Operating Income (noi) of Prime Consultant Plc
Essay by Marcello Cimino • July 3, 2016 • Case Study • 1,687 Words (7 Pages) • 805 Views
Question 1
To be able to compute the net operating income (NOI) of Prime Consultant Plc, there is the need to find the present value (PV) of all the items making up both the revenue and expenses for the project in question, as follows;
Present Value (PV) = cashflow or expenses/discount factor
Revenue (consultancy fee) = 1.9m/0.91743 + 1.9m/0.84168 + 1.9m/0.77218 = 3,094,702.30
Salaries expense = 0.4m/0.91743 + 0.4m/0.84168 + 0 4m/0.77218 = 651,516.28
Other expenses = 0.2m/0.91743 + 0.2m/0.84168 + 0.2m/0.77218 =325,758.14
Depreciation expense = ( 3m - 0) /3 = 1m
Net Operating Income. £. £
Revenue- 3,094,702.30
Expenses
Salaries. 651,516.28
Other expenses 325,758.14
Depreciation 1,000,000.00
1.977,274.42
Net Operating Income (NOI) 1,117,427.88
Return On Income (ROI) =
(NOI /Operating Asset) X 100% = (1,117,427.88/3,000,000) X 100% = 37.25%
Residual Income RI = NOI - (Required Rate of Return X Operating Asset)
= 1,117,427.88 - (0.09 X 3,000,000) = 847,427.88
Residual Income Return on Assets = 847,427.88/3,000,000 X 100% = 28.25%
A.
The profitability or otherwise of projects are assessed based on the return it can generate on assets can be measured Rrturn on Income (ROI). In general, projects whose ROI are higher than the required cost of capital should be accepted. Conversely, projects whose ROI are lower than the required return should not be accepted.
As it can be seen from the calculations above, Prime Consultant's ROI are way higher (37.25%) than the project's cost of capital (9%).
The ROI is used worldwide as an important measure of management performance on various projects. The manager has exceeded the project's cost of capital, and therefore, he or she can therefore be awarded based It.
B.
The decision on acceptability of this new project would not have changed even if it was based on the Residual Income (RI) measure. This is because, as can be seen from the calculations above, the RI is positive (£847,427.88), which translates into 28.25% when divided by the project's assets. Since this is higher than the required cost of capital, it does not change the decision based on the ROI. The manager has outperformed and can still be awarded even by the use of Residual Income method.
D.
A look at the two formulas, Residual Income (RI) and Economic Value Added (EVA), which both measure management performance, reveals their basic differences.
The two respective formulars are as follows;
RI = Net Operating Income - (Average Operating Assets X Required Rate of Return)
EVA =
After-tax Operating Income - [(Weighted-average cost of capital) X (Longterm assets + working assets)]
One of the basic differences between them is that whereas the RI uses just the NOI in its calculations, the RI takes into consideration the effects of tax by replacing the NOI with an after tax operating income.
Another difference is that whereas RI uses required rate of return as the cost of capital, EVA, on the otherhand uses weighted average cost of capital in its calculations. It can be said that EVA is more detailed as it takes into account various details such as tax, and also weights its cost of capital. The EVA tends to be used most often by bigger companies.
Reference
C.T. Horngren, 1998. Management and Cost Accounting. 4th Edition. Prentice Hall.
Hi Alex, thank you for your contribution in this case study.
ROI should be average annual profit / initial cost of income, which should be 10% for year 1, 15% for year 2 and 30% for year 3. Please see below the solution to check your answer against:
A
Revenue £1,900,000
Less salaries (£400,000)
Less other expenses (£200,000)
Less depreciation (£1,000,000)
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