EXERCISE 12-11. Evaluating Investment Centers with Residual Income [LO 6] Lakeside
Hospital is a division of Superior Healthcare organized as an investment center. In the past year,
the hospital reported an after-tax income of $2,500,000.Total interest expense was $1,900,000,and
the hospital’s tax rate was 35 percent.Hospital assets totaled $33,000,000, and noninterest-bearing
current liabilities were $10,400,000. Superior has established a required rate of return equal
to 17 percent of invested capital.
Required
Calculate the residual income/EVA of Lakeside Hospital.
EXERCISE 12-13. Overinvestment and Underinvestment [LO 5] Consider two companies:
Quantum Products and Aquafin Products. Senior managers at Quantum Products are evaluated in
terms of increases in profit. In fiscal 2011, Quantum Products had a net operating profit after taxes
of $2,500,000 and invested capital of $25,000,000. In fiscal 2012, the company had net operating
profit after taxes of $3,000,000 and invested capital of $37,500,000. Senior managers at Aquafin
Products are evaluated in terms of ROI. In fiscal 2012, ROI was 16 percent while the cost of capital
was only 12 percent.Near the end of fiscal 2012, managers had an opportunity to make an investment
that would have yielded a return of 14 percent. However, the senior managers did not support
making the investment.
Required
a. Explain why the senior managers at Quantum Products have an incentive to overinvest.
b. Explain why the senior managers at Aquafin Products have an incentive to underinvest
PROBLEM 12-6. Return on Investment, Profit Margin, and Investment Turnover [LO 4]
Consider the following information for HandyCraft Stores for 2011 and 2012.
2011 2012
Total assets $45,000,000 $51,300,000
Noninterest-bearing current liabilities 4,000,000 4,500,000
Net income 3,500,000 4,500,000
Interest expense 2,200,000 2,700,000
Sales 60,000,000 87,500,000
Tax rate 40% 40%
Required
a. Compute ROI for both years.
b. Break ROI down into profit margin and investment turnover.
c. Comment on the change in financial performance between 2011 and 2012.
PROBLEM 12-7. ROI and EVA [LO 6] ELN Waste Management has a subsidiary that disposes of
hazardous waste and a subsidiary that collects and disposes of residential garbage. Information
related to the two subsidiaries follows.
Hazardous Residential
Waste Waste
Total assets $13,000,000 $70,000,000
Noninterest-bearing current liabilities 3,000,000 12,000,000
Net income 1,700,000 6,000,000
Interest expense 1,250,000 7,300,000
Required rate of return 12% 14%
Tax rate 40% 40%
Required
a. Calculate ROI for both subsidiaries.
b. Calculate EVA for both subsidiaries.Note that since no adjustments for accounting distortions
are being made, EVA is equivalent to residual income.
c. Which subsidiary has added the most to shareholder value in the last year?
d. Based on the limited information, which subsidiary is the best candidate for expansion?
Explain.
PROBLEM 12-8. EVA [LO 6] Atomic Electronics is considering instituting a plan whereby
managers will be evaluated and rewarded based on a measure of economic value added (EVA).
Before adopting the plan, management wants you to calculate what EVA will be in 2012 based
on financial forecasts for 2012 and prior financial data.
Fiscal Forecast
2012
Total assets $ 55,000,000
Noninterest-bearing current liabilities 21,000,000
Sales 100,000,000
Net income 5,500,000
Interest expense 1,200,000
Research and development 2,400,000
Tax rate 35%
Cost of capital 14%
Research and development expenditures in 2010 and 2011 were $1,200,000 and $2,100,000,
respectively. In calculating EVA, prior research and development will be capitalized and amortized
assuming a three-year life (i.e., one-third will be expensed in the year incurred, and two-thirds will
be capitalized and expensed in the following two years).
Required
a. Explain why it is important to capitalize research and development if managers are to be
rewarded based on EVA.
b. Calculate forecasted EVA for 2012.
c. Will management be likely to support use of EVA as a financial performance measure?
PROBLEM 12-16. (Appendix) Transfer Pricing [LO A1] Montana Woolen Products has two divisions:
a Fabric division that manufactures woolen fabrics and a Clothing division that manufactures
woolen dresses, coats, shirts, and accessories. All fabric used by the Clothing division is
supplied by the Fabric division, which also supplies fabric to outside companies.
Required
a. Suggest a transfer price for the fabric assuming that the Fabric division is operating at only
60 percent of capacity due to a surge in popularity of “easy-care” fabrics made of polyester and
rayon.
b. Suggest a transfer price for fabric assuming that the Fabric division is operating at capacity
due to a revival of consumer interest in natural products and development of lightweight, wrinkle-
resistant woolen fabrics.
c. Explain how your choices in parts a and b are related to the opportunity cost concept
PROBLEM 12-18. Comparing Performance Evaluation Methods [LO 4,5,6] Top management
of the Gates Corporation is trying to construct a performance evaluation system to use to evaluate
each of its three divisions.This past year’s financial data are as follows:
Division A Division B Division C
Total assets $530,000 $10,700,000 $6,375,000
Noninterest-bearing current liabilities 30,000 1,250,000 600,000
Net income 102,000 1,040,000 780,000
Interest expense 30,000 1,100,000 700,000
Tax rate 40% 40% 40%
Required rate of return 10% 12% 14%
Required
a. How would the divisions be ranked (from best to worst performance) if the evaluation were
based on net income?
b. How would the divisions be ranked (from best to worst performance) if the evaluation were
based on ROI?
c. How would the divisions be ranked (from best to worst performance) if the evaluation were
based on residual income?
Yoyo! You are!
This is a homework HELP site, not a homework cheat site.
To calculate the values requested in the exercises, you'll need to use some financial performance measures. Here's how you can calculate them:
1. Residual Income/EVA:
Residual Income (RI) is calculated by subtracting the required rate of return (RRR) from the after-tax income of the investment center. The formula is:
RI = After-tax income - (Total assets - Noninterest-bearing current liabilities) * RRR
Economic Value Added (EVA) is equivalent to Residual Income. Therefore, EVA can be calculated in the same way.
2. Return on Investment (ROI):
ROI is calculated by dividing net income by average invested capital and multiplying by 100. The formula is:
ROI = (Net income / Average invested capital) * 100
To calculate average invested capital, add the beginning and ending invested capital and divide by 2.
3. Profit Margin and Investment Turnover:
Profit Margin is the ratio of net income to sales. The formula is:
Profit Margin = (Net income / Sales) * 100
Investment Turnover is the ratio of sales to average invested capital. The formula is:
Investment Turnover = Sales / Average invested capital
Now, let's calculate the values for each exercise using the given information.