Question

A division is considering the purchase of a new machine which costs

$1,500,000 and is expected to generate cost savings of $450,000 a
year.
The asset is expected to have a useful life of five years with no
residual value. Depreciation is charged on a straight line basis.
Divisional performance is evaluated on Residual Income (RI). The
division’s cost of capital is 10%.

Calculate for this machine for each of the five years:

(i) The Residual Income (RI);

(ii) The Return on Investment (ROI).

Note: When calculating performance measures the division always

uses capital values as at the start of the year.

1
Solution

Year 1($) Year 2($) Year 3($) Year 4($) Year 5($)
Cost savings 450,000 450,000 450,000 45,000 450,000
Depreciation 300,000 300,000 300,000 300,000 300,000
Profit 150,000 150,000 150,000 150,000 150,000
Cost of capital (W-1) 150,000 120,000 90,000 60,000 30,000
RI Nil 30,000 60,000 90,000 120,000

ROI (W_2) 10% 12.50% 16.70% 25% 50%

Capital value 1·5 12 0.9 0.6 0.3

2
Solution:

Return = £320,000 + £200,000 + £100,000 + £70,000 = £690,000

Investment = £3·64 million + £0·42 million - £0·37 million = £3·69
million
[(690,000 ÷ 3,690,000) × 100] = 18·7%

3
Question
ZP Plc operator two subsidiaries X and Y, X is component
manufacturing subsidiary and Y is an assembly and final product
subsidiary. Both subsidiaries produce one type of output only.
Subsidiary Y needs one component from subsidiary X for every unit of
Product W produced. Subsidiary X transfers to Subsidiary Y all of the
components needed to produce Product W. Subsidiary X also sell
components o the external market.
The following budgeted information is available for each subsidiary:
X Y
Market price per component $800
Market price per unit of W $1,200
Production costs per component $600
Assembly costs per unit of W $400
Non production fixed costs $1.5m $1.3m

External demand 10,000 units 12,000 units

Capacity 22,000 units
Taxation rates 25% 30%

4
The production cost per component is 60% variable. The fixed
production costs are absorbed based on budgeted output.

X sets a transfer price at marginal cost plus 70%.

Calculate the post tax profit generated by each subsidiary.

5
Solution
X Y
Sales (10, 000x $800 ) 8,000,000
12,000 x $612 (W-3) for Y demand 7,344,000
12,000 x $1,200 14,400,000
Total Revenue 15,344,000 14,400,000
Cost
22,000 X 360 -7,920,000
12,000 x $1,012 (400 +612) -12,144,000
Fixed Costs
Production 22,000 x $240 (600*40/100) -5,280,000
Non production -1,500,000.00 -1,300,000
Total Cost -14,700,000 -13,444,000
Profit 644,000 956,000
Tax 25 % and 30% respectively -161,000 -286,800
Profit after tax 483,000 669,200

6
Question
Division L has reported a net profit after tax of £8.6m for the year ended 30
April 2006.
Included in the costs used to calculate this profit are the following items:
• Interest payable of £2.3m;
• Development costs of £6.3m for a new product that was launched in
May 2005, and is expected to have a life of three years.
• Advertising expenses of £1.6m that relate to the re-launch of a
product in June 2006.
The net assets invested in Division L are £30m.
The cost of capital for Division L is 13% per year.
Calculate the Economic Value Added® for Division L for the year ended 30
April 2006.

7
Solution

£m £m
Net profit after tax 8.6
Add
Interest 2.3
Development costs 6.3
Advertising 1.6 10.2
18.8
Less 1/3 development costs 2.1

Adjusted profit 16.7

Less capital charge: 30* 13% 3.9

EVA 12.8

8
Question
(i) Briefly explain the main features of Economic Value Added
(EVA) as it would be used to assess the performance of divisions.
(ii) Briefly explain how the use of EVA to assess divisional
performance might affect the behavior of divisional senior executives.

9
Solution

EVA attempts to modify accounting operating profit to become closer

to an economic concept of income. To do this many of the accounting
conventions and adjustments are altered, for example:

•Goodwill will be amortized over its effective life.

•R&D expenditure will be written off over its useful life.
•Depreciation will model the decline in asset values.
•Assets will be valued at current cost not historical cost.

After this adjusted profit has been calculated, an interest rate charge
is deducted to produce the EVA.
The interest rate used in EVA is usually complex and it is usually
based on the Capital Asset Pricing Model.
All the above features require systems to be implemented so that the
required data can be produced quickly and with minimum cost.
For example, to compute EVA a separate depreciation calculation and
separate records of assets are needed.
The objective of EVA is to better measure the true economic
performance of a division.
10
Solution:
It is argued that meeting an EVA target will usually require managers to act in
the best interests of the firm. In particular, EVA is said to encourage long term
decision making, rather than decisions that maximize short-run profits.
EVA proponents argue that it has strong motivational advantages because
maximizing EVA will maximize shareholder value.
Providing incentives for managers and workers to maximize value creation for
shareholders has been recognized as a significant problem for decades; this
claim for EVA has made it popular.

The adjustments that are made to accounting profit to derive EVA are
designed to minimize any benefit that managers can obtain by manipulating
accounting numbers.
So, for example, there would be little gain to short run profit from failing to
invest in new machinery, and at least part of the cost of advertising would be
deferred until the benefits arose.
Some companies set EVA targets and rewards are paid if these targets are
reached.
The adjustments to operating profit remove some of the accounting choices
that can be used to manipulate profit, and so EVA provides an incentive to
produce more shareholder value.

11
Question
Y and Z are two divisions of a large company that operate in similar markets. The
divisions are treated as investment centres and every month they each prepare an
operating statement to be submitted to the parent company. Operating statements
for these two divisions for October are shown below:
Operating Statements for October
Y Z
£000 £000
Sales revenue 900 555
Less: variable costs 345 312
Contribution 555 243
Less: controllable fixed costs (directly 95 42
attributable fixed cost )
(includes depreciation on divisional assets)
Controllable income 460 201
Less: apportioned central costs (allocated cost, 338 180
HR, Finance dept. etc. )
Net income before tax 122 21
Total divisional net assets £9·76m £1·26m

12
The company currently has a target return on capital of 12% per annum.
However, the company believes its cost of capital is likely to rise and is
considering increasing the target return on capital. At present the
performance of each division and the divisional management are assessed
primarily on the basis of Return on Investment (ROI).

13
Required:
 Calculate the annualized Return on Investment (ROI) for
divisions Y and Z, and discuss the relative performance of
the two divisions using the ROI data and other information
given above.
 Calculate the annualized Residual Income (RI) for divisions Y
and Z, and explain the implications of this information for
the evaluation of the divisions’ performance.
 Briefly discuss the strengths and weaknesses of ROI and RI
as methods of assessing the performance of divisions.
Explain two further methods of assessment of divisional
performance that could be used in addition to ROI or RI.

14
 ROI Y Z
a.
£m £m
Monthly net income 0·122 0·021
Annualised net income 1·464 0·252
Divisional net assets 9·76 1·26
ROI 15% 20%

The following comments can be made regarding the relative performance

of the two divisions: On pure ROI division Z is performing better than
division Y.
• Division Y is earning a larger absolute amount by more than five times,
and is exceeding the target return on capital, thus Y is increasing the wealth
of the company more than Z, but this is not reflected in the ROI figures.
• The availability of capital and other projects are critical to the
assessment of relative performance. If there is (virtually) unlimited
availability of capital then any division earning more than the target rate of
return is increasing the company’s wealth and both divisions are making a
positive contribution.
•If division Z could repeat its performance by adding similar projects, then it
should be allocated more funds as its rate of return is higher.
15
• If there is a chance that the target rate of return will have to be
raised, then division Y is at greater risk as its actual return is much
closer to the current target.
• Controllable income return on sales is 51% (460 / 900) for division
Y and 36% (201/555) for division Z. This indicates that the operations
of division Y are producing income at a higher rate per £ of sales than
division Z.
• The controllable income return on net assets is 57% for division Y
and 191% for division Z. Thus division Z is earning its income with
much less use of divisional net assets – it could be argued that it is
being more efficient.
• The net income figures are being strongly influenced by the
apportionment of central costs. More needs to be known about the
basis of the apportionment before a more definite evaluation can be
made.

16
b.
RI Y Z
£m £m
Annualised net income 1·464 0·252
Interest charge at 12% of Divisional 1·171 0·151
Net Assets
Residual Income 0·293 0·101

The following points could be made regarding the performance of

the two divisions in the light of the RI calculations:

• If capital is freely available then the higher RI indicates the

division that is contributing most to the company as a whole. Thus
division Y is contributing more. This is the opposite conclusion to
that indicated by ROI.
• The comments above concerning availability of capital and
projects also apply.
• Overall the issue is that Y earns more income, but Z earns its
income at a better rate.

17
c.

Strengths and weaknesses of ROI and RI can include:

• ROI gives a percentage result that is often considered to have
intuitive appeal.
• ROI as a percentage is said to make comparison easier.
• ROI does not require a cost of capital to be specified.
• ROI has significant behavioral consequences that appear to
make optimal decision making less likely.
• Maximizing RI leads to maximizing company wealth in most
cases.

18
• Both ROI and RI can be affected by the age of assets and the
method of asset valuation, resulting in a similar performance by
two companies showing different values for ROI and RI if the assets
are valued on a different basis.
• Different interest rates can be used in the calculation of RI for each
division, to reflect the different risk characteristics of each division.
• Other methods of assessment that could be used alongside either
ROI or RI include:
• Economic Value Added® which is an adaption of RI.
• Balanced scorecards and other non-financial measures of divisional
performance.
• Controllable profit, or other pure profit measures.
• Cash generated.

19
Question
(a) For each division suggest, with reasons, the behavioral
consequences that might arise as a result of the current
policy for the structure and performance evaluation of the
divisions.
(b) The senior management of C plc has requested a review of
the cost-plus transfer pricing policy that is currently used.
Suggest with reasons, an appropriate transfer pricing policy
that could be used for transfers from PD to TD, indicating any
problems that may arise as a consequence of the policy you
suggest.

20
Answer (a)
The senior management of C plc states that the three divisions
should see themselves as independent businesses as far as
possible. However, the primary issue is that they are highly related
and dependent on each other.
The WD sells approximately two-thirds of its output to the PD. Thus
the profits of WD and PD depend crucially on the cost-plus transfer
price.
Further, with only one third of output being sold to external
customers, these internal transfers will significantly affect the ROI
measure that is used to assess performance. This may lead to a
variety of behavioral problems, including:

21
• Attempts to manipulate internal pricing procedures, particularly by
increasing costs;
• Attempts to manipulate internal pricing procedures, particularly by
increasing costs;
• Lack of effort and incentive to control costs;
• Lack of effort in selling to external customers as the
consequences may be small in relation to internal transfers;
• Short-term decisions may be made at the expense of long run
profits.
PD must sell all its output to the TD and buy all its timber from WD.
Thus the problems mentioned for WD apply even more so to PD.
It has little control over its business activities and thus cannot really
be considered an independent business.
22
• The major emphasis for PD should be quality and technical
efficiency. Control through ROI is likely to divert attention away from
this at best, and at worst may conflict with this aim. For example not
replacing machinery because it would worsen ROI.
• PD needs to work very closely with WD and TD and being
structured as a separate profit centre may inhibit this (maybe a cost
centre would be more appropriate?)
TD sells to the final market, and thus its sales revenue is not unduly
affected by the structure of C. Its major costs are determined by
internal transfers, so its ROI is not a good measure of performance,
just as for the other two divisions.

23
Other behavioral consequences include:
• Problems with motivation if the transfer costs from PD mean that
overall profit and ROI is low.
• Frustration if the management of TD believes it could
substantially increase sales and ROI by having a wider product
range.

24
Question
The annual operating statement for a company is shown below:
£000
Sales revenue 800
Less variable costs 390
Contribution 410
Less fixed costs 90
Less depreciation 20
Net income 300

Assets £ 6.75m

The cost of capital is 13% per annum.

25
Solution
The return on investment (ROI) for the company is closest to:

A 4·44%
B 4·74%
C 5·77%
D 6·07%

Solution:
ROI 300,000 / 6,750,000 x 100 = 4·44%

26
The residual income (RI) for the company is closest to:

£000
A (467)
B (487)
C (557)
D (577)

Solution:

RI £300K – 877·5K (13% x £6·75m) = -£577·5K

27
Question

• A company has reported annual operating profits for the year of £89·2m after charging
£9·6m for the full development costs of a new product that is expected to last for the
current year and two further years.
• The cost of capital is 13% per annum. The balance sheet for the company shows fixed
assets with a historical cost of £120m.
• A note to the balance sheet estimates that the replacement cost of these fixed assets at
the beginning of the year is £168m. The assets have been depreciated at 20% per year.
• The company has a working capital of £27·2m.

Ignore the effects of taxation.

The Economic Value Added® (EVA) of the company is closest to:

A £64·16m
B £70·56m
C £83·36m
D £100·96m

28
Solution # 9:
£m
Profit 89.20
Add
Current depreciation (120 x 20%) 24.00
Development costs (9·60 x 2/3) 6.40
Less
Replacement depreciation (168 x 20%) 33.60
Adjusted profit 86.00
Less cost of capital charge (Working 1) 21.84
EVA 64.16
Cost of capital charge (Working 1 )
Fixed assets (168 – 33·6) 134.4
Working capital 27.2
Development costs 6.4
168.0 x 13% = 21.84

29
Question
• (Calculate Weighted Average Cost of Capital for
EVA)
• Golden Gate construction Associates, a real
estate developer and building contractor is San
Francisco, has two sources of long-term capital:
debt and equity.
• The cost to Golden Gate of issuing debt is the
after-tax cost of the interest payments on the
debt, taking into account the fact that the
interest payments are tax deductible.
30
. The cost of Golden Gate’s equity capital is the
investment opportunity rate of Golden Gate’s
investors, that is, the rate they could earn on
investments of similar risk to that of investing
in Golden Gate Construction Associates.

31
The interest rate on Golden Gate’s $60 million of long-term debt is 10 percent, and the
company’s tax rate is 40 percent. The cost of Golden Gate’s equity capital is 15
percent. Moreover, the market value (and book value) of Golden Gate’s equity is $90
million.

Required: Calculate Golden Gate Construction Associates’ weighted-average cost of

capital.

Refer to the data in the preceding exercise for Golden Gate, Construction
Associates. The company has two divisions: the real estate division and construction
division. The division’s total assets, current liabilities, and before-tax operating income
for the most recent year are as follows:
Division Total Assets Current Liabilites Before Tax Operating Income
Real Estate $100,000,000 $6,000,000 $20,000,000
Construction 60,000,000 4,000,000 18,000,000

Required: Calculate the Economic value added (EVA) for each Golden Gate
Construction Associates’ divisions. (You will need to use the weighted-average cost of
capital, which was computed in the preceding exercise.)

32
 ((60*(10%(1 - 0.4)) + 90*15%) /
WACC = (60+90))*100

WACC = 11.40%

OR

Weight Cost WACC

Debt 60 40% 6% 2.40%

Equity 90 60% 15% 9.00%

150 11.40%
33
 Before-tax
Current Operating
Division Total Assets Liabilities Income

($)
Real
estate………
………………
…………. 100,000,000 6,000,000 20,000,000
Construction
………………
……………….
. 60,000,000 4,000,000 18,000,00034