ACCT 210 1st Edition Lecture 12 Outline of Last Lecture I Review of in class activity II Chapter 10 1 Centralized versus decentralized organizations III Chapter 10 2 Segment evaluation Outline of Current Lecture I 10 2 continued II 10 3 Return on investment III 10 4 Residual income and EVA Current Lecture 1 10 2 continued a Segment margin Revenue variable costs traceable fixed costs Segment margin operating income of that division b Segment margin income statement format Division 1 Division 2 Total Revenue Variable costs Contribution margin Traceable fixed costs Segment margin Common fixed costs Net operating income 2 10 3 Return on investment a Return on investment ROI Operating income average total assets i Expressed as a percent b Exercise 10 8 i Paula Boothe president of the Armange Corporation has mandated a minimum 11 return on investment for any project undertaken by the company Given the company s decentralization Paula leaves all investment decisions to the divisional managers as long as they anticipate a minimum rate of return of at least 11 The Energy Drinks division under the direction of manager Martin Koch has achieved a 16 return on investment for the past three years This year is not expected to be different from the past three Koch has just received a proposal to invest 1 800 000 in a new line of energy drinks that is expected to generate 228 600 in operating income Calculate the return on investment expected on the new line of energy drinks ii ROI 228 600 1 800 000 12 7 c Exercise 10 7b i Browning Design Works generated 340 000 in operating income on sales revenue of 2 000 000 The company had 2 093 280 in assets on January 1 and 2 890 720 in assets on December 31 Calculate Browning s return on investment 2 093 280 2 890 720 ii ROI 340 000 2 340 000 ROI 2 492 000 ROI 13 6 d Dupont Model i Breaks down ROI giving you relevant information ii ROI Margin x Turnover Operating income iii Margin Salesrevenue Salesrevenue iv Turnover Average total assets e Exercise 10 9 i Resilon Inc reported the following results for last year Net operating income Sales revenue Average operating assets Liles Division Marston Division Outland Division 114 000 48 000 264 000 600 000 150 000 1 200 000 1 023 000 300 000 1 517 000 Which division generates the highest margin ii Liles margin 114 000 600 000 19 Marston 48 000 150 000 32 Outland 264 000 1 200 000 22 Marston generated the highest margin 3 10 4 Residual income and EVA a Residual income i Income earned above a minimum level of return ii Residual income Operating income average assets x require minimum rate of return b Exercise 10 14 i Colleen Barry is the general manager of Whitten Industries Industrial Products division The division is treated as an investment center and Colleen s performance is measured using residual income In preparing the forecast for next year Colleen assumes the division will generate 30 130 000 in revenue using average operating assets of 19 172 000 The required minimum rate of return is 16 If Colleen wants the division to achieve 1 980 700 in residual income what is the maximum amount of operating expenses the division can incur to achieve that target ii Residual income OI avg assets x required minimum rate Residual income Revenue expenses avg assets x req rate 1 980 700 30 130 000 x 19 172 000 x 16 1 980 700 30 130 000 x 3 067 520 1 980 700 27 062 480 x x 27 062 480 1 980 700 Maximum operating expenses 25 081 780 c Economic value added EVA i Variation of residul income that measures economic profict ii EVA Net operating profit invested capital x WACC iii Net operating income Operating income income taxes iv Invested capital Total assets current liabilities d Exercise 10 15 i Lewiston Industries finances its operations with 50 000 000 in debt and 100 000 000 in stockholders equity The debt carries a 8 interest rate and stockholders require a 14 return What is Lewiston s weighted average cost of capital 50 000 000 ii Debt x 8 2 67 50 000 000 100 000 000 100 000 000 Equity x 14 9 33 50 000 000 100 000 000 WACC 2 67 9 33 WACC 12 e Exercise 10 16 i Paula Boothe president of the Armange Corporation has mandated a minimum 10 return on investment for any project undertaken by the company Given the company s decentralization Paula leaves all investment decisions to the divisional managers as long as they anticipate a minimum rate of return of at least 10 The Energy Drinks division under the direction of manager Martin Koch has achieved a 16 return on investment for the past three years This year is not expected to be different from the past three Koch has just received a proposal to invest 1 844 000 in a new line of energy drinks that is expected to generate 237 900 in operating income Assume that Armange Corporation s actual weighted average cost of capital is 8 and its tax rate is 32 Calculate the economic value added of the proposed new line of energy drinks ii Net operating income 237 900 0 64 152 064 WACC 8 Invested capital 1 844 000 EVA Net operating income invested capital x WACC EVA 152 064 1 844 000 x 8 EVA 152 064 147 520 EVA 4 544