Question

The camp’s weighted-average cost of capital is 9%, and Isabelle requires that all new investments generate a return on investment of at least 14%. The camp’s current tax rate is 25%. At last week’s advisory board meeting, Isabelle told the board that she had up to $50,000 to invest in new facilities at the camp and asked them to recommend some projects. Today the board’s president presented Isabelle with the following list of three potential investments to improve the camp facilities. Playground Swimming PoolGymIncremental operating income $3,500$ 4,800 2,700Average total assets 25,000 40,000 15,000 Required(a) Calculate the return on investment, residual income, and economic value added for each of the three projects.(b) Which of the three projects do you recommend Isabelle undertake? Why?

Answer 1

Answer and Explanation:

(a)

Playground

ROI 3500/25,000 = 14%

Residual 3500 – (.14x25,000)

Income = $0

EVA (1-0.25)x3500 – 0.09(25,000)

=0.75×3500-2250

=2625-2250

= $375

Pool

ROI 4800/40,000 = 12%

Residual 4800 – (0.14x40,000)

Income =-800

EVA (1-0.25)x4800 – 0.09(40,000)

=0.75×4800-3600

=3600-3600

=$ 0

Gym

ROI 2700/15,000= 18%

Residual 2700 - (0.14x15000)

Income = $600

EVA(1-0.25)x2700 – 0.09(15,000)

=0.75×2700-1350

=2025-1350

=$675

(b)

Isabelle should undertake the GYM, because it brings in the most highest profit.