Question

Performance Auto Company operates a new car division (that sells high-performance sports cars) and a performance parts division (that sells performance-improvement parts for family cars). The financial measures for some divisions for 2014 are as follows: New Car Performance Division Parts Division Total assets $33,000,000 S28,500,000 Current liabilities S 6,600,000 S8,400,000 Operating income 2,475,000 2,565,000 Required rate of return 12% 12%1. Calculate the return on investment (ROI) for each division, using the operating income as a measure of income and total assets as a measure of investment.2. Calculate the residual income (RI) for each division, using operating income as a measure of income and total assets minus current liabilities as a measure of investment.3. William Abraham, the new car division manager, argues that the performance parts division has "loaded up on a lot of short-term debt" to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken by the performance parts division. Comment on the result.4. Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a market value of $18,000,000 at an interest rate of 10% and equity capital with a market value of $12,000,000 and a cost of equity of 15%. Applying the same weighted-average cost of capital (WACC) for each division, calculate EVA for each division.5. Use your preceding calculations to comment on the relative performance of each division.

Answer 1

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%.