion from an earlier chapter that the first activity that must occur when a company goes into business is financing. All assets are ‘financed’ by the two equities on the right side of the accounting equation. Debt financing occurs when a company obtains long-term loans or issues bonds. Debt creates an interest cost measured using an annual percentage rate. Because interest expense is reported on the income statement, it reduces profit. Equity financing has no interest cost, but investors expect some type of return, either dividends or an increase in shareholder equity. Neither dividends nor stock values have an income statement impact, as they both impact stockholders' equity.


Suppose there are two divisions, the South and the West divisions. Assume the South division is financed by issuing stock. Whether dividends are distributed or not, they are not an expense, leaving the South Division with no financing cost effect on income. Assume also that the assets invested in the West division were financed by issuing debt, resulting in interest expense on the West Division's income statement. Because top level executives handle strategic decisions such as financing, segment managers are unable to decide how their respective segments are financed.


Is it fair to punish the West Division's manager with interest expense which causes his profits be lower than the manager of the South Division? Likely not. To even the playing field, you must remove interest expense from the 'profit' amount so that the means of financing has no impact on how these managers are evaluated.


To calculate NOPAT, you begin with net income and remove interest expense and the related income taxes:

NOPAT = Net income + [Interest expense - Tax savings from interest expense]

              = NI + [Interest expense x (1 - t)

       Where t = tax rate and NI = net income


Interest expense is removed by adding it to net income, on a 'net of tax' basis. The goal is to remove interest as if it had not been part of the net income computation. Because interest was initially subtracted to determine net income, you must add it back. The more expenses a company incurs, the smaller income taxes it must pay. As such, when a company recognizes interest expense, taxable income is reduced, which in turn reduces income taxes expense. Had interest been omitted from the calculation of net income, the amount on which a company calculates its income taxes would be larger. As such, the income tax effect is removed from interest expense before adding interest to net income. 


How Assets are Measured

The majority of these assets held by a division have a cost of capital associated with them. Think about the accounting equation: Assets = Liabilities + Owners' Equity. There are generally two classifications of assets and two classification of liabilities. Some assets and liabilities are current, while others are long-term. The classified accounting equation looks like this:


Current assets + Long-term assets = Current liabilities + Long-term liabilities + Owners' equity


Top management's ultimate goal is to maximize the return on the assets utilized by the company. Each investment center is expected to generate a return on the assets invested in the respective divisions. All assets on the left side of the equation are financed with at least one of the equities on the right side of the equation. Recall that owners' equity has a cost as a result of the dividends and reinvestment of profits to grow the company. There is also an obvious interest cost of long-term liabilities such as loans or bond financing, referred to as debt financing. That leaves one equity on the right side of the equation---current liabilities---many components of which have no financing cost attached to them. Two common current liabilities bear an interest cost---short-term notes payable and the current portion of long-term debt. These obligations create interest expense for the company that issued the obligations, and are considered to be interest-bearing. All other current liabilities are considered to be non-interest bearing.


Non-Interest Bearing Current Liabilities

Non-interest bearing liabilities bear no interest cost. These include accounts payable, dividends payable, a number of different accrued liabilities such as salaries payable, taxes payable, interest payable, warranty expense payable, utilities, payable, etc. All of these liabilities are essentially 'free' financing. They have no interest cost attached to them for the short time period during which the company uses the assets associated with the obligation. In essence, a company is using assets that were financed by credit, without having to pay interest. This group of non-interest bearing current liabilities is called NIBCL for short, and is considered free financing. 


Invested Capital

Invested capital include all assets tied up in a segment that have a financing cost associated with them. All assets carry a financing cost except for those acquired with non-interest-bearing current liabilities (NIBCL). The 'free-financing' assets are removed from total assets to calculate invested capital because from a corporate perspective, top executives are concerned with generating a return that exceeds the cost of capital. When there is no cost associated with some to those assets, the entire return increases shareholder value. The calculation of invested capital removes assets with free financing so that the calculation of invested capital represents only the assets that carry a cost of capital:


Invested capital = Total assets - Non-interest bearing current liabilities


Calculating ROI and its Components

There are two methods to calculate ROI. The first method is straight-forward and is calculated by dividing invested capital into NOPAT: 


Invested Capital


The second method breaks ROI into its two essential components---profit margin and investment turnover:


ROI =  Profit Margin x Investment Turnover
ROI =  NOPAT x Sales
Sales Invested Capital


Profit margin is the ratio of 'income' to sales. This is the same concept as the profit margin ratio you learned in financial accounting, except that the amount used as profit is modified to become NOPAT. Profit margin indicates the portion of each sales dollar that a company generates as profit. It is expressed as a percentage answer with 2 decimals displayed.


Investment turnover is the ratio of sales to invested capital, similar to the asset turnover ratio you learned in financial accounting. Investment turnover indicates the number of times a company generates sales for each dollar invested in assets in the segment. It is expressed with two decimals displayed, and the label 'times.'


The breakdown of ROI into its two components enables managers to see what causes changes in the ROI from period to period. In general, an increase in ROI can be achieved by increasing profit margin or increasing investment turnover. More specifically, if profit margin declines, a manager knows he must work on generating more profit out of each sales dollar. If investment turnover declines, a manager must put his efforts towards generating more sales out of each dollar of assets. Drilling down to a lower level, ROI can be increased by:

Problems with Evaluating Performance

ROI is not a guaranteed measure of performance. Managers learn what elements are used in its calculation and make special efforts to maximize the measure's outcome so that they will rewarded. There are two major problems with performance evaluation--overinvestment and underinvestment. Both exist because managers often exhibit goal incongruence---they act in their own interest rather than the best interest of the company.



When managers are evaluated in terms of only profit, they may be motivated to overinvest. Their goal is to increase profit. Profit can be increased by investing in new projects that carry any rate of return, including a rate that is less than the minimum required rate specified by management. The focus on profit causes managers to accept investments which earn less than the required rate of return solely to increase profit.


Take for example a proposed investment of $10,000 with an expected ROI of 5%, and a required rate of return of 12%. The manager should not invest because the investment is expected to generate a return less than the minimum 12% return specified by top management. However, because this investment will increase profit by $500 (5% of $10,000), the segment manager will likely invest without regard to the required rate of return. Why? If the manager is evaluated on profit, he will be motivated to make himself appear to be performing well by increasing profit.


A solution to the overinvestment problem is to use ROI for performance evaluation. ROI adds an evaluation factor that requires profit to be a percentage of the invested assets. 



An investment center's manager that is evaluated using ROI may be motivated to underinvest. If an investment center has a high ROI, the manager will be motivated to turn down projects that don’t increase ROI, even though certain investments may earn a return that exceeds the required rate of return. Managers turn these projects down because these investments reduce the investment center's overall ROI in the short-run causing the manager to appear to be performing poorly.


For example, assume a segment manager is debating the purchase of a machine costing $10,000 with an expected ROI of 12%. Top level executives have specified a required rate of return of 10%. Two actions by the divisional manager are possible. First, the manager may accept the investment because he should accept all investments that exceed the minimum required rate of return. If accepted, the division's overall ROI will drop due to the operations pertaining to the new machine being combined with the existing 12% return.


Second, the manager may reject the investment because he does not want to lower his divisional ROI, which would cause him to look as if he is performing poorly. What the manager should do is accept the investment. What the manager will most likely do is reject the investment. A manager that rejects the investment is exhibiting goal incongruence as he is acting in his best interest rather than the company as whole.


Managers typically figure out that when new assets are acquired, the additional cost of the new assets causes the denominator---invested capital---to increase, which in turn, decreases ROI. Because managers do not want ROI to appear to drop, they often defer new equipment purchases. However, failing to acquire new equipment typically has a negative impact on the company's performance in the long run as the company becomes less competitive. 


Comparing ROIs 

Because assets are carried in the accounting records at historical costs, it is difficult to compare one company's ROI with another company's ROI. This is because older assets typically have smaller book values than assets acquired more recently. Companies with smaller book values have higher ROIs than companies with larger book values, even if the assets are similar in original costs.


Residual Income

Residual income (RI), another method of measuring performance of investment centers,  (RI) measures the amount a division adds to shareholder value of the parent company. Shareholder value is the net worth of a company---the owners' equity component of the accounting equation.


Residual income is an alternative evaluation method used to mitigate problems that result when using ROI or profit to evaluate performance. It encourages managers to make profitable investments that may be rejected by managers using ROI because it focuses on increasing corporate shareholder value.


When a division or other segment generates profit that exceeds the cost of the invested assets, the excess profit increases retained earnings, which then causes owners' equity to rise. This amount is the residual income. Residual income is NOPAT minus the profit required to cover the cost of financing. Required profit is the cost of financing times the amount of assets tied up in the segment that have a cost attached to them. When subtracting the required profit from the profit generated by the segment (NOPAT), the difference is residual income:


          Residual Income = NOPAT – Required profit

                                   = NOPAT – (Cost of capital x Invested capital)


A positive residual income indicates the segment created shareholder wealth. A negative residual income indicates the segment is depleting shareholder wealth.


Bigger investment centers (asset size) are expected to generate a larger residual income than smaller divisions. This occurs simply because they are larger, and is not necessarily a result of management performance. Examine information from the following two divisions:




Division A

Division B

Invested assets








Cost of capital @10%



Residual income







Division A contributed $40,000 to shareholder wealth (i.e., residual income), which is greater than the contribution of $30,000 by Division B. However, Division B has the higher ROI indicating that it generated about 16 cents of profit for every dollar of assets invested.  Division A  generated only 12 cents for each dollar of assets. The key difference is the size of the two divisions. Division A is expected to generate more residual income because it has more assets that it able to use for this purpose. However, Division B is the better candidate for expansion because it is able to generate about 4 cents more of profit for each dollar of assets it holds.


Residual income helps solve both over- and under-investment problems because there is no denominator effect. Ideally, top management should use a combination of methods to evaluate performance to be fair to the managers of the investment centers.


Walk Through Problem

Robotics, Inc. compiled the following for its Toy Division for 2018:




 Non-interest-bearing current liabilities 


 Interest expense 


 Interest-bearing current liabilities 




 Net income 



Robotics' tax rate is 33%. Its cost of capital is 8.1%, and its required rate of return is 9.4. Calculate the two components of ROI and show how the two components can be used to calculate ROI. Prove your ROI is correct by using the straight-forward approach to calculating ROI. Calculate residual income. Interpret all amounts.


The two components are profit margin and investment turnover:


Profit margin = 



Net income + [Interest expenses, net of taxes]




=     $98,930 + [$41,000 x (1 - 33%)]  = 3.95%


Robotics' profit margin indicates that the Toy Division generated about 3.95 cents of profit out of each dollar of sales.

Investment turnover =  Sales = Sales
Invested Capital Total assets - NIBCL


=    $3,200,000 = 2.77 times
$1,210,000 - $55,000

Investment turnover indicates that for each dollar of assets tied up in the segment, the company generated about $2.77 of sales revenue. 


ROI using the two components is:

ROI = Profit margin x Investment turnover

ROI = 3.95% x 2.77 = 10.94%

ROI using the straight-forward calculation is:


ROI =  NOPAT = $98,930 + [$41,000 X (1 - 33%)]  = 10.94%
Invested Capital  $1,210,000 - $55,000


Toy Division generated about 11 cents of profit for each dollar of assets tied up in the division.


Residual income is NOPAT less the cost of capital times invested assets:


NOPAT = $98,930 + [$41,000 x (1 - 33%)] = $126,400

Residual income = NOPAT - (Cost of capital) x (Invested capital)

= $126,400 - (8.1% x ($1,210,000 - $55,000)) = $32,845


Toy Division contributed $32,485 to shareholder value of Robotics, Inc.

This page was last edited on Friday October 07, 2016 04:02 PM
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