Complete the following activities from the Financial & Managerial Accounting textbook:
E25.4
Sapsora Company uses ROI to measure the performance of its operating divisions and to reward
division managers. A summary of the annual reports from two divisions is shown below. The company-
weighted-average cost of capital is 12 percent.
Division A Division B
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000,000 $8,750,000
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 1,750,000
After-tax operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,180,000
ROI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25% 14%
a. Which division is more profitable?
b. Would EVA more clearly show the relative contribution of the two divisions to the company as
a whole? Show the computations.
c. Suppose the manager of Division A was offered a one-year project that would increase his
investment base by $250,000 and show a profit of $37,500. Would the manager choose to
invest in the new project?
E25.5
An investment center in Shellforth Corporation was asked to identify three proposals for its capital budget. Details of those proposals are
Capital Budget Proposals
A B C
Capital required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $50,000 $150,000
Annual operating return . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 16,000 15,000
Shellforth uses residual income to evaluate all capital budgeting projects. Its minimum required
return is 12 percent.
a. Assume you are the investment center manager. Which project do you prefer? Why?
b. Assume your investment center- current ROI is 18 percent and that the president of Shellforth
is thinking about using ROI for the investment center- evaluation. Would your preferences for
the projects listed above change? Why?
E25.6
Jennifer Baskiter is president and CEO of Plants& More.com , an Internet company that sells plants
and flowers. The success of her startup Internet company has motivated her to expand and create
two divisions. One division focuses on sales to the general public and the other focuses on
business-to-business sales to hotels, restaurants, and other firms that want plants and flowers for
their businesses. She is considering using return on investment as a means of evaluating her divisions
and their managers. She has hired you as a compensation consultant. What issues or concerns
would you raise regarding the use of ROI for evaluating the divisions and their managers?
E25.7
You are the manager of the Midwest Region, a 27-restaurant division that is part of the chain “Bites
and Bits.†The restaurants offer casual dining and compete with such chains in your region as
Olive Garden and Outback Steakhouse . You receive an annual cash bonus of 5 percent of sales
when residual income in your region exceeds the required minimum return on invested capital of
15 percent. You are using a similar performance evaluation plan to reward each of the managers in
your 27 restaurants.
You are concerned that important performance variables are being overlooked. For example,
you have heard complaints from other regions and in your own region that the quality of the food is
bad, it is difficult to retain serving staff in the restaurants, and finding a good chef is very difficult.
At an upcoming planning meeting for all regional directors, the agenda includes considering the
business performance evaluation and compensation plan. What could you say about the current
compensation plan and what would you propose to remedy the problems?
• E26.8
Pack & Carry is debating whether to invest in new equipment to manufacture a line of high-quality
luggage. The new equipment would cost $1,728,125, with an estimated five-year life and no salvage
value. The estimated annual operating results with the new equipment are as follows:
Revenue from sales of new luggage . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Expenses other than depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $306,250
Depreciation (straight-line basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345,625 651,875
Increase in net income from the new line . . . . . . . . . . . . . . . . . . . . . . . $148,125
All revenue from the new luggage line and all expenses (except depreciation) will be
received or paid in cash in the same period as recognized for accounting purposes. You are
to compute the following for the investment in the new equipment to produce the new luggage
line:
a. Annual cash flows.
b. Payback period.
c. Return on average investment.
d. Total present value of the expected future annual cash inflows, discounted at an annual rate of
10 percent.
e. Net present value of the proposed investment discounted at 10 percent.
E26.9
The division managers of Chester Construction Corporation submit capital investment proposals
each year for evaluation at the corporate level. Typically, the total dollar amount requested by the
divisional managers far exceeds the company- capital investment budget. Thus, each proposal is
first ranked by its estimated net present value as a primary screening criterion.
Jeff Hensel, the manager of Chester- commercial construction division, often overstates the
projected cash flows associated with his proposals, and thereby inflates their net present values. He
does so because, in his words, “Everybody else is doing it.â€Â
a. Assume that all the division managers do overstate cash flow projections in their proposals.
What would you do if you were recently promoted to division manager and had to compete for
funding under these circumstances?
b. What controls might be implemented to discourage the routine overstatement of capital budgeting
estimates by the division managers?
• E26.10
EnterTech has noticed a significant decrease in the profitability of its line of portable CD players.
The production manager believes that the source of the trouble is old, inefficient equipment used
to manufacture the product. The issue raised, therefore, is whether EnterTech should (1) buy new
equipment at a cost of $120,000 or (2) continue using its present equipment.
It is unlikely that demand for these portable CD players will extend beyond a five-year time
horizon. EnterTech estimates that both the new equipment and the present equipment will have a
remaining useful life of five years and no salvage value.
The new equipment is expected to produce annual cash savings in manufacturing costs of
$34,000, before taking into consideration depreciation and taxes. However, management does not
believe that the use of new equipment will have any effect on sales volume. Thus, its decision rests
entirely on the magnitude of the potential cost savings.
The old equipment has a book value of $100,000. However, it can be sold for only $20,000 if it
is replaced. EnterTech has an average tax rate of 40 percent and uses straight-line depreciation for
tax purposes. The company requires a minimum return of 12 percent on all investments in plant
assets.
a. Compute the net present value of the new machine using the tables in Exhibits 26-3
and 26-4.
b. What nonfinancial factors should EnterTech consider?
c. If the manager of EnterTech is uncertain about the accuracy of the cost savings estimate, what
actions could be taken to double-check the estimate?
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