EXERCISE 12-2 (15 Minutes)

EXERCISE 12-2 (15 minutes)
1. ROI computations:
Net Operating Income Sales
ROI = x
Sales Average Operating Assets
K Division:
$150,000 $2,500,000
ROI = x = 15.00%
$2,500,000 $1,000,000
L Division:
$250,000 $3,000,000
ROI = x = 25.00%
$3,000,000 $1,000,000
2. K Division’s profit ratio to sales and asset turnover are both

lower, producing a lower ROI of 15%, compared to 25% for L
Division. K Division should increase sales and improve its
profitability.
1.
Division
K L M
Sales $4,800,000 $5,000,000 $5,000,000
Operating income 240,000 450,000 250,000
Operating assets (average) 600,000 4,500,000 2,500,000
Margin 5% 9% 5%
Turnover 8 1.11 2
Return on investment (ROI) 40% 10% 10%
2. Both K Division and M Division show the same margin ratio of 5%,
but the total ROI (40%) of K Division is much higher than M Division’s
10%. Choose K Division.
3. Both L Division and M Division show the same ROI of 10%,

despite L Division’s higher operating income of $450,000 versus M
Division’s $250,000. Assuming that the sales of both divisions are the
same $5,000,000, M Division could achieve the same ROI with a higher
asset turnover, because M Division’s margin would be lower.
1. ROI computations:

ROI = x
Division K:
$120,000 $2,000,000
ROI = x = 15.00%
$2,000,000 $800,000
Division L:
$560,000 $8,000,000
ROI = x = 18.69%
$8,00,000 $3,000,000
2. Residual income computations:
Division K Division
L
Average operating assets (a) $800,000 $3,000,000
Net operating income 120,000 560,000
Minimum required return on average
operating assets 18% X (a) 144,000 540,000
Residual income $(24,000) $20,000
3. Only Division L met the minimum required rate of return of 18%,

because it shows a positive residual income.
1. ROI Computations:

ROI = x
Company P:
$200,000 $5,000,000
ROI = x = 10.00%
$5,000,000 $2,000,000
Company Q:
$240,000 $4,000,000
ROI = x = 20.00%
$4,000,000 $1,200,000
Company R:
$30,000 $8,000,000
ROI = x = 15.00%
$8,000,000 $2,000,000
EXERCISE 12-6 (Continued)
2.
Co. P Co. Q Co. R
Average operating assets $2,000,000 $1,200,000 $2,000,000
x Required rate of return 11% 14% 15%
Required operating income 220,000 168,000 300,000
Actual operating income 200,000 240,000 300,000
Required operating income 220,000 168,000 300,000
Residual income $(20,000) $72,000 $0
3. Yes, Company P would be able to meet the minimum required

rate of return if the operating income were $300,000. From (2), we
know that any amount over $220,000 would produce a positive residual
income.
1. Weighted-average cost of capital:
(a) (b) (c) (d) (e=c-d) (f=bxe)

Cost 30% Tax Cost Rate Weighted
Amount Weight Rate Break After Tax Cost Rate
Bonds $200,000 33.33% 6.00% 1.80% 4.20% 1.400%
Stocks 400,000 66.67% 11.00% 11.00% 7.333%
$600,000 100.00% 8.733%
Actual cost of capital: Weighted-average capital cost % x Total capital used

= 8.733% x $600,000 = $52,400
2. EVA Computation:
Operating income after tax .......................................... $130,000

Actual cost of capital .................................................... (52,400)
EVA ...................................................................… $ 77,600
PROBLEM 12-17 (25 minutes)
1. Computation of ROI:
$300,000
For Co. A: = 20%
$1,500,000
$270,000
For Co. B: = 9%
$3,000,000
$1,080,000
For Co. C: = 18%
$6,000,000
2. Residual income:
For Co. A: $ 300,000 - ($1,500,000 x 0.15) = $75,000
For Co. B: $ 270,000 - ($3,000,000 x 0.12) = $(90,000)
For Co. C: $1,080,000 - ($6,000,000 x 0.18) = 0
3. Co. A Co. B Co. C

a. ROI 20% 9% 18%
16%-return project reject accept reject

b. Minimum required return
for computing residual income 15% 12% 18%
16%-return project accept accept reject

PROBLEM 12-17 (Continued)
If performance is measured by ROI, both companies A and C

probably would reject the 16% investment opportunity, because these
companies are presently earning a higher return (20% and 18%). The
new investment would reduce the overall rate of return and divisional
managers would not favor the project. Company B probably would accept
the project since its acceptance would increase the company's overall
rate of return.
If performance is measured by residual income, both companies A

and B would accept the 16% investment opportunity, since it is greater
than 15% and 12% of minimum required return. Company C would reject
the opportunity, since the 16% is less than its 18% required return.
PROBLEM 12-20 (25 minutes)
1. Weighted-average capital cost (%):
(a) (b) (c) (d) ( e = c - d) (f = b x e)

Cost 30% Tax Cost Rate Weighted
Amount Weight Rate Break After Tax Cost Rate
Bonds $400,000 50.00% 6.00% 1.80% 4.20% 2.1%
Stocks 400,000 50.00% 11.00% 11.00% 5.5%
$800,000 100.00% 7.6%
Now, actual cost of capital is:
Weighted-average capital cost (%) x Total capital used

= 7.6% x $800,000 = $60,800
2. We can compute EVA as follows:
Operating income after tax ..................................... $ 270,000

Actual cost of capital .............................................. (60,800)
EVA ..................................................................…. $ 209,200

EXERCISE 12-2 (15 Minutes)

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EXERCISE 12-2 (15 minutes)

2. K Division’s profit ratio to sales and asset turnover are both

3. Both L Division and M Division show the same ROI of 10%,

Net Operating Income Sales

2. Residual income computations:

3. Only Division L met the minimum required rate of return of 18%,

EXERCISE 12-6 (20 minutes)

Net Operating Income Sales

3. Yes, Company P would be able to meet the minimum required

1. Weighted-average cost of capital:

(a) (b) (c) (d) (e=c-d) (f=bxe)

Actual cost of capital: Weighted-average capital cost % x Total capital used

Operating income after tax .......................................... $130,000

3. Co. A Co. B Co. C

16%-return project reject accept reject

16%-return project accept accept reject

If performance is measured by ROI, both companies A and C

If performance is measured by residual income, both companies A

1. Weighted-average capital cost (%):

(a) (b) (c) (d) ( e = c - d) (f = b x e)

Now, actual cost of capital is:

Weighted-average capital cost (%) x Total capital used

2. We can compute EVA as follows:

Operating income after tax ..................................... $ 270,000

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