Exercise 25.4: ROI versus EVA Measures

| June 7, 2016

Question
Exercise 25.4: ROI versus EVA Measures

Sapsora Company uses ROI to measure the performance of its operating divisions and to reward

division managers. A summary of the annual reports from two divisions is shown below. The company’s weighted-average cost of capital is 12 percent.

Division A Division B

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000,000 $8,750,000

Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 1,750,000

After-tax operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,180,000

ROI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25% 14%

a. Which division is more profitable?

b. Would EVA more clearly show the relative contribution of the two divisions to the company as

a whole? Show the computations.

c. Suppose the manager of Division A was offered a one-year project that would increase his

investment base by $250,000 and show a profit of $37,500. Would the manager choose to

invest in the new project?

Exercise 25.5: Performance and ROI versus Residual Income

An investment center in Shellforth Corporation was asked to identify three proposals for its capital

Capital Budget Proposals

A B C

Capital required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $50,000 $150,000

Annual operating return . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 16,000 15,000

Shellforth uses residual income to evaluate all capital budgeting projects. Its minimum required

return is 12 percent.

a. Assume you are the investment center manager. Which project do you prefer? Why?

b. Assume your investment center’s current ROI is 18 percent and that the president of Shellforth

is thinking about using ROI for the investment center’s evaluation. Would your preferences for the projects listed above change? Why?

Exercise 25.6: Concerns about ROI

Jennifer Baskiter is president and CEO of Plants& More.com , an Internet company that sells plants and flowers. The success of her startup Internet company has motivated her to expand and create two divisions. One division focuses on sales to the general public and the other focuses on business-to-business sales .homeworkminutes.com/answer/view/71900#”>to hotels, restaurants, and other firms that want plants and flowers for their businesses. She is considering using return on investment as a means of evaluating her divisions and their managers. She has hired you as a compensation consultant. What issues or concerns would you raise regarding the use of ROI for evaluating the divisions and their managers?

Exercise 25.7: Compensation Choices

You are the manager of the Midwest Region, a 27-restaurant division that is part of the chain “Bites and Bits.” The restaurants offer casual dining and compete with such chains in your region as Olive Garden and Outback Steakhouse . You receive an annual cash bonus of 5 percent of sales when residual income in your region exceeds the required minimum return on invested capital of 15 percent. You are using a similar performance evaluation plan to reward each of the managers in your 27 restaurants. You are concerned that important performance variables are being overlooked. For example, you have heard complaints from other regions and in your own region that the quality of the food is bad, it is difficult to retain serving staff in the restaurants, and finding a good chef is very difficult. At an upcoming planning meeting for all regional directors, the agenda includes considering the business performance evaluation and compensation plan. What could you say about the current compensation plan and what would you propose to remedy the problems?

Exercise 26.8: Analyzing a Capital Investment Proposal

Pack & Carry is debating whether to invest in new equipment to manufacture a line of high-quality

luggage. The new equipment would cost $1,728,125, with an estimated five-year life and no salvage value. The estimated annual operating results with the new equipment are as follows:

Revenue from sales of new luggage . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000

Expenses other than depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $306,250

Depreciation (straight-line basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345,625 651,875

Increase in net income from the new line . . . . . . . . . . . . . . . . . . . . . . . $148,125

All revenue from the new luggage line and all expenses (except depreciation) will be received or paid in cash in the same period as recognized for accounting purposes. You are to compute the following for the investment in the new equipment to produce the new luggage line:

a. Annual cash flows.

b. Payback period.

c. Return on average investment.

d. Total present value of the expected future annual cash inflows, discounted at an annual rate of

10 percent.

e. Net present value of the proposed investment discounted at 10 percent.

Exercise 26.9: Competing Investment Proposals

The division managers of Chester Construction Corporation submit capital investment proposal each year for evaluation at the corporate level. Typically, the total dollar amount requested by the divisional managers far exceeds the company’s capital investment budget. Thus, each proposal is first ranked by its estimated net present value as a primary screening criterion. Jeff Hensel, the manager of Chester’s commercial construction division, often overstates the projected cash flows associated with his proposals, and thereby inflates their net present values. He does so because, in his words, “Everybody else is doing it.”

a. Assume that all the division managers do overstate cash flow projections in their proposals. What would you do if you were recently promoted to division manager and had to compete for funding under these circumstances?

b. What controls might be implemented to discourage the routine overstatement of capital budgeting estimates by the division managers?

Exercise 26.10: Replacing Existing Equipment

Exhibit 26-3 Present Value of $1 Payable in n Periods

Number Present Value of $1 Due in n Periods *

of Periods ( n ) Discount Rate

1% 1½% 5% 6% 8% 10% 12% 15% 20%

1 .990 .985 .952 .943 .926 .909 .893 .870 .833

2 .980 .971 .907 .890 .857 .826 .797 .756 .694

3 .971 .956 .864 .840 .794 .751 .712 .658 .579

4 .961 .942 .823 .792 .735 .683 .636 .572 .482

5 .951 .928 .784 .747 .681 .621 .567 .497 .402

6 .942 .915 .746 .705 .630 .564 .507 .432 .335

7 .933 .901 .711 .665 .583 .513 .452 .376 .279

8 .923 .888 .677 .627 .540 .467 .404 .327 .233

9 .914 .875 .645 .592 .500 .424 .361 .284 .194

10 .905 .862 .614 .558 .463 .386 .322 .247 .162

20 .820 .742 .377 .312 .215 .149 .104 .061 .026

24 .788 .700 .310 .247 .158 .102 .066 .035 .013

36 .699 .585 .173 .123 .063 .032 .017 .007 .001

*The present value of $1 is computed by the formula p 5 1 / (1 + 1 i ) n , where p is the present value of $1, i is the discount rate, and n is the number of periods until the future cash flow will occur. Amounts in this table have been rounded to three decimal places and are shown for a limited number of periods and discount rates. Many calculators are programmed to use this formula and can compute present values when the future amount is entered along with values for i and n.

EXHIBIT 26–4 Present Value of a $1 Annuity Receivable Each Period for n Periods

Number Present Value of $1 to Be Received Periodically for n Periods

of Periods (n) Discount Rate

1% 1½% 5% 6% 8% 10% 12% 15% 20%

1 0.990 0.985 0.952 0.943 0.926 0.909 0.893 0.870 0.833

2 1.970 1.956 1.859 1.833 1.783 1.736 1.690 1.626 1.528

3 2.941 2.912 2.723 2.673 2.577 2.487 2.402 2.283 2.106

4 3.902 3.854 3.546 3.465 3.312 3.170 3.037 2.855 2.589

5 4.853 4.783 4.329 4.212 3.993 3.791 3.605 3.352 2.991

6 5.795 5.697 5.076 4.917 4.623 4.355 4.111 3.784 3.326

7 6.728 6.598 5.786 5.582 5.206 4.868 4.564 4.160 3.605

8 7.652 7.486 6.463 6.210 5.747 5.335 4.968 4.487 3.837

9 8.566 8.361 7.108 6.802 6.247 5.759 5.328 4.772 4.031

10 9.471 9.222 7.722 7.360 6.710 6.145 5.650 5.019 4.192

20 18.046 17.169 12.462 11.470 9.818 8.514 7.469 6.259 4.870

24 21.243 20.030 13.799 12.550 10.529 8.985 7.784 6.434 4.937

36 30.108 27.661 16.547 14.621 11.717 9.677 8.192 6.623 4.993

EnterTech has noticed a significant decrease in the profitability of its line of portable CD players. The production manager believes that the source of the trouble is old, inefficient equipment used to manufacture the product. The issue raised, therefore, is whether EnterTech should (1) buy new equipment at a cost of $120,000 or (2) continue using its present equipment. It is unlikely that demand for these portable CD players will extend beyond a five-year time horizon. EnterTech estimates that both the new equipment and the present equipment will have a remaining useful life of five years and no salvage value. The new equipment is expected to produce annual cash savings in manufacturing costs of $34,000, before taking into consideration depreciation and taxes. However, management does not believe that the use of new equipment will have any effect on sales volume. Thus, its decision rests on the magnitude of the potential cost savings. The old equipment has a book value of $100,000. However, it can be sold for only $20,000 if it is replaced. EnterTech has an average tax rate of 40 percent and uses straight-line depreciation for tax purposes. The company requires a minimum return of 12 percent on all investments in plant assets.

a. Compute the net present value of the new machine using the tables in Exhibits 26–3 and 26–4.

b. What nonfinancial factors should EnterTech consider?

c. If the manager of EnterTech is uncertain about the accuracy of the cost savings estimate, what actions could be taken to double-check the estimate?

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