Reference no: EM132962013
Problem 1 - Reliant Auto Company operates a new car division that sells high performance sports cars and a performance parts division that sells performance improvement parts for family cars. Some division financial measures for 2021 are as follows:
New Car Division (in pesos) Performance Parts Division (in pesos)
Total Assets 33,000,000 28,500,000
Current Liabilities 6,600,000 8,400,000
Operating Income 2,475,000 2,565,000
Required rate of return 12% 12%
Required -
1. Calculate return on investment (ROI) for each division using operating income as a measure of income and total assets as a measure of investment.
2. Calculate the residual income (RI) for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment.
3. William Dar, the New Car Division manager, argues that the performance parts division has "loaded up on short-term debt" to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the performance parts division. Comment on the result.
4. Performance auto parts whose tax rate is 40% has two sources of funds: long-term debt with a market value of P 1,800,000 at an interest rate of 10% and equity capital with a market value of P 12,000,000 and cost of equity of 15%. Applying the same weighted average cost of capital (WACC) to each division, calculate the EVA for the two divisions.
5. Using the results of your computation above, comment on the relative performance of each division.
Problem 2 - Lovely Manufacturing makes fashion products and competes on the basis of quality and leading edge designs. The company has P 3,000,000 invested in assets in its clothing manufacturing division. After tax operating income from sales of clothing this year is P 660,000. The cosmetics division has P 8,000,000 invested in assets and after tax operating income of P 1,200,000. Income for the clothing division has grown steadily over the past few years. The weighted average cost of capital for EVA is 10% and the previous period's after tax return on investment for each division was 15%. The CEO of Lovely has told the manager of each division that the division that "performs best" this year will get a bonus.
Required -
1. Calculate the ROI and residual income for each division of Lovely and briefly explain which manager will get the bonus. What are the advantages of each measure?
2. The CEO of lovely has recently heard of another measure similar to residual income called EVA and wants to calculate EVA for both divisions. The CEO has the accountant calculate EVA adjusted incomes of clothing and cosmetics and finds that the adjusted after tax operating incomes are P 900,000 and P 1,400,000 respectively. Also the clothing division has P 1,000,000 of current liabilities while the cosmetics division has only P 400,000 of current liabilities. Calculate EVA and discuss which manager will get the bonus?