Exercise 14-25 (Algo) Compute RI and ROI (LO 14-2, 3) The Campus Division of All-States Bank has assets of $2,000 million. During the past year, the division had profits of $235 million. All-States Bank has a cost of capital of 6 percent. Ignore taxes. Required: a. Compute the divisional ROI for the Campus Division. (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).) b. Compute the divisional RI for the Campus Division. (Enter your answer in dollars, not in millions.)
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Exercise 14-25 (Algo) Compute RI and ROI (LO 14-2, 3)
The Campus Division of All-States Bank has assets of $2,000 million. During the past year, the division had profits of $235 million. All-States Bank has a cost of capital of 6 percent. Ignore taxes.
Required:
a. Compute the divisional ROI for the Campus Division. (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)
b. Compute the divisional RI for the Campus Division. (Enter your answer in dollars, not in millions.)
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- Effect of proposals on divisional performance A condensed income statement for the Jet Ski Division of Amazing Rides Inc. for the year ended December 31. 20Y2, is as follows Assume that the Jet Ski Division received no charges from service departments. The president of Amazing Rides has indicated that the division's rate of return on a $15,000,000 investment must be increased to at least 12% by the end of the next year if operations are to continue. The division manager is considering the following three proposals Proposal 1: Transfer equipment with a book value of J3.000.000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would exceed the amount of depreciation expense on the old equipment by $264,000. This increase in expense would be included as part of the cost of goods sold. Sales would remain unchanged. Proposal 2: Purchase new and more efficient machining equipment and thereby reduce the cost of goods sold by $480,000. Sales would remain unchanged, and the old equipment, which has no remaining book value, would be scrapped at no gain or loss. The new equipment would increase invested assets by an additional $1,000,000 for the year. Proposal 5? Reduce invested assets by discontinuing the tandem jet ski line. This action would eliminate sales of $2,280,000, cost of goods sold of $1,400,000, and operating expenses of $463,600. Assets of $4,200,000 would be transferred to other divisions at no gain or loss. Instructions Which of the three proposals would meet the required 12% return on investment?'OPTIMAL CAPITAL STRUCTURE Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were 1,100,000 last year, variable costs were 60% of sales, and fixed costs were 40,000. Therefore, EBIT totaled 400,000. Because the universitys enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is 2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the counter market. CD currently has no debtit is an all-equity firmand its 80,000 shares outstanding sell at a price of 25 per share, which is also the book value. The firms federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CDs shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion. In todays market, the risk-free rate, rRF, is 6%, and the market risk premium, RPM, is 6%. CDs unlevered beta, bU, is 1 0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions. a. 1. What is business risk? What factors influence a firms business risk? 2. What is operating leverage, and how does it affect a firms business risk? 3. What is the firms return on invested capital (ROIC)? b. 1. What do the terms financial leverage and financial risk mean? 2. How does financial risk differ from business risk? c. To develop an example that can be presented to CDs management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with , of 12% debt. Both firms have 20,000 in invested capital and a 40% federal-plus-state tax rate, and they have the following EBIT probability distribution for next year: Probability EBIT 025 2,000 0.50 3,000 025 4,000 1. Complete the partial income statements and the firms ratios in Table IC 14.1. 2. Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of financial leverage on expected rate of return and risk. d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars): Amount Borrowed Debt/Capital Ratio D/E Ratio Bond Rating rj 0 0 0 250 0.125 0.1429 AA 8.0% 500 0.250 03333 A 9.0 750 0375 0.6000 BBB 113 1,000 0.500 1.0000 BB 14.0 Now consider the optimal capital structure for CD. 1. To begin, define the terms optimal capital structure and target capital structure. 2. Why does CDs bond rating and cost of debt depend on the amount of money borrowed? 3. Assume that shares could be repurchased at the current market price of 25 per share. Calculate CDs expected EPS and TIE at debt levels of 0, 250,000, 500,000, 750,000, and 1,000,000. How many shares would remain after recapitalization under each scenario? 4. Using the Hamada equation, what is the cost of equity if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? 5. Considering only the levels of debt discussed, what is the capital structure that minimizes CDs WACC? 6. What would be the new stock price if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? Recall that the payout ratio is 100%, so g 0. 7. Is EPS maximized at the debt level that maximizes share price? Why or why not? 8. Considering only the levels of debt discussed, what is CDs optimal capital structure? 9. What is the WACC at the optimal capital structure? d. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated? e. What are some factors a manager should consider when establishing his or her firms target capital structure? f. Put labels on Figure IC 14.1 and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt. g. How does the existence of asymmetric information and signaling affect capital structure?Evaluating divisional performance The three divisions of Yummy Foods are Snack Goods, Cereal, and Frozen Foods. The divisions are structured as investment centers. The following responsibility reports were prepared for the three divisions for the prior year: 1. Which division is making the best use of invested assets and should be given priority for future capital investments? 2. Assuming that the minimum acceptable rate of return on new projects is 19%, would all investments that produce a return in excess of 19% be accepted by the divisions? 3. Can you identify opportunities for improving the companys financial performance?
- Communication The Norse Division of Gridiron Concepts Inc. experienced significant revenue and profit growth from 20Y4 to 20Y6 as shown in the following divisional income statements: There are no support department allocations, and the division operates as an investment center that must maintain a 15% return on invested assets. Determine the profit margin, investment turnover, and return on investment for the Norse Division for 20Y420Y6. Based on your computations, write a brief memo to the president of Gridiron Concepts Inc., Knute Holz, evaluating the divisions performance.CAMPUS DELI INC. OPTIMAL CAPITAL STRUCTURE Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were 1,100,000 last year, variable costs were 60% of sales, and fixed costs were 40,000. Therefore, EBIT totaled 400,000. Because the university's enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is 2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the-counter market. CD currently has no debtit is an all-equity firmand its 80,000 shares outstanding sell at a price of 25 per share, which is also the book value. The firm's federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CD's shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion. In today's market, the risk-free rate, rRF, is 6%, and the market risk premium, RPM, is 6%. CD's unlevered beta, bU, is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions. a. 1. What is business risk? What factors influence a firm's business risk? 2. What is operating leverage, and how does it affect a firm's business risk? 3. What is the firm's return on invested capital (ROIC)? b. 1. What do the terms financial leverage and financial risk mean? 2. How does financial risk differ from business risk? c. To develop an example that can be presented to CD's management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with 10,000 of 12% debt. Both firms have 20,000 in invested capital and a 40% federal-plus-state tax rate, they have the following EBIT probability distribution for next year: Probability EBIT 0.25 2,000 0.50 3,000 0.25 4,000 d. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars): Now consider the optimal capital structure for CD. 1. To begin, define the terms optimal capital structure and target capital structure. 2. Why does CD's bond rating and cost of debt depend on the amount of money borrowed? 3. Assume that shapes could be repurchased at the current market price of 25 per share. Calculate CD's expected EPS and TIE at debt levels of 0, 250,000, 500,000, 750,000, and 1,000,000. How many shares would remain after recapitalization under each scenario? 4. Using the Hamada equation, what is the cost of equity if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? 5. Considering only the levels of debt discussed, what is the capital structure that minimizes CD's WACC? 6. What would be the new stock price if CD recapitalizes with 250,000 of debt? 500,000? 750,000? 1,000,000? Recall that the payout ratio is 100%, so g = 0. 7. Is EPS maximized at the debt level that maximizes share price? Why or why not? 8. Considering only the levels of debt discussed, what is CD's optimal capital structure? 9. What is the WACC at the optimal capital structure? e. Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated? Income Statements and Ratios TABLE IC 13.1 f. What are some factors a manager should consider when establishing his or her firm's target capital structure? g. Put labels on Figure IC 13.1 and then discuss the graph as you might use it to explain to your boss why CD might want to use some debt. h. How does the existence of asymmetric information and signaling affect capital structure? FIGURE IC 13.1 Relationship between Capital Structure and Stock PriceUse the following information for Exercises 11-31 and 11-32: Washington Company has two divisions: the Adams Division and the Jefferson Division. The following information pertains to last years results: Washingtons actual cost of capital was 12%. Exercise 11-31 Economic Value Added Refer to the information for Washington Company above. Required: 1. Calculate the EVA for the Adams Division. 2. Calculate the EVA for the Jefferson Division. 3. CONCEPTUAL CONNECTION Is each division creating or destroying wealth? 4. CONCEPTUAL CONNECTION Describe generally the types of actions that Washingtons management team could take to increase Jefferson Divisions EVA?
- Evaluating division performance Last Resort Industries Inc. is a privately held diversified company with five separate divisions organized as investment centers. A condensed income statement for the Specialty Products Division for the past year, assuming no Service department charges, is as follows: The manager of the Specialty Products Division was recently presented with the opportunity to add an additional product line, which would require invested assets of 14,400,000. A projected income statement for the new product line is as follows: The Specialty Products Division currently has 27.000.000 in invested assets, and Last Resort Industries Inc.s overall rate of return on investment, including all divisions, is 10%. Each division manager is evaluated on the basis of divisional rate of return all investment A bonus is paid, in 8.000 increments, for each whole percentage point that the divisions rate of return on investment exceeds the company average. The president is concerned that the manager of the Specialty Products Division rejected the addition of the new product line, even though all estimates indicated that the product line would be profitable and would increase overall company income. You have been asked to analyze the possible reasons why the Specialty Products Division manager rejected the new product line. 1. Determine the rate of return on investment for the Specialty Products Division for the past year. 2. Determine the Specialty Products Division managers bonus for the past year. 3. Determine the estimated rate of return on investment for the new product line. Round whole percents to one decimal place and investment turnover to two decimal places. 4. - Why might the manager of the Specialty Products Division decide to reject the new product line? Support your answer by determining the projected rate of return all investment for 2016, assuming that the new product line was launched in the Specialty Products Division, and 2016 actual operating results were similar to those of 2015. 5. Can you suggest an alternative performance measure for motivating division managers to accept new investment opportunities that would increase the overall company income and rate of return on investment?Use the following information for Exercises 11-31 and 11-32: Washington Company has two divisions: the Adams Division and the Jefferson Division. The following information pertains to last years results: Washingtons actual cost of capital was 12%. Exercise 11-32 Residual Income Refer to the information for Washington Company above. In addition, Washington Companys top management has set a minimum acceptable rate of return equal to 8%. Required: 1. Calculate the residual income for the Adams Division. 2. Calculate the residual income for the Jefferson Division.7. Jordan Company has two divisions, which reported the following results for the most recent year. Division I Division II Income ₱ 02,700,000 ₱ 00,600,000 Average invested capital ₱ 18,000,000 ₱ 03,000,000 ROI 15% 20% Imputed interest rate = 10% Under residual income, which division is considered to have a better performance? Show solution Group of answer choices Neither Division I nor II Cannot be determined Division I Division II
- Jordan Company has two divisions, which reported the following results for the most recent year. Division I Division II Income ₱ 02,700,000 ₱ 00,600,000 Average invested capital ₱ 18,000,000 ₱ 03,000,000 ROI 15% 20% Imputed interest rate = 10% What is the residual income of Division II? Group of answer choices ₱ 0 ₱ 300,000 ₱ 900,000 ₱ 294,00031 company branch has an investment turnover of 2 times. The minimum return on investment set as quota for the branch was 10%, which was 5% lower than actual RoI. What was the division’s return on sales based on operating income?a. 2.5 %b. 5.0 %c. 7.5 %d. 15.0%Subject: accounting ABC Corporation has divisions. One of the division is currently, making a profit of OMR 82,000 per year. On investment of OMR 500,000 and has a target return of 15%. The manager of a company is considering a new investment, which will require additional investment of OMR 100,000 and will generate additional profit of OMR 17,000 per year. Calculate whether or not the new investment is attractive to the company as a whole. Calculate the ROI of the division, with and without new investment and hence determine whether or not manager would decide to accept the new investment
