ROI and profitability index: A note on managerial performance

This note deals with the case of a principal (e.g., a firm’s board of directors) which delegates execution of an economic activity to a business unit (or a subsidiary firm) managed by a manager. It is assumed that the manager has no control over the cash flows injected into the unit or withdrawn from it: such decisions are made by the principal. The principal aims at measuring the manager’s performance in a given interval of time. Neither the Net Present Value (NP V ) nor its companion Net Terminal Value (NT V ) are appropriate measures for this purpose, because they depend on the cash flows injected and withdrawn by the principal. We introduce the manager’s profitability index (MP I), which is invariant under changes in the cash flows, so neutralizing the effect on value creation of the principal’s decisions. We also break down the project’s NT V into two components, which measure the manager’s contribution and the principal’s contribution to value creation.