Page 62 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes

Notes The importance of management information system has increased in recent times
because of the following:
1. Emergence of global economy
2. Transformation of industrial economics – knowledge and information intense
products have become available.
3. Transformation of multinational enterprises
4. Emergence of digital form.

Example:A division has a budgeted income of 10 lakhs and a budgeted investment of
60 lakhs. The average cost of capital for the firm is 12 per cent. The budgeted residual income
is:
Divisional Income 10 lakhs

Interest charge
12% on 60 lakhs 7.20
Residual income/ Economic value added 2.80

!

Caution Different interest rates may be applied to different components of investment like
fixed assets, inventories, receivables and cash.

During the 1990s, residual income has been refined and remained as Economic Value Added
(EVA) by Stern Steward Counseling Organization and they have registered EVA (TM) as their
trademark.
The EVA concept extends the traditional residual income measures by incorporating adjustments
to the divisional performance measures against distortions introduced by generally accepted
accounting principles (GAAP).
EVA can be defined as = Conventional divisional profit ± Accumulated
adjustment – Cost of capital charge on divisional assets.

Adjustments are made to the chosen, conventional divisional profit measures in order to
replace historical accounting data with a measure of economic profit and asset values. Stern
Stewart has developed approximately 160 accounting adjustments but most organisations
will only need to use about 10 of the adjustments. These adjustments result in the capitalization
of many discretionary adjustments such as research and development, marketing and
advertising by spreading these costs over the periods in which the benefits are received.
Therefore, adopting EVA reduces some of the harmful side effects arising from using financial
measures. Also, because it is restatement of the residual income measure compared to ROI,
EVA is more likely to encourage goal congruence in terms of asset acquisition and disposal
decisions. Managers are also made aware that capital has a cost and they are thus encouraged
to dispose of underutilized assets that do not generate sufficient income to cover their cost of
capital. There are a number of issues that apply to ROI, residual income or its replacement
(EVA). They concern determining which assets should be included in a divisions asset base

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