Question

ABC Broadcasting Company is comprised of two divisions: Music and News. A summary of expected operations in 2019 for each division and the total corporation follows:
Music News Total
Sales $ 800,000 $1,200,000 $2,000,000
Expenses $ 700,000 $ 900,000 $1,600,000
Total assets $1,000,000 $ 2,000,000 $3,000,000

A new project has just been identified that could be purchased and put in place by 2020. The required investment in assets is $500,000 and it would generate net income of $70,000 in 2020. This project is an investment that is available to managers of either the Music or News Division. The company has a target rate return of 12%.

Who would be in favor of investing in the new project assuming that the divisions are organized as investment centers and their performance is evaluated on the basis of residual income?

Music Manager News Manager

Group of answer choices

A. no yes

B. yes yes

C. yes no

D. no no

Answer 1

Answer:

A. no yes

The New Manager will be in favor of the new project.  Her division's residual income increased from $60,000 to $70,000 using EVA.

EVA is economic value added.  It compares the cost of capital with the operating profit to determine the residual income generated.

In the explanation, the ROI was also calculated to determine the division's respective performances before and after the new project.  But, the ROI is not relevant for this case.

Explanation:

We shall calculate the Return on Investment (ROI) and the Economic Value Added (EVA) for the two divisions:

Music's Division:

ROI before new project = $100,000/1,000,000 x 100 = 10%

ROI after new project = $170,000/1,500,00 x 100 = 11%

EVA before new project = $100,000 - 1,000,000 x 12% = ($20,000)

EVA after new project = $170,000 - 1,500,000 x 12% = ($10,000)

News Division:

ROI before new project = $300,000/2,000,000 x 100 = 15%

ROI after new project = $370,000/2,500,00 x 100 = 14%

EVA before new project = $300,000 - 2,000,000 x 12% = $60,000

EVA after new project = $370,000 - 2,500,000 x 12% = $70,000