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

2023
Views:

134

Pages:

2
Author:

T. Elton

The Measurement of Assets The surveys of Mauriel and Anthony (1966), Reece and Cool (1978) and Vancil (1979) found only a small minority of organizations using any basis other than net book value derived from historical cost to measure their assets in ROI and RI calculations. This might appear surprising in view of the well-publicized distortions in the comparative values of ROI and RI that result from the conventional application of this basis. Example 10 illustrates the problem. Example A division buys a machine for £1m, which will yield a constant £300,000 per annum over its 5-year life and have no residual value. The division uses straight-line depreciation, and a cost of capital of 10 per cent. All figures are in £000s. Tax ignored. Despite the fact that the Net Cash Inflows (NCIs) remain unchanged each year, ROI and RI (using either version of historic NBV) rise dramatically, simply because of the shrinking investment base. Example The same data as example 10 apply, except that the cost of capital is now 14 per cent. The investment is worthwhile and should be accepted. However, ROI and RI for years 1-3 show the following pattern: Book ROI is below the minimum required in years 1 and 2 in case (1), and in year 1 of case (1), with year 2 showing only a very marginal positive return. The RI is strongly negative in years 1 and 2 in case (1), and in year 1 of case (2), and is barely positive in year 2 of the latter. The divisional manager, seeing that the acceptance of the project in example 11 would penalize his performance in the first 2 years under (1), and in the first year of (2), with little compensation in year 2 of the latter, might be tempted to ignore the returns after this period and reject the investment, particularly if he is hoping for a promotion or transfer before year 3 is through. Obviously, the performance indicators would be worse, and the motivation to reject even stronger, in the more normal situation, where some considerable "lead time' is required by a new investment - to launch a new product, build a plant, install machinery, test a new operation adequately and remove any 'bugs', and generally reach peak profitability.