Question

Lucy Manufacturing makes fashion products and competes on the basis of quality and​ leading-edge designs. The company has two​ divisions, clothing and cosmetics. Lucy has $8,000,000 invested in assets in its clothing division.​ After-tax operating income from sales of clothing this year is $1,600,000. The cosmetics division has $4,800.000 invested in assets and an​ after-tax operating income this year of $1,200,000. The​ weighted-average cost of capital For Lucy is 9​%. The CEO of Lucy has told the manager of each division that the division that​ "performs best" this year will get a bonus.

1. Calculate the ROI and residual income for each division of Lucy Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each measure?
2. The CEO of Lucy Manufacturing has recently heard of another measure similar to the residual income called EVA. The CEO has the accountant calculate the EVA-adjusted incomes of clothing and cosmetics and finds that the adjusted after-tax operating incomes are $938,000 and $1,147,200, respectively. Also, the clothing division has $520,000 of current liabilities, while the cosmetics division has only $330,000 of current liabilities. Using the preceding information, calculate EVA and discuss which division manager will get the bonus.
3. What non-financial measures could Lucy use to evaluate divisional performances?

Answer 1

1. ROI clothing is 20%

ROI cosmetics is 25%

Residual income clothing is $880,000

Residual income cosmetics is $768,000

2. EVA clothing is $264,800

EVA cosmetics is $744,900

3. The non-financial measures could Lucy use to evaluate divisional performances is involve the manager in the quest for higher shareholder's value

Step-by-step explanation:

1. In order to calculate the ROI we would have to use the following formula:

ROI clothing=(After-tax operating income from sales/invested assets)*100

ROI clothing=($1,600,000/$8,000,000)*100

ROI clothing=20%

ROI cosmetics=($1,200,000/$4,800.000)*100

ROI cosmetics=25%

To calculate the Residual income we would have to use the following formula:

Residual income= Income-(Required rate of return*Investment)

Residual income clothing=$1,600,000-(9%*$8,000,000)

Residual income clothing=$880,000

Residual income cosmetics=$1,200,000-(9%*$4,800.000)

Residual income cosmetics=$768,000

2. To calculate the EVA we would have to use the following formula:

EVA=After-tax operating income-weighted-average cost of capital*(Total Assets-current liabilities)

EVA clothing=$938,000-9%*($8,000,000-$520,000)

EVA clothing=$264,800

EVA cosmetics=$1,147,200-9%*($4,800.000-$330,000)

EVA cosmetics=$744,900

3. The non-financial measures could Lucy use to evaluate divisional performances is involve the manager in the quest for higher shareholder's value