EVALUATING PERFORMANCE essay
When a company is starting operations in new environment and has to choose a project to invest in, there are a lot of conditions to take to account. At the same time, there are a lot of specific economic measuring to make to see the profitability and liability of each project, and one of the most popular methods to do it is to calculate the return on equity (ROE). This rate shows how efficient the firm is at generating profits from every unit of shareholders’ equity; it is used to determine whether the investment funds are used to generate new earnings or whether they are wasted; in other words, it shows whether the company is an asset creator or a cash consumer.
To get this rate, it is necessary to know the net income of the fiscal year and to divide it by total equity without preferred shares. The average shareholder equity is taken from the balance sheet. Three pillars of corporate management, such as profitability, asset management, and financial leverage are encompassed by ROE (Hazen 2003, p. 35). So, this tool is rather useful to see how effectively the management is employing the investors’ capital invested in the company.
Still, when the earnings are not reinvested, the rate of ROE can be irrelevant and the measure should be used carefully, as it is anyway not an absolute indicator of investment value. Sometimes it is better to use the rate of return on capital instead of ROE as “return on equity indicates how well a company is doing with the money it has now, whereas return on capital indicates how well it will do with further capital” (Price 1999). After all, return on equity is usually calculated from the company’s perspective, and the company’s operations on the whole do matter. The project is considered to be worth of investment when the return of equity is at least 15 percent.
Another valuable rate used in capital budgeting is the internal rate of return (IRR). This measure is also known as the effective interest rate and discounted cash flow rate of return, which means that this is a discount rate resulting in a net present value of zero for a series of future cash flows, by definition. Meanwhile, the word “internal” is also essential because here environmental factors (like inflation, compatibility and so on) are not incorporated.
To count internal rate of return, one needs to equalize the investment’s net present value (NPV) to zero. NPV demonstrates how the future cash flow will be discounted back to the present value, and that percentage represents the minimum desired rate of return. The break-even discount rate is such a figure, according to which the value of cash outflows is the same as the value of cash inflows. The mechanism of decision-making consists in finding out how the internal rate of return refers to the cost of capital: if the IRR is higher than the cost of capital, then it is advised to accept the project; if it is lower, then it is better to reject the project
The advantage of this tool is that it is considered to be a simple hurdle rate for making investment decisions. This tool is rather popular with accountants and other people dealing with finance to use it as a kind of “go/no-go investment threshold”. When the IRR is equal to the hurdle rate or exceeds it, than the decision is usually positive. However, this method has some drawbacks too. Actually it is not as easy to understand as to compute. Sometimes the computations lead to mistakes which can totally disorient the investor. “It’s the break-even discount rate, the rate at which the value of cash outflows equals the value of cash inflows,” Hartman & Schafrick (2004, p. 140) explain.
Both these measures are useful in comparing the rates of the projects within the same industry. The sphere of information technologies is one of the most indicative, as the IT project favor short-tern results. For example, the balance sheets for 2011 of Microsoft Corporation and Apple (AAPL) can be compared. The net income of the Microsoft Corporation made up $5.23 billion, while the total shareholder’s equity is presented as $64.12 billion. According to the formula, we should divide the first figure by the second. The result is 0.08. The return on equity of the Microsoft Corporation is thus 41.53%. As for the results of Apple, the total shareholder’s equity is $76.62 billion and the net income made up $5.99 billion. If we divide the second figure by the first one, we will get 0.078, and the return on equity of the Apple is thus 46.83. If we compare the results of the two companies, we will see that they are quite close in their results, but still Apple is slightly leading and is more effective in its operations. The same conclusion can be met in the reports of world analytics, which proves that the return on equity is a useful tool in evaluating the profitability of the projects.
