Answer:
Solomons Company
North and South Divisions
North/South Divisions:
Operating Profit = $6,000,000/$40,000,000
Investment = $30,000,000/$320,000,000
Cost of Capital (WACC) = 8%
a-1) ROI for both North and South Divisions:
ROI = Return on Investment
= Operating Profit/Investment x 100
North's ROI = 6/30 x 100 = 20%
South's ROI = 40/320 x 100 = 12%
a-2) If Solomons measures performance using ROI, the North division had the better performance.
b-1) Calculation of EVA for both North and South divisions:
EVA = Economic Value Added.
EVA = Net Operating Profit After Taxes minus (Invested Capital x WACC)
North's EVA = $6,000,000 - ($30,000,000 x 8%) =6m - 2.4m = $3,600,000
South's EVA = $40,000,000 - ($320,000,000 x 8%) = 40m - 25.6m = $14,400,000
b-2) If Solomons measures performance using economic value added, the South division had the better performance.
c) 1. When ROI is evaluated using 16% cost of capital, the North division had a better performance. So the evaluation changes based on the 16% cost of capital. Whereas, North makes 20% ROI as against 16% cost of capital, the South manages 12% ROI as against 16% cost of capital.
c) 2. When performances are evaluated by EVA with 16% cost of capital:
North's EVA = $6,000,000 - ($30,000,000 x 16%) = 6m - 4.8m = $1,200,000
South's EVA = $40,000,000 - ($320,000,000 x 16%) = $40m - $51.2m = ($11,200,000)
When evaluated by EVA using 16% cost of capital, my evaluation would favour the North instead of the South.
Step-by-step explanation:
ROI or Return on Investment is a financial performance measure which measures the profitability of an investment in a simple way. It compares the return on an investment relative to its cost. It is expressed as a percentage.
EVA or Economic Value Added is also a financial performance measure which subtracts the cost of capital from the operating profit in order to gauge in dollars terms the value created by the firm.