23-16 (30 min.) ROI, comparisons of three companies.
1.
The separate components highlight several features of return on investment not revealed
by a single calculation:
a. The importance of investment turnover as a key to income is stressed.
b. The importance of revenues is explicitly recognized.
c. The important components are expressed as ratios or percentages instead of dollar
figures. This form of expression often enhances comparability of different divisions,
businesses, and time periods.
d. The breakdown stresses the possibility of trading off investment turnover for income
as a percentage of revenues so as to increase the average ROI at a given level of
output.
2.
(Filled-in blanks are in bold face.)
Revenue
Income
Investment
Income as a % of revenue
Investment turnover
Return on investment
Companies in Same Industry
A
B
C
$1,000,000
$ 500,000
$10,000,000
$ 100,000
$ 50,000
$
50,000
$ 500,000
$ 5,000,000
$5,000,000
0.5%
10%
10%
2.0
2.0
0.1
1%
20%
1%
Income and investment alone shed little light on comparative performances because of
disparities in size between Company A and the other two companies. Thus, it is impossible to
say whether B's low return on investment in comparison with A’s is attributable to its larger
investment or to its lower income. Furthermore, the fact that Companies B and C have identical
income and investment may suggest that the same conditions underlie the low ROI, but this
conclusion is erroneous. B has higher margins but a lower investment turnover. C has very small
margins (1/20th of B) but turns over investment 20 times faster.
I.M.A. Report o. 35 (page 35) states:
“Introducing revenues to measure level of operations helps to disclose specific areas for
more intensive investigation. Company B does as well as Company A in terms of income
margin, for both companies earn 10% on revenues. But Company B has a much lower turnover
of investment than does Company A. Whereas a dollar of investment in Company A supports
two dollars in revenues each period, a dollar investment in Company B supports only ten cents in
revenues each period. This suggests that the analyst should look carefully at Company B’s
investment. Is the company keeping an inventory larger than necessary for its revenue level?
Are receivables being collected promptly? Or did Company A acquire its fixed assets at a price
level that was much lower than that at which Company B purchased its plant?”
“On the other hand, C’s investment turnover is as high as A’s, but C’s income as a
percentage of revenue is much lower. Why? Are its operations inefficient, are its material costs
too high, or does its location entail high transportation costs?”
“Analysis of ROI raises questions such as the foregoing. When answers are obtained, basic
reasons for differences between rates of return may be discovered. For example, in Company B’s
case, it is apparent that the emphasis will have to be on increasing turnover by reducing
investment or increasing revenues. Clearly, B cannot appreciably increase its ROI simply by
increasing its income as a percent of revenue. In contrast, Company C’s management should
concentrate on increasing the percent of income on revenue.”
23-1
23-19 (30 min.) Pricing, ROI, performance evaluation.
1.
ROI
=
20%
=
Operating income
Investment
Operating income
$80,000,000
$16,000,000
Operating income
=
Target revenues:
Fixed costs
Variable costs, 100,000 × $1,600
Desired operating income
Revenues
$ 24,000,000
160,000,000
16,000,000
$200,000,000
The selling price per unit to achieve ROI of 20% is $200,000,000 ÷ 100,000 units = $2,000.
2.
ROI at Various Sales Volumes over 3 Years
150,000
50,000
Volume (units)
100,000
Revenues, $2,000 per unit
$200*
$300*
$100*
Variable costs, $1,600 per unit
160
240
80
Fixed costs
24
24
24
Total costs
184
264
104
$ 36
$(4)
Operating income
$ 16
Return on investment
$16; $36; $(4) ÷ 80
20%
45%
– 5%
*All revenues, costs, and operating income are in millions of dollars.
A summary analysis of these three cases follows:
Volume
100,000
150,000
50,000
Operating Income
Revenues
8% ($16 ÷ $200)
12% ($36 ÷ $300)
–4% ($(4) ÷ $100)
×
×
×
×
Revenues
Total Assets
2.50 ($200 ÷ $80)
3.75 ($300 ÷ $80)
1.25 ($100 ÷ $80)
Return on Investment
20%
45%
–5%
3.
Lauren Snyder may feel that the measure is unfair since the ROI is very sensitive to volume
and selling price. If she has no control on the selling price, and therefore on the demand for Hardy
motorcycles, she may feel that she is being measured on a factor that is not controllable by her. It is
also unclear how much she can control costs in the short run. It would be better to measure her
division's performance on ROI relative to competitors, if possible. Also, one year may be too short
a time span in the use of an operating income measure for gauging performance or for paying
bonuses. For instance, motorcycle sales may be heavily influenced by general economic conditions
that are uncontrollable by the division managers whose bonuses are significantly affected thereby.
Further, some short-run savings in manufacturing costs, which may temporarily boost ROI and
bonuses, may have long-run damaging effects. Examples include repairs, maintenance, quality
control, and exerting severe pressures on employees for productivity.
23-2
23-21
(15 min.) ROI, RI, EVA®.
Requirements 1 and 2 are answered together:
Atlantic Division
Total assets
Operating income
Return on investment
Pacific Division
$1,000,000
$5,000,000
$ 200,000
$ 750,000
$200,000 ÷ $1,000,000 = 20% $750,000 ÷ $5,000,000 = 15%
Residual income at 12%
required rate of return*
$80,000
$150,000
*$200,000 – (0.12 × $1,000,000) = $80,000; $750,000 – (0.12 × $5,000,000) = $150,000
The tabulation shows that, while the Atlantic Division earns the higher return on investment, the
Pacific Division earns the higher residual income at the 12% required rate of return.
3.
After-tax cost of debt financing = (1 – 0.4) × 10% = 6%
After-tax cost of equity financing = 14%
The weighted-average cost of capital (WACC) is given by
WACC =
(0.06 × $3,500,000) + (0.14 × $3,500,00)
$3,500,000 + $3,500,000
=
$210,000 + $490,000
$7,000,000
=
$700, 000
= 0.10 or 10%
$7, 000, 000
Economic value added (EVA) calculations are as follows:
After-Tax
Operating
Income
–
WeightedAverage Cost of
Capital
Atlantic
$200,000 × 0.6
–
[10%
×
($1,000,000 – $250,000)]
Pacific
$750,000 × 0.6
–
[10%
×
($5,000,000 – $1,500,000)]
Division
×
Economic
= Value Added
(EVA)
Total Assets Minus
Current Liabilities
= $120,000 – $75,000
=
$ 45,000
= $450,000 – $350,000 =
$100,000
Potomac should use the EVA measure for evaluating the economic performance of its
divisions for two reasons: (a) It is a residual income measure and, so, does not have the
dysfunctional effects of ROI-based measures. That is, if EVA is used as a performance
evaluation measure, divisions would have incentives to make investments whenever after-tax
operating income exceeds the weighted-average cost of capital employed. These are the correct
incentives to maximize firm value. ROI-based performance evaluation measures encourage
managers to invest only when the ROI on new investments exceeds the existing ROI. That is,
managers would reject projects whose ROI exceeds the weighted average cost of capital but is
less than the current ROI of the division; using ROI as a performance evaluation measure creates
incentives for managers to reject projects that increase the value of the firm simply because they
may reduce the overall ROI of the division; (b) EVA calculations incorporate tax effects that are
costs to the firm while the simple RI measure calculated in requirement 2 does not. EVA
therefore provides an after-tax comprehensive summary of the effects of various decisions on the
company and its shareholders.
23-3
23-22 (25 min.) ROI, RI, EVA®.
1.
The required division ROIs using total assets as a measure of investment is shown in the
row labeled (1) in Solution Exhibit 23-22.
SOLUTIO: EXHIBIT 23-22
(1)
(2)
(3)
Total assets
Current liabilities
Operating income
Required rate of return
Total assets – current liabilities
ROI (based on total assets) ($825,000 ÷ $11,000,000;
$855,000 ÷ $9,500,000)
RI (based on total assets – current liabilities)
($825,000 – (12% × $8,800,000); $855,000 – (12%
× $6,700,000))
RI (based on total assets) ($825,000 – (12%
× $11,000,000); $855,000 – (12% × $9,500,000))
Truck Rental
Division
$11,000,000
$2,200,000
$825,000
12%
$8,800,000
Transportation
Division
$9,500,000
$2,800,000
$855,000
12%
$6,700,000
7.5%
9.0%
($231,000)
$51,000
($495,000)
($285,000)
2.
The required division RIs using total assets minus current liabilities as a measure of
investment is shown in the row labeled (2) in the table above.
3.
The row labeled (3) in the table above shows division RIs using assets as a measure of
investment. Even with this new measure that is insensitive to the level of short-term debt, the
truck rental division has a relatively worse RI than the transportation division. Both RIs are
negative, indicating that the divisions are not earning the 12% required rate of return on their
assets.
4.
After-tax cost of debt financing = (1– 0.4) × 10% = 6%
After-tax cost of equity financing = 15%
($9,000,000 × 6%) + ($6,000,000 × 15%)
Weighted average
=
= 9.6%
cost of capital
$9,000,000 + $6,000,000
Operating income after tax
0.6 × operating income before tax
(0.6 × $825,000; 0.6 × $855,000)
Required return for EVA
9.6% × Investment
(9.6% × $8,800,000; 9.6% × $6,700,000)
EVA (Optg. inc. after tax – reqd. return)
$ 495,000
$ 513,000
844,800
$(349,800)
643,200
$(130,200)
5.
Both the residual income and the EVA calculations indicate that the Transportation
Division is performing nominally better than the Truck Rental Division. The Transportation
Division has a higher residual income. The negative EVA for both divisions indicates that, on an
after-tax basis, the divisions are destroying value––the after-tax economic returns from them are
less than the required returns.
23-4
23-23 (20–30 min.) ROI, RI, measurement of assets.
The method for computing profitability preferred by each manager follows:
Manager of
Bristol
Darden
Gregory
Method Chosen
RI based on net book value
RI based on gross book value
ROI based on either gross or net book value
Supporting Calculations:
ROI Calculations
Division
Bristol
Darden
Gregory
Operating Income
Gross Book Value
$94,700 ÷ $800,000 = 11.84% (3)
$91,700 ÷ $760,000 = 12.07% (2)
$61,400 ÷ $500,000 = 12.28% (1)
Operating Income
:et Book Value *
$94,700 ÷ $370,000 = 25.59% (3)
$91,700 ÷ $350,000 = 26.20% (2)
$61,400 ÷ $220,000 = 27.91% (1)
RI Calculations
Division
Bristol
Darden
Gregory
Operating Income – 10% Gross BV
$94,700 – $80,000 = $14,700 (2)
$91,700 – $76,000 = $15,700 (1)
$61,400 – $50,000 = $11,400 (3)
Operating Income – 10% :et BV*
$94,700 – $37,000 = $57,700 (1)
$91,700 – $35,000 = $56,700 (2)
$61,400 – $22,000 = $39,400 (3)
*Net book value is gross book value minus accumulated depreciation.
The biggest weakness of ROI is the tendency to reject projects that will lower historical ROI
even though the prospective ROI exceeds the required ROI. RI achieves goal congruence
because subunits will make investments as long as they earn a rate in excess of the required
return for investments. The biggest weakness of RI is that it favors larger divisions in ranking
performance. The greater the amount of the investment (the size of the division), the more likely
that larger divisions will be favored assuming that income grows proportionately. The strength of
ROI is that it is a ratio and so does not favor larger divisions. In general, though, achieving goal
congruence is very important. Therefore, the RI measure is often preferred to ROI.
23-5
23-24 (20 min.) Multinational performance measurement, ROI, RI.
1a.
U.S. Division's ROI in 2006 =
Operating income
Operating income
=
= 15%
Total assets
$8,000,000
Hence, operating income = 15% × $8,000,000 = $1,200,000.
1b.
Swedish Division's ROI in 2006 (based on kronas) =
8,100,000 kronas
= 15.43%
52,500,000 kronas
2.
Convert total assets into dollars using the December 31, 2005 exchange rate, the rate
prevailing when the assets were acquired (7 kronas = $1):
52,500,000 kronas
7 kronas per dollar
= $7,500,000
Convert operating income into dollars at the average exchange rate prevailing during
2006 when operating income was earned (7.5 kronas = $1):
8,100,000 kronas
= $1,080,000
7.5 kronas per dollar
$1,080,000
Comparable ROI for Swedish Division =
= 14.4%
$7,500,000
The Swedish Division’s ROI based on kronas is helped by the inflation that occurs in Sweden in
2006 (that caused the Swedish krona to weaken against the dollar from 7 kronas = $1 on 12-312005 to 8 kronas = $1 on 12-31-2006). Inflation boosts the division's operating income. Since the
assets are acquired at the start of the year 2006, the asset values are not increased by the inflation
that occurs during the year. The net effect of inflation on ROI calculated in kronas is to use an
inflated value for the numerator relative to the denominator. Adjusting for inflationary and
currency differences negates the effects of any differences in inflation rates between the two
countries on the calculation of ROI. After these adjustments, the U.S. Division earned a higher
ROI than the Swedish Division.
3.
U.S. Division’s RI in 2006 = $1,200,000 − (12% × $8,000,000)
= $1,200,000 − $960,000 = $240,000
Swedish Division’s RI in 2006 (in U.S. dollars) is calculated as:
$1,080,000 − (12% × $7,500,000) = $1,080,000 − $900,000 = $180,000.
The U.S. Division’s RI also exceeds the Swedish Division’s RI in 2006 by $60,000 ($240,000 −
$180,000).
23-6