Chapter 20

Tutorial questions

Week 6

20.2 What are the six steps in designing accounting-based performance measures?

20.12 Explain the role of benchmarking in evaluating managers.

20.19

Hamilton Ltd is a reinsurance and financial services company. Hamilton strongly believes in evaluating
the performance of its stand-alone divisions using financial metrics such as ROI and residual income. For
the year ended 31 December 2017, Hamilton’s CFO received the following information about the
performance of the property/casualty division:

Sales revenues $900 000

Operating profit 225 000

Total assets 1 500 000

Current liabilities 300 000

Debt (interest rate: 5%) 400 000

Common equity 500 000

For the purposes of divisional performance evaluation, Hamilton defines investment as total assets, and
income as operating profit (i.e. profit before interest and taxes). The firm pays a flat rate of 25% in taxes
on its income.
Required
1. What was the net profit after taxes of the property/casualty division?
2. Calculate the division’s ROI for the year.
3. Based on Hamilton’s required rate of return of 8%, calculate the property/casualty division’s
residual income for 2017.
4. Hamilton’s CFO has heard about EVA® and is curious about whether it might be a better
measure to use for evaluating division managers. Hamilton’s four divisions have similar risk
characteristics. Hamilton’s debt trades at book value while its equity has a market value
approximately 150% that of its book value. The company’s cost of equity capital is 10%.
Calculate each of the following components of EVA® for the property/casualty division, as well
as the final EVA® figure:
a. Net operating profit after taxes
b. Weighted-average cost of capital
c. Investment, as measured for EVA® calculations
20.24

Telum Ltd manufactures electronic devices and competes on the basis of quality and leading-edge
designs. The company has $1 750 000 invested in assets in its Mobile Phone Division. After-tax operating
profit from sales of mobile phones this year is $325 000. The Tablet Division has $6 000 000 invested in
assets and an aftertax operating profit this year of $1 050 000. Income for the Mobile Phone Division has
grown steadily over the past few years. The weighted-average cost of capital for Telum Ltd is 9% and the
previous period’s after-tax return on investment for each division was 13%. The CEO of Telum Ltd 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 Telum Ltd, and briefly explain which
manager will get the bonus. What are the advantages and disadvantages of each measure?

2. The CEO of Telum Ltd has recently heard of another measure similar to residual income called EVA®.
The CEO has the accountant calculate EVA®-adjusted incomes of the Mobile Phone and Tablet Divisions,
and finds that the adjusted after-tax operating profits are $700 000 and $1 300 000, respectively. Also,
the Mobile Phone Division has $525 000 of current liabilities, whereas the Tablet Division has only $105
000 of current liabilities. Using the above information, calculate EVA® and discuss which division
manager will get the bonus.

3. What non-financial measures could Telum Ltd use to evaluate divisional performances?

20.31
News Report Group has two major divisions, Print and Internet. Summary financial data (in millions) for 2016 and
2017 are as follows:

A B C D E F G H I
1 Operating profit Revenues Total assets
2 2016 2017 2016 2017 2016 2017
3 Print $3720 $4500 $18 700 $22 500 $18 200 $26 000
4 Internet 525 690 25 000 23 000 11 150 10 000
5

The two division managers’ annual bonuses are based on division ROI (defined as operating profit divided by
total assets). If a division reports an increase in ROI from the previous year, its management is automatically
eligible for a bonus; however, the management of a division reporting a decline in ROI has to present an
explanation to the News Report Group board and is unlikely to get any bonus.

Carol Mays, manager of the Print division, is considering a proposal to invest $2580 million in a new
computerised news reporting and printing system. It is estimated that the new system’s state-of-the-art
graphics and ability to quickly incorporate late-breaking news into papers will increase 2018 division
operating income by $360 million. News Report Group uses a 10% required rate of return on investment for
each division.
REQUIRED
1. Use the DuPont method of profitability analysis to explain differences in 2017 ROIs between the two
divisions. Use 2017 total assets as the investment base.
2. Why might Mays be less than enthusiastic about accepting the investment proposal for the new system
despite her belief in the benefits of the new technology?
3. John Mendenhall, CEO of News Report Group, is considering a proposal to base division executive
compensation on division RI.
a. Calculate the 2017 RI of each division.
b. Would adoption of an RI measure reduce Mays’s reluctance to adopt the new computerized system
investment proposal?
4. Mendenhall is concerned that the focus on annual ROI could have an adverse long-run effect on News Report
Group’s customers. What other measurements, if any, do you recommend that Mendenhall use? Explain
briefly.

20.32

CEO John Mendenhall seeks your advice on revising the existing bonus plan for the division managers of
News Report Group. Assume that the division managers do not like bearing risk. Mendenhall is
considering three ideas:

• Make each division manager’s compensation depend on division RI.

• Make each division manager’s compensation depend on company-wide RI.

• Use benchmarking and compensate division managers on the basis of their division’s RI minus the RI of
the other division.
Required
1. Evaluate the three ideas Mendenhall has put forth, using the performance-evaluation concepts
described in this chapter. Indicate the positive and negative features of each proposal.

2. Mendenhall is concerned that the pressure for short-run performance may cause managers to cut
corners. What systems might Mendenhall introduce to avoid this problem? Explain briefly.

3. Mendenhall is also concerned that the pressure for short-run performance might cause managers to
ignore emerging threats and opportunities. Determine what system Mendenhall might introduce to
prevent this problem. Explain briefly.