# Operating Division

Your firm would like to evaluate a proposed new operating division. You have forecasted cash

flows for this division for the next five years, and have estimated that the cost of capital is 12%.

You would like to estimate a continuation value. You have made the following forecasts for the

last year of your five-year forecasting horizon (in millions of dollars):

Year 5

Revenues 1200

Operating Income 100

Net income 50

Free cash flows 110

Book value of equity 400

a. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate

the continuation value in year 5, using the perpetuity with growth formula.

b. You have identified several firms in the same industry as your operating division. The average

P/E ratio for these firms is 30. Estimate the continuation value assuming the P/E ratio

for your division in year 5 will be the same as the average P/E ratio for the comparable firms

today.

c. The average market/book ratio for the comparable firms is 4.0. Estimate the continuation

value using the market/book ratio.

https://brainmass.com/business/finance/operating-division-558789

#### Solution Preview

This question can also be solved with the use of formulas.

a. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate

the continuation value in year 5, using the perpetuity with growth formula.

Year 6 = $110 free cash flow (from above) x 1.02 ...

#### Solution Summary

This solution shows the steps, calculations, and answers all questions in the operating division scenario listed.

Accounting

13-4

The following data have been collected for the past two years for the Northern Division of Loring Company:

2005 2006

Sales $50,000,000 $50,000,000

Operating Income 4,500,000 4,100,000

Average Operating Assets 25,000,000 25,000,000

REQUIRED:

1. COMPUTE THE MARGIN AND TURNOVER RATIOS FOR EACH YEAR.

2. COMPUTE THE ROI FOR EACH YEAR.

3. EXPLAIN WHY THE DIVISION EXPERIENCED A DECREASED A ROI FROM 2005 TO 2006.

13-6

CHERYL MANNERS, DIVISION MANAGER OF RADIOTECH, INC., WAS DEBATING THE MERITS OF A NEW PRODUCT-A WEATHER RADIO THAT WOULD PUT OUT A WARNING IF THE COUNTY IN WHICH THE LISTENER LIVED WAS UNDER A SEVERE THUNDERSTORM OR TORNADO ALERT. THE BUDGETED INCOME OF THE DIVISION WAS $480,000 WITH OPERATING ASSETS OF $8,000,000. THE PROPOSED INVESTMENT WOULD ADD INCOME OF $270,000 AND WOULD REQUIRE AN ADDITIONAL INVESTMENT IN EQUIPMENT OF $1,500,000.

REQUIRED

1. COMPUTE THE ROI OF:

A. THE DIVISION IF THE RADIO PROJECT IS NOT UNDERTAKEN

B. THE RADIO PROJECT ALONE

C. THE DIVISION IF THE RADIO PROJECT IS UNDERTAKEN

2. DO YOU SUPPOSE THAT CHERYL WILL DECIDE TO INVEST IN THE NEW RADIO? WHY OR WHY NOT?

16-2

SUPPOSE THAT THE ADAMS COMPANY SELLS A PRODUCT FOR $16. UNIT COSTS ARE AS FOLLOWS:

DIRECT MATERIALS $3.90

DIRECT LABOR $1.40

VARIABLE OVERHEAD $2.10

VARIABLE SELLING EXPENSES $1.60

TOTAL FIXED OVERHEAD IS $52,000 PER YEAR, AND TOTAL FIXED SELLING AND ADMINISTRATIVE EXPENSES ARE $37,950. NORMAL PRODUCTION IS 13,000 UNITS PER YEAR.

REQUIRED:

MATCH A TERM FROM COLUMN A WITH THE CORRECT NUMBER BASED ON THE ABOVE INFORMATION FOR ADAMS COMPANY IN COLUMN B.

# COLUMN A COLUMN B

1 CONTRIBUTION MARGIN A. 12,850

2 CONTRIBUTION MARGIN RATIO B. 0.5625

3 VARIABLE COST RATIO C. $9.00

4 BREAK-EVEN UNITS D. 0.4375

5 PRIME COST PER UNIT E. $7.50

6 CONVERSION COST PER UNIT F. $7.00

7 VARIABLE COST PER UNIT G. $5.30

16-4

THE CONTROLLER OF KERRISK COMPANY PREPARED THE FOLLOWING PROJECTED INCOME STATEMENT:

SALES (5,000 UNITS @ $15) $75,000

LESS: VARIABLE COSTS 60,000

CONTRIBUTION MARGIN 15,000

LESS: FIXED COSTS 10,350

OPERATING INCOME 4,650

REQUIRED:

1. WHAT IS THE CONTRIBUTION MARGIN PER UNIT FOR KERRISK COMPANY? WHAT IS THE CONTRIBUTION MARGIN RATIO?

2. WHAT IS THE VARIABLE COST RATIO FOR KERRISK COMPANY?

3. CALCULATE THE BREAK- EVEN REVENUE.

4. HOW MUCH REVENUE MUST KERRISK MAKE TO ERAN OPERATING INCOME EQUAL TO $9,900?

17-7

SHERWOOD COMPANY IS CURRENTLY MANUFACTURING PART Z911, PRODUCING 40,000 UNITS ANNUALLY. The part is used in the procution of several products made by Sherwood. The cost per unit for z911 is as follows:

DIRECT MATERIALS $9.00

DIRECT LABOR 3.00

VARIABLE OVERHEAD 2.50

FIXED OVERHEAD 4.00

TOTAL $18.50

OF THE TOTAL FIXED OVERHEAD ASSIGNED TO Z911, $88,000 IS DIRECT FIXED OVERHEAD (THE LEASE OF PRODUCTION MACHINERY AND SALARY OF A PRODUCTION LINE SUPERVISOR- NIETHER OF WHICH WILL BE NEEDED IF THE LINE IS DROPPED). THE REMAINING FIXED OVERHEAD IS COMMON FIXED OVERHEAD. AN OUTISDE SUPPLIER HAS OFFERED TO SELL THE PART TO SHEWOOD FOR $16. THERE IS NO ALTERNATIVE USE FOR THE FACILITIES CURRENTLY USED TO PRODUCE THE PART.

REQUIRED:

1. SHOULD SHERWOOD COMPANY MAKE OR BUY PART Z911?

2. WHAT IS THE MOST SHERWOOD WOULD BE WILLING TO PAY AN OUTSIDE SUPPLIER?

3. IF SHERWOOD BOUGHT THE PART, BY HOW MUCH WOULD INCOME INCREASE OR DECREASE?

18-2

EACH OF THE FOLLOWING PARTS IS INDEPENDENT. ASSUME ALL CASH FLOWS ARE AFTER-TAX CASH FLOWS.

1. KAYLIN DAY HAS JUST INVESTED $480,000 IN A BOOK AND VIDEO STORE. SHE EXPECTS TO RECEIVE AN INCOME OF $144,000 PER YEAR FROM THE INVESTMENT. WHAT IS THE PAY-BACK PERIOD FOR KAYLIN?

2. JAN BOOTH PLACED $128,000 IN A 3 YR SAVINGS PLAN. THE PLAN PAYS 5 PERCENT, AND SHE CANNOT WITHDRAW THE MONEY EARLY WITHOUT A PENALTY. ASSUMING THAT JAN LEAVES THE MONEY IN THE PLAN FOR THE FULL THREE YEARS, HOW MUCH MONEY WILL SHE HAVE?

3. COLBY HEPWORTH, MANAGER OF THE FEDER CREDIT UNION, IS CONSIDERING THE PURCHASE OF A NEW AUTOMATED TELLER SYSTEM. THE CASH BENEFITS WILL BE $208,000 PER YEAR. THE SYSTEM COSTS $1,088,000 AND WILL LAST TEN YEARS. COMPUTE THE NPV SUMING A DISCOUNT RATE OF 12 PERCENT. SHOULD THE BANK BUY THE NEW TELLER SYSTEM?

4. EMILY HANSEN HAS JUST INVESTED $200,000 IN A COMPANY. SHE EXPECTS TO RECEIVE $32,200 PER YEAR FOR THE NEXT EIGHT YEARS. HER COST OF CAPITAL IS 6 PERCENT. COMPUTE THE INTERNAL RATE OF RETURN. DID EMILY MAKE A GOOD DECISION?