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Fundamentals of Cost Accounting

William Lanen, Shannon Anderson, Michael Maher

Chapter 14

Business Unit Performance Measurement - all with Video Answers

Educators


Chapter Questions

Problem 1

What are the advantages of divisional income as a business unit performance measure? What are the disadvantages?

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Problem 2

How is divisional income like income computed for the firm? How is it different?

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Problem 3

What are the advantages of using an ROI-type measure rather than the absolute value of division profits as a performance evaluation technique for business units?

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Problem 4

Give an example in which the use of ROI measures might lead the manager to make a decision that is not in the firm's interests.

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Problem 5

How does residual income differ from ROI?

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Problem 6

How does EVA differ from residual income?

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Problem 7

What impact does the use of gross book value or net book value in the investment base have on the computation of ROI?

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Problem 8

What are the dangers of using only business unit measures to evaluate the performance of business unit managers?

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01:38

Problem 9

A company prepares the master budget by taking each division manager's estimate of revenues and costs for the coming period and entering the data into the budget without adjustment. At the end of the year, division managers are given a bonus if their actual division profit exceeds the budgeted profit. Do you see any problems with this system?

Adriano Chikande
Adriano Chikande
Numerade Educator

Problem 10

"If every division manager maximizes divisional income, we will maximize firm income. Therefore, divisional income is the best performance measure." Comment.

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Problem 11

What problems might there be if the same methods used to compute firm income are used to compute divisional income? Does your answer depend on the type of business a firm is in?

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Problem 12

The chapter identified some problems with ROI-type measures and suggested that residual income reduces some of them. Why do you think that ROI is a more common performance measure in practice than residual income?

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Problem 13

"Failure to invest in projects is not a problem when you use ROI. If there is a good project, corporate headquarters will just tell the division manager to invest." What are the difficulties with this view?

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Problem 14

How would you respond to the following comment? "Residual income and economic value added are identical."

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09:32

Problem 15

"I think that EVA is the best performance measure. I am going to recommend that we evaluate all managers, of plants, divisions, subsidiaries, up to the chief executive officer (CEO), using it." Do you think this statement is appropriate? Explain.

Paul A.
Paul A.
California State Polytechnic University, Pomona

Problem 16

Management of Division A is evaluated based on residual income measures. The division can either rent or buy a certain asset. Might the performance evaluation technique have an impact on the rent-or-buy decision? Why or why not? Will your answer change if EVA is used?

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Problem 17

"Every one of our company's divisions has a return on investment in excess of our cost of capital. Our company must be a blockbuster." Comment on this statement.

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00:54

Problem 18

"Residual income solves some of the problems with ROI, but because it is an absolute number, it is difficult to compare divisions. We should use residual income divided by assets and then we would have the best of both measures." Do you agree with this statement?

Ameer Said
Ameer Said
Numerade Educator
04:12

Problem 19

By using economic value-added, we avoid managers focusing on short-term gains like they would with accounting income. Do you agree with this statement?

Jennifer Stoner
Jennifer Stoner
Numerade Educator

Problem 20

Eastern Merchants shows the following information for its two divisions for year 1:
$$
\begin{array}{lrr}
\text { } &\text { Eastern } &\text { Western } \\
\text { Sales revenue } \ldots \ldots \ldots \ldots \ldots \ldots & \$ 1,200,000 & \$ 3,800,000 \\
\text { Cost of sales } \ldots \ldots \ldots \ldots \ldots & 769,500 & 1,900,000 \\
\text { Allocated corporate overhead } \ldots \ldots \ldots & 72,000 & 228,000 \\
\text { Other general and administration. . . } & 158,500 & 1,100,000
\end{array}
$$
Required
Compute divisional operating income for the two divisions. Ignore taxes. How well have these divisions performed?

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Problem 21

Refer to Exercise 14-20. The results for year 2 have just been posted:
$$
\begin{array}{|c|c|c|}
\hline \text { } &\text { Eastern }& \text { Western } \\
\hline \text { Sales revenue } & \$ 1,200,000 & \$ 2,800,000 \\
\hline \text { Cost of sales } & 769,500 & 1,400,000 \\
\hline \text { Allocated corporate overhead } & 90,000 & 210,000 \\
\hline \text { Other general and administration. .... } & 158,500 & 1,100,000 \\
\hline
\end{array}
$$
Required
Compute divisional operating income for the two divisions. How well have these divisions performed?

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Problem 22

TL Division of Giant Bank has assets of $$\$ 14.4$$ billion. During the past year, the division had profits of $$\$ 1.8$$ billion. Giant Bank has a cost of capital of 6 percent. Ignore taxes.
Required
a. Compute the divisional ROI.
b. Compute the divisional RI.

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02:26

Problem 23

A division is considering the acquisition of a new asset that will cost $$\$ 720,000$$ and have a cash flow of $$\$ 252,000$$ per year for each of the four years of its life. Depreciation is computed on a straight-line basis with no salvage value. Ignore taxes.
Required
a. What is the ROI for each year of the asset's life if the division uses beginning-of-year asset balances and net book value for the computation?
b. What is the residual income each year if the cost of capital is 15 percent?

Breanna Ollech
Breanna Ollech
Numerade Educator

Problem 24

The following data are available for two divisions of Solomons Company:
$$
\begin{array}{lrr}
& \text { North Division } & \text { South Division } \\
\text { Division operating profit } \ldots \ldots . . & \$ 6,000,000 & \$ 40,000,000 \\
\text { Division investment } \ldots \ldots \ldots & 30,000,000 & 320,000,000
\end{array}
$$
The cost of capital for the company is 8 percent. Ignore taxes.
Required
a. If Solomons measures performance using ROI, which division had the better performance?
b. If Solomons measures performance using economic value added, which division had the better performance? (The divisions have no current liabilities.)
c. Would your evaluation change if the company's cost of capital were 16 percent?

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Problem 25

Ocean Division currently earns $$\$ 780,000$$ and has divisional assets of $$\$ 3.9$$ million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $$\$ 675,000$$ and will have a yearly cash flow of $$\$ 168,000$$. The asset will be depreciated using the straight-line method over a six-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company's cost of capital is 15 percent. Ignore taxes.
Required
a. What is the divisional ROI before acquisition of the new asset?
b. What is the divisional ROI in the first year after acquisition of the new asset?

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Problem 26

Refer to the data in Exercise 14-25. The division manager learns that he has the option to lease the asset on a year-to-year lease for $$\$ 148,000$$ per year. All depreciation and other tax benefits would accrue to the lessor. What is the divisional ROI if the asset is leased?

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Problem 27

a. What is the division's residual income before considering the project?
b. What is the division's residual income if the asset is purchased?
c. What is the division's residual income if the asset is leased?

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Problem 28

Noonan Division has total assets (net of accumulated depreciation) of $$\$ 3,300,000$$ at the beginning of year 1. One of the assets is a machine that has a net book value of $$\$ 300,000$$. Expected divisional income in year 1 is $$\$ 495,000$$ including $$\$ 42,000$$ in income generated by the machine (after depreciation). Noonan's cost of capital is 12 percent. Noonan is considering disposing of the asset today (the beginning of year 1).
Required
a. Noonan computes ROI using beginning-of-the-year net assets. What will the divisional ROI be for year 1 assuming Noonan retains the asset?
b. What would divisional ROI be for year 1 assuming Noonan disposes of the asset for its book value (there is no gain or loss on the sale)?
c. Noonan computes residual income using beginning-of-the-year net assets. What will the divisional residual income be for year 1 assuming Noonan retains the asset?
d. What would divisional residual income be for year 1 assuming Noonan disposes of the asset for its book value (there is no gain or loss on the sale)?

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Problem 29

Refer to the facts in Exercise 14-28, but assume that Noonan has been leasing the machine for $$\$ 60,000$$ annually. Assume also that the machine generates income of $$\$ 42,000$$ annually after the lease payment. Noonan can cancel the lease on the machine without penalty at any time.
Required
a. Noonan computes ROI using beginning-of-the-year net assets. What will the divisional ROI be for year 1 assuming Noonan retains the asset?
b. What would divisional ROI be for year 1 assuming Noonan disposes of the asset?
c. Noonan computes residual income using beginning-of-the-year net assets. What will the divisional residual income be for year 1 assuming Noonan retains the asset?
d. What would divisional residual income be for year 1 assuming Noonan disposes of the asset for its book value (there is no gain or loss on the sale)?

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Problem 30

The Caribbean Division of Mega-Entertainment Corporation just started operations. It purchased depreciable assets costing $$\$ 30$$ million and having a four-year expected life, after which the assets can be salvaged for $$\$ 6$$ million. In addition, the division has $$\$ 30$$ million in assets that are not depreciable. After four years, the division will have $$\$ 30$$ million available from these nondepreciable assets. This means that the division has invested $$\$ 60$$ million in assets with a salvage value of $$\$ 36$$ million. Annual depreciation is $$\$ 6$$ million. Annual operating cash flows are $$\$ 15$$ million. In computing ROI, this division uses end-of-year asset values in the denominator. Depreciation is computed on a straight-line basis, recognizing the salvage values noted. Ignore taxes.
Required
a. Compute ROI, using net book value for each year.
b. Compute ROI, using gross book value for each year.

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03:12

Problem 31

Refer to the data in Exercise 14-30. Assume that the division uses beginning-of-year asset values in the denominator for computing ROI.
Required
a. Compute ROI, using net book value.
b. Compute ROI, using gross book value.
c. If you worked Exercise 14-30, compare those results with those in this exercise. How different is the ROI computed using end-of-year asset values, as in Exercise 14-30, from the ROI using beginning-of-year values in this exercise?

Satish Yadav
Satish Yadav
Numerade Educator

Problem 32

Refer to the information in Exercise 14-30. In computing ROI, this division uses end-of-year asset values. Assume that all cash flows increase 10 percent at the end of each year. This has the following effect on the assets' replacement cost and annual cash flows:
$$
\begin{array}{cccc}
\text{End of Year} &\text{Replacement Cost}&\text{Annual Cash Flow}\\
1 \ldots \ldots & \$ 60,000,000 \times 1.1=\$ 66,000,000 & \$ 15,000,000 \times 1.1=\$ 16,500,000 \\
2 \ldots \ldots & \$ 66,000,000 \times 1.1=\$ 72,600,000 & \$ 16,500,000 \times 1.1=\$ 18,150,000 \\
3 \ldots \ldots & & \text { Etc. } & \text { Etc. }
\end{array}
$$
Depreciation is as follows:
$$
\begin{array}{lrc}
\text { Year } & \text { For the Year } & \text { "Accumulated" } \\
1 \ldots \ldots \ldots & \$ 6,600,000 & \$ 6,600,000(=10 \% \times \$ 66,000,000) \\
2 \ldots \ldots & 7,260,000 & 14,520,000(=20 \% \times 72,600,000) \\
3 \ldots \ldots & 7,986,000 & 23,958,000 \\
4 \ldots \ldots & 8,784,600 & 35,138,400
\end{array}
$$
Required
a. Compute ROI using historical cost, net book value.
b. Compute ROI using historical cost, gross book value.
c. Compute ROI using current cost, net book value.
d. Compute ROI using current cost, gross book value.

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01:56

Problem 33

Upper Division of Lower Company acquired an asset with a cost of $$\$ 600,000$$ and a fouryear life. The cash flows from the asset, considering the effects of inflation, were scheduled as follows:
$$
\begin{array}{|c|c|}
\hline \text { Year } & \text { Cash Flow } \\
\hline1 & \$ 225,000 \\
\hline 2& 255,000 \\
\hline 3& 285,000 \\
\hline 4& 300,00 \\
\hline
\end{array}
$$
The cost of the asset is expected to increase at a rate of 10 percent per year, compounded each year. Performance measures are based on beginning-of-year gross book values for the investment base. Ignore taxes.
Required
a. What is the ROI for each year of the asset's life, using a historical cost approach?
b. What is the ROI for each year of the asset's life if both the investment base and depreciation are determined by the current cost of the asset at the start of each year?

Nick Johnson
Nick Johnson
Numerade Educator

Problem 34

Back Mountain Industries (BMI) has two divisions: East and West. BMI has a cost-of-capital of $15 \%$. Selected financial information (in thousands of dollars) for the first year of business follows:
$$
\begin{array}{|c|c|}
\hline&\text { East } & \text { West} \\
\hline \text { Sales revenue }&\$1,000 & \$ 5,000 \\
\hline \text { Income. . }&200 & 390 \\
\hline \text { Investment (beginning of year). }& 2,000& 3,000 \\
\hline \text { urrent liabilities (beginning of year) . . }& 200 & 20 \\
\hline \& D \text { expenditures (note a)....... }& 500& 40 \\
\hline
\end{array}
$$
Evaluate the performance of the two divisions assuming BMI uses return on investment (ROI).

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02:23

Problem 35

Refer to the data in Exercise 14-34.
Required Evaluate the performance of the two divisions assuming BMI uses residual income.

Raymond Matshanda
Raymond Matshanda
Numerade Educator
02:23

Problem 36

Refer to the data in Exercise 14-34.
Required
Evaluate the performance of the two divisions assuming BMI uses economic value added.

Raymond Matshanda
Raymond Matshanda
Numerade Educator

Problem 37

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $$\$ 4$$ million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $$\$ 5$$ million in automated equipment for test machine assembly. The division's expected income statement at the beginning of the year was as follows:
$$
\begin{array}{|c|c|}
\hline \begin{array}{l}
\text { Sales revenue } \ldots \ldots \ldots \ldots \ldots \ldots \\
\text { Operating costs }
\end{array} & \$ 16,000,000 \\
\hline \text{Variable}& 2,000,000 \\
\hline \text { Fixed (all cash). } & 7,500,000 \\
\hline \text { Depreciation } & \\
\hline \text { New equipment. } & 1,500,000 \\
\hline \text { Other } . . . \ldots \ldots & 1,250,000 \\
\hline \text { Division operating profit . } & \overline{\$ 3,750,000} \\
\hline
\end{array}
$$
A sales representative from LSI Machine Company approached Oscar in October. LSI has for $$\$ 6.5$$ million a new assembly machine that offers significant improvements over the equipment Oscar bought at the beginning of the year. The new equipment would expand division output by 10 percent while reducing cash fixed costs by 5 percent. It would be depreciated for accounting purposes over a three-year life. Depreciation would be net of the $$\$ 500,000$$ salvage value of the new machine. The new equipment meets Pitt's 20 percent cost of capital criterion. If Oscar purchases the new machine, it must be installed prior to the end of the year. For practical purposes, though, Oscar can ignore depreciation on the new machine because it will not go into operation until the start of the next year.
The old machine, which has no salvage value, must be disposed of to make room for the new machine.
Pitt has a performance evaluation and bonus plan based on ROI. The return includes any losses on disposal of equipment. Investment is computed based on the end-of-year balance of assets, net book value. Ignore taxes.
Required
a. What is Forbes Division's ROI if Oscar does not acquire the new machine?
b. What is Forbes Division's ROI this year if Oscar acquires the new machine?
c. If Oscar acquires the new machine and it operates according to specifications, what ROI is expected for next year?

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Problem 38

Oscar Clemente (Problem 14-37) is still assessing the problem of whether to acquire LSI's assembly machine. He learns that the new machine could be acquired next year, but if he waits until then, it will cost 15 percent more. The salvage value would still be $$\$ 500,000$$. Other costs or revenue estimates would be apportioned on a month-by-month basis for the time each machine (either the current machine or the machine Oscar is considering) is in use. Fractions of months may be ignored. Ignore taxes.
Required
a. When would Oscar want to purchase the new machine if he waits until next year?
b. What are the costs that must be considered in making this decision?

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Problem 39

Refer to the facts in Problem 14-37. Assume that Pitt's performance measurement and bonus plans are based on residual income instead of ROI. Pitt uses a cost of capital of 12 percent in computing residual income.
Required
a. What is Forbes Division's residual income if Oscar does not acquire the new machine?
b. What is Forbes Division's residual income this year if Oscar acquires the new machine?
c. If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year?

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Problem 40

Refer to the facts in Problem 14-39. Assume that Pitt's performance measurement and bonus plans are based on residual income instead of ROI. Pitt uses a cost of capital of 12 percent in computing residual income.
Required
a. When would Oscar want to purchase the new machine if he waits until next year?
b. What are the costs that must be considered in making this decision?

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Problem 41

Division managers at Asher Company are granted a wide range of decision authority. With the exception of managing cash, which is done at corporate headquarters, divisions are responsible for sales, pricing, production, costs of operations, and management of accounts receivable, inventories, accounts payable, and use of existing facilities.
If divisions require funds for investment, division executives present investment proposals to corporate management, which analyzes and documents them. The final decision to commit funds for investment purposes rests with corporate management.
The corporation evaluates divisional executive performance by using the ROI measure. The asset base is composed of fixed assets employed plus working capital, exclusive of cash. The ROI performance of a division executive is the most important appraisal factor for salary changes. In addition, each executive's annual performance bonus is based on ROI results, with increases in ROI having a significant impact on the amount of the bonus.
Asher adopted the ROI performance measure and related compensation procedures about 10 years ago and seems to have benefited from it. The ROI for the corporation as a whole increased during the first years of the program. Although the ROI continued to increase in each division, corporate ROI has declined in recent years. The corporation has accumulated a sizable amount of short-term marketable securities in the past three years.
Corporate management is concerned about the increase in the short-term marketable securities. A recent article in a financial publication suggested that some companies have overemphasized the use of ROI, with results similar to those experienced by Asher.
Required
a. Describe the specific actions that division managers might have taken to cause the ROI to increase in each division but decrease for the corporation. Illustrate your explanation with appropriate examples.
b. Using the concepts of goal congruence and motivation of division executives, explain how the overemphasis on the use of the ROI measure at Asher Company might have resulted in the recent decline in the company's ROI and the increase in cash and short-term marketable securities.
c. What changes could be made in Asher Company's compensation policy to avoid this problem? Explain your answer.
d. Is it ethical for a manager to take actions that increase her ROI but decrease the firm's ROI?

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Problem 42

Pharmaceutical firms, oil and gas companies, and other ventures inevitably incur costs on unsuccessful investments in new projects (e.g., new drugs or new wells). For oil and gas firms, a debate continues over whether those costs should be written off as period expense or capitalized as part of the full cost of finding profitable oil and gas ventures. For pharmaceutical firms, GAAP in the United States is clear that R\&D costs are to be expensed when incurred.
Pharm-It has been writing R\&D costs off to expense as incurred for both financial reporting and internal performance measurement. However, this year a new management team was hired to improve the profit of Pharm-It's Cardiology Division. The new management team was hired with the provision that it would receive a bonus equal to 10 percent of any profits in excess of base-year profits of the division. However, no bonus would be paid if profits were less than 20 percent of end-of-year investment. The following information was included in the performance report for the division:
$$
\begin{array}{|c|c|c|c|}
\hline & \text { This Year } & \text { Base Year } & \begin{array}{c}
\text { Increase over } \\
\text { Base Year }
\end{array} \\
\hline \begin{array}{l}
\text { Sales revenues } \ldots \ldots \ldots \ldots \ldots \ldots \ldots \ldots \\
\text { Costs incurred }
\end{array} & \$ 20,500,000 & \$ 20,000,000 & \\
\hline \text { R\&D Expense. } & -0 \text { - } & 4,000,000 & \\
\hline \text { Depreciation and other amortization... } & 3,900,000 & 3,750,000 & \\
\hline \text { Other costs } \ldots \ldots \ldots \ldots \ldots \ldots \ldots \ldots & 8,000,000 & 7,750,000 & \\
\hline \text { Division profit. } & \$ 8,600,000 & \$ 4,500,000 & \$ 4,100,000 \\
\hline \text { End-of-year investment. } & \$ 45,500,000^a & \$ 37,500,000 & \\
\hline
\end{array}
$$
During the year, the new team spent $$\$ 5$$ million on R\&D activities, of which $$\$ 4,500,000$$ was for unsuccessful ventures. The new management team has included the $$\$ 4,500,000$$ in the current end-of-year investment base because "You can't invent successful drugs without missing on a few unsuccessful ones."
Required
a. What is the ROI for the base year and the current year? Ignore taxes.
b. What is the amount of the bonus that the new management team is likely to claim? Is this ethical?
c. If you were on Pharm-It's board of directors, how would you respond to the new management's claim for the bonus?

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Problem 43

Several years ago, Seville Company acquired Salvador Components. Prior to the acquisition, Salvador manufactured and sold automotive components to third-party customers. Since becoming a division of Seville, Salvador has manufactured components only for products made by Seville's Luxo Division.
Seville's corporate management gives the Salvador Division management considerable latitude in running the division's operations. However, corporate management retains authority for decisions regarding capital investments, product pricing, and production quantities.
Seville has a formal performance evaluation program for all division managements. The evaluation program relies substantially on each division's ROI. Salvador Division's income statement provides the basis for the evaluation of Salvador's management. (See the following income statement.)
The corporate accounting staff prepares the divisional financial statements. Corporate general services costs are allocated on the basis of sales dollars, and the computer department's actual costs are apportioned among the divisions on the basis of use. The net divisional investment includes divisional fixed assets at net book value (cost less depreciation), divisional inventory, and corporate working capital apportioned to the divisions on the basis of sales dollars.
table can't copy
Required
a. Discuss Seville Company's financial reporting and performance evaluation program as it relates to the responsibilities of Salvador Division.
b. Based on your response to requirement $(a)$, recommend appropriate revisions of the financial information and reports used to evaluate the performance of Salvador's divisional management. If revisions are not necessary, explain why.
(CMA adapted)

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Problem 44

House Station, Inc., is a nationwide hardware and furnishings chain. The manager of the House Station Store in Portland is evaluated using ROI. House Station headquarters requires an ROI of 10 percent of assets. For the coming year, the manager estimates revenues will be $$\$ 2,340,000$$, cost of goods sold will be $$\$ 1,467,000$$, and operating expenses for this level of sales will be $$\$ 234,000$$. Investment in the store assets throughout the year is $$\$ 1,687,500$$ before considering the following proposal.
A representative of Sharp's Appliances approached the manager about carrying Sharp's line of appliances. This line is expected to generate $$\$ 675,000$$ in sales in the coming year at the Portland House Station store with a merchandise cost of $$\$ 513,000$$. Annual operating expenses for this additional merchandise line total $$\$ 76,500$$. To carry the line of goods, an inventory investment of $$\$ 495,000$$ throughout the year is required. Sharp's is willing to floor plan the merchandise so that the House Station store will not have to invest in any inventory. The cost of floor planning would be $$\$ 60,750$$ per year. House Station's marginal cost of capital is 10 percent. Ignore taxes.
Required
a. What is the Portland House Station store's expected ROI for the coming year if it does not carry Sharp's appliances?
b. What is the store's expected ROI if the manager invests in Sharp's inventory and carries the appliance line?
c. What would the store's expected ROI be if the manager elected to take the floor plan option?
d. Would the manager prefer $(a),(b)$, or $(c)$ ? Why?
e. Would your answers to any of the above change if EVA was used to evaluate performance? For purposes of this problem, assume no current liabilities.

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Problem 45

Suwon Pharmaceuticals invests heavily in research and development (R\&D), although it must currently treat its R\&D expenditures as expenses for financial accounting purposes. To encourage investment in R\&D, Suwon evaluates its division managers using EVA. The company adjusts accounting income for R\&D expenditures by assuming these expenditures create assets with a two-year life. That is, the R\&D expenditures are capitalized and then amortized over two years.
BK division of Suwon shows after-tax income of $$\$2.5$$ million for year 2. R\&D expenditures in year 1 amounted to $$\$ 1$$ million and in year 2, R\&D expenditures were $$\$ 1.6$$ million. For purposes of computing EVA, Suwon assumes all R\&D expenditures are made at the beginning of the year. Before adjusting for R\&D, BK division shows assets of $$\$ 10$$ million at the beginning of year 2 and current liabilities of $$\$ 200,000$$. Suwon computes EVA using divisional investment at the beginning of the year and a 12 percent cost of capital.
Required
Compute EVA for BK division for year 2.

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Problem 46

Biddle Company uses EVA to evaluate the performance of division managers. For the Wallace Division, after-tax divisional income was $$\$ 400,000$$ in year 3.
The company adjusts the after-tax income for advertising expenses. First, it adds the annual advertising expenses back to after-tax divisional income. Second, the company managers believe that advertising has a three-year positive effect on the sale of the company's products, so it amortizes advertising over three years. Advertising expenses in year 1 will be expensed 50 percent, 40 percent in year 2 , and 10 percent in year 3 . Advertising expenses in year 2 will be expensed 50 percent, 40 percent in year 3 , and 10 percent in year 4 . Advertising expenses in year 3 will be amortized 50 percent, 40 percent in year 4 , and 10 percent in year 5 . Third, unamortized advertising expenses become part of the divisional investment in the EVA calculations. Wallace Division had incurred advertising expenses of $$\$ 100,000$$ in year 1 and $$\$ 200,000$$ in year 2. It incurred $$\$ 240,000$$ of advertising in year 3 .
Before considering the unamortized advertising, the Wallace Division had total assets of $$\$ 4,200,000$$ and current liabilities of $$\$ 600,000$$ at the beginning of year 3. Biddle Company calculates EVA using the divisional investment at the beginning of the year. The company uses a 12 percent cost of capital to compute EVA.
Required
Compute the EVA for the Wallace Division for year 3. Is the division adding value to shareholders?

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Problem 47

I thought evaluating performance would be easier than this. I have three vice presidents, operating the same business in three different countries. I need to be able to compare them in order to prepare compensation recommendations to the board. The problem is that there are so many variables that each of the managers can make some claim to having the best performance. I hope our consultant can help me sort this out.
a. What are some of the factors causing the problems in measuring performance in the Southeast Asia Sector?
b. Rank the three countries using each of the following measures of performance:
1. Country profit.
2. Return on investment.
3. Economic value added (EVA).
c. Are there other performance measures you would suggest? How would you measure these?
d. Write a one-page memo to Ms. Karlson explaining which country performed best. Be sure to explain your reasoning.

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Problem 48

The following exchange occurred just after the finance staff at Diversified Electronics rejected a capital investment proposal.
a. Was the decision to reject the new product proposal the right one? If top management used the discounted cash flow (DCF) method instead, what would the results be? The company uses a 15 percent after-tax cost of capital (i.e., discount rate) in evaluating projects such as these.
b. Evaluate the manner in which Diversified Electronics has implemented the investment center concept. What pitfalls did it apparently not anticipate? What, if anything, should be done with regard to the investment center approach and the use of ROI as a measure of performance?
c. What conflicting incentives for managers can occur when yearly $\mathrm{ROI}$ is used as a performance measure and DCF is used for capital budgeting?

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