University:
Stanford University
Course:
ECON 202 | Microeconomics I
Academic year:

2023
Views:

240

Pages:

2
Author:

T. Elton

ROI And Dysfunctional Behaviour We noted at the beginning of this chapter that selection of an inappropriate performance measure can lead managers to act in a manner that is inconsistent with the goals of the organization as a whole. In chapter 5, we saw that, ceteris paribus, the firm should accept all proposed investments which show an expected return in excess of the cost of capital (i.e. which would give rise to a positive NPV at this rate of return), and that the use of a ratio (in the case of capital budgeting, IRR) is unreliable for ranking alternative investments. It follows therefore that appraisal of divisional performance on the basis of ROI alone could give rise to decisions which are dysfunctional. This point is easily demonstrated when one considers that ROI represents an average return on divisional investment. An average will be reduced by adding individual investments that offer a return lower than the existing average, and increased by the divestment of similar existing individual investments. Obviously, divisional management would be motivated to reject (or never bring forward for consideration) investments of the former type, despite the fact that their acceptance might actually increase the firm's economic wealth; and it would tend to adopt the latter policy of divestment, despite its potential for making the firm worse off as a result. The problem centres on the firm's cost of capital, as the following simple examples illustrate: Example A division currently earns a profit of £20,000 on an investment of £100,000, giving an ROI of 20 per cent (£20k/£100k). The firm's cost of capital for investments of this type is 10 per cent. An investment opportunity appears that offers a profit of £3,000 on an outlay of £20,000, a return of 15 per cent. The return is clearly well in excess of the cost of capital, but its acceptance will reduce the division's ROI: If divisional management is judged solely on the basis of ROI, it would be inclined to reject this proposed investment, not wishing to see a decline in its performance measure, notwithstanding the fact that the firm's economic wealth would actually increase by £1000 (£3k - [10% × £20k]) as a result of its acceptance (and, indeed, we could say that there is an opportunity cost to this firm of £1,000 in rejecting it. Example Let us assume that, among the investments of the same division, there is an asset which earns £4,200 on its carrying cost of £30,000. Even though this represents a return of 14 per cent, which again is well in excess of the relevant cost of capital of 10 per cent, divisional management would be motivated to divest itself of the asset, because it is able to significantly increase its ROI by so doing: Again, we can see that the firm would be £1,200 worse off (£4.2k - [10% × £30k]) by disposing of this asset, despite the increase in divisional ROI that would result from the move. Indeed, the reductio ad absurdum of this divestment policy is that the divisional investment base is ultimately reduced to the one asset that generates the highest individual ROI. A similar problem is seen when the performance of two divisions is compared by means of ROI, as example 5 demonstrates.