Answer:
New Car Division Parts Division
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%
1)
return on investment = profit / investment
$2,475/$33,000 $2,565/$28,500
= 7.5% = 9%
2)
residual income = operating income - [rrr x (total assets - current liabilities)]
2,475 - (12% x 26,400) 2,565 - (12% x 20,100)
= -$693,000 = $153,000
3) alternative 1
residual income = operating income - [rrr x (total assets + current liabilities)]
2,475 - (12% x 39,600) 2,565 - (12% x 36,900)
= -$2,277,000 = -$1,863,000
alternative 2
residual income = operating income - (rrr x total assets)
2,475 - (12% x 33,000) 2,565 - (12% x 28,500)
= -$1,485,000 = -$855,000
No matter which alternative RI you want to use, the parts division's RI is always better, not necessarily good, but better than the new cars division's.
4) economic value added (EVA) = net profit after taxes - (WACC x invested capital)
WACC = (12/30 x 15%) + (18/30 x 10% x (1 - 40%) = 6% + 3.6% = 9.6%
2,475 - (9.6% x 33,000) 2,565 - (9.6% x 28,500)
= -$693,000 = -$171,000
5) No division performs well, but one performs a little bit better or less worse than the other one. The parts division is less inefficient than the new cars division, but it doesn't mean that it is generating enough profit or performing correctly. It means that the new cars division simply performs worse with a ROI of 7.5% when the WACC is 9.6%.
