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Evaluating Profit and Investment Preformance

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Ricky Bobbie, the managing partner of the law firm Bobbie, Bagan, and Clark, LLP, makes asset acquisition and disposal decisions for the firm. As managing partner, he supervises the partners in charge of the firm's three branch offices. Those partners have the authority to make employee compensation decisions. The partners' compensation depends on the profitability of their branch office. Victoria Smith manages the City Branch, which has the following master budget and actual results for the year.

Master Budget Actual Results
Billed hours 5,000 4,900
Revenue $250,000 $254,800
Controllable variable costs
Direct labor 120,000 137,200
Variable overhead 40,000 34,300
Contribution margin $90,000 $83,300
Controllable fixed costs
Rent 30,000 30,000
Other administrative expenses 45,000 42,000
Branch operating income $15,000 $11,300

1. Assume that City Branch is a profit center. Please help me prepare a performance report that includes a flexible budget. And determine the variances between actual results, the flexible budget, and the master budget.

2. Evaluate Victoria Smith's performance as manager of the City Branch.

3. Assume that the branch managers are assigned responsibility for capital expenditures and that the branches are thus investment centers. City Branch is expected to generate a desired ROI of at least 30 percent on average invested assets of $40,000.
a. Compute the branch's return on investment and residual income.
b.Using the ROI and residual income, evaluate Victoria Smith's performance as a branch manager.

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7 Finance Problems: Rate of return, Residual income, ROI, EVA, R&D, Transfer price

Unit 9 Managerial & Accounting

EXERCISE 12-11. Evaluating Investment Centers with Residual Income [LO 6] Lakeside
Hospital is a division of Superior Healthcare organized as an investment center. In the past year, the hospital reported an after-tax income of $2,500,000.Total interest expense was $1,900,000,and the hospitalâ??s tax rate was 35 percent.Hospital assets totaled $33,000,000, and noninterest-bearing current liabilities were $10,400,000. Superior has established a required rate of return equal to 17 percent of invested capital.

Calculate the residual income/EVA of Lakeside Hospital.

EXERCISE 12-13. Overinvestment and Underinvestment [LO 5] consider two companies: Quantum Products and Aquafin Products. Senior managers at Quantum Products are evaluated in terms of increases in profit. In fiscal 2011, Quantum Products had a net operating profit after taxes of $2,500,000 and invested capital of $25,000,000. In fiscal 2012, the company had net operating profit after taxes of $3,000,000 and invested capital of $37,500,000. Senior managers at Aquafin Products are evaluated in terms of ROI. In fiscal 2012, ROI was 16 percent while the cost of capital was only 12 percent.Near the end of fiscal 2012, managers had an opportunity to make an investment that would have yielded a return of 14 percent. However, the senior managers did not support making the investment.

a. Explain why the senior managers at Quantum Products have an incentive to overinvest.
b. Explain why the senior managers at Aquafin Products have an incentive to underinvest

PROBLEM 12-6. Return on Investment, Profit Margin, and Investment Turnover [LO 4]
Consider the following information for HandyCraft Stores for 2011 and 2012.
2011 2012
Total assets $45,000,000 $51,300,000
Noninterest-bearing current liabilities 4,000,000 4,500,000
Net income 3,500,000 4,500,000
Interest expense 2,200,000 2,700,000
Sales 60,000,000 87,500,000
Tax rate 40% 40%

a. Compute ROI for both years.
b. Break ROI down into profit margin and investment turnover.
c. Comment on the change in financial performance between 2011 and 2012.

PROBLEM 12-7. ROI and EVA [LO 6] ELN Waste Management has a subsidiary that disposes of hazardous waste and a subsidiary that collects and disposes of residential garbage. Information related to the two subsidiaries follows.
Hazardous Residential
Waste Waste
Total assets $13,000,000 $70,000,000
Noninterest-bearing current liabilities 3,000,000 12,000,000
Net income 1,700,000 6,000,000
Interest expense 1,250,000 7,300,000
Required rate of return 12% 14%
Tax rate 40% 40%

a. Calculate ROI for both subsidiaries.
b. Calculate EVA for both subsidiaries.Note that since no adjustments for accounting distortions
are being made, EVA is equivalent to residual income.
c. Which subsidiary has added the most to shareholder value in the last year?
d. Based on the limited information, which subsidiary is the best candidate for expansion?

PROBLEM 12-8. EVA [LO 6] Atomic Electronics is considering instituting a plan whereby managers will be evaluated and rewarded based on a measure of economic value added (EVA). Before adopting the plan, management wants you to calculate what EVA will be in 2012 based on financial forecasts for 2012 and prior financial data.
Fiscal Forecast
Total assets $ 55,000,000
Noninterest-bearing current liabilities 21,000,000
Sales 100,000,000
Net income 5,500,000
Interest expense 1,200,000
Research and development 2,400,000
Tax rate 35%
Cost of capital 14%

Research and development expenditures in 2010 and 2011 were $1,200,000 and $2,100,000, respectively. In calculating EVA, prior research and development will be capitalized and amortized assuming a three-year life (i.e., one-third will be expensed in the year incurred, and two-thirds will be capitalized and expensed in the following two years).

a. Explain why it is important to capitalize research and development if managers are to be
rewarded based on EVA.
b. Calculate forecasted EVA for 2012.
c. Will management be likely to support use of EVA as a financial performance measure?

PROBLEM 12-16. (Appendix) Transfer Pricing [LO A1] Montana Woolen Products has two divisions: a Fabric division that manufactures woolen fabrics and a Clothing division that manufactures woolen dresses, coats, shirts, and accessories. All fabric used by the Clothing division is supplied by the Fabric division, which also supplies fabric to outside companies.

a. Suggest a transfer price for the fabric assuming that the Fabric division is operating at only 60 percent of capacity due to a surge in popularity of 'easy-care' fabrics made of polyester and rayon.
b. Suggest a transfer price for fabric assuming that the Fabric division is operating at capacity
due to a revival of consumer interest in natural products and development of lightweight, wrinkle-
resistant woolen fabrics.
c. Explain how your choices in parts a and b are related to the opportunity cost concept

PROBLEM 12-18. Comparing Performance Evaluation Methods [LO 4,5,6] Top management of the Gates Corporation is trying to construct a performance evaluation system to use to evaluate each of its three divisions.This past yearâ??s financial data are as follows:
Division A Division B Division C
Total assets $530,000 $10,700,000 $6,375,000
Noninterest-bearing current liabilities 30,000 1,250,000 600,000
Net income 102,000 1,040,000 780,000
Interest expense 30,000 1,100,000 700,000
Tax rate 40% 40% 40%
Required rate of return 10% 12% 14%

a. How would the divisions be ranked (from best to worst performance) if the evaluation were based on net income?
b. How would the divisions be ranked (from best to worst performance) if the evaluation were based on ROI?
c. How would the divisions be ranked (from best to worst performance) if the evaluation were based on residual income?

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