Download E 12-13. Overinvestment and Underinvestment As indicated, senior

E 12-13. Overinvestment and Underinvestment
As indicated, senior managers at Quantum increased profit while ROI slipped from
10.00% to 8.33%. They increased profit by taking on investments that earned a
low return. But since the returns were positive, income increased. Since they are
evaluated in terms of profit increases, they have an incentive to overinvest (take on
projects with a rate of return less than the required rate).
Managers at Aquafin are evaluated in terms of ROI. Since their current ROI is high
(18%) they are not interested in investing in projects with a rate of return less than
18% (since such projects will lower their current ROI) even if the return is greater
than the cost of capital which is only 14%. In other words, the managers at
Aquafin have an incentive to underinvest.
P 12-7. ROI and EVA
a.
Net income
Hazardous
Waste
$1,600,000
Plus interest
1,200,000
7,000,000
480,000
2,800,000
$2,320,000
$9,900,000
$12,000,000
$65,000,000
2,500,000
10,300,000
$9,500,000
$54,700,000
Less tax effect of interest
NOPAT
Total assets
Residential
Waste
$5,700,000
Less noninterest-bearing
current liabilities
Investment
ROI (NOPAT ÷ Investment)
b.
NOPAT
24.42%
$2,320,000
18.10%
$9,900,000
Less cost of capital × investment
(.12 × $9,500,000)
1,140,000
(.14 × $54,700,000)
EVA
7,658,000
$1,180,000
$2,242,000
c. As measured in terms of EVA, Residential Waste has created the most
shareholder value.
d. Based on the limited information, Hazardous Waste is the best candidate for
expansion. Its current ROI is quite high suggesting it may be able to earn a
higher rate of return on additional assets compared to Residential Waste.
P 12-10. Economic Value Added and the Balanced Scorecard
a.
Net income (loss)
Plus interest
Less tax effect of interest
NOPAT
Total assets
Brick and Mortar
Division
$30,900,000
Internet
Division
($1,250,000)
1,400,000
465,000
560,000
0
$31,740,000
($ 785,000)
$180,000,000
$17,200,000
7,800,000
2,800,000
$172,200,000
$14,400,000
$31,740,000
($ 785,000)
Less noninterest-bearing
current liabilities
Investment
NOPAT
Less cost of capital × investment
(.13 × $172,200,000)
22,386,000
(.15 × $14,400,000)
EVA
2,160,000
$ 9,354,000
($2,945,000)
b. In its early years, the Internet Division needs to make substantial investments in
infrastructure (software development, servers, etc.) and prices may be set at a
low level to build a customer base. Thus, it is not surprising that EVA is
negative. Managers of the Internet Division could take actions that are in the
long-run interest of the company and still reduce EVA. Since current period
EVA does not capture what the managers of the Internet division are doing to
create future value, it might be better to turn to a balanced scorecard to
measure what the division is doing in terms of its customers, internal
processes, and innovation to create future value.
c. Brick and Mortar Division
Customer measures: Customer satisfaction, market share
Internal process measures: Current titles out of stock, discount sales as a
percentage of total sales.
Internet Division
Customer measures: Time to deliver titles to customers, percent of customers
making repeat purchases
Internal process measures: Percent of Web site visits that translate into sales,
number of times per month that the Web site is down.
d. Brick and Mortar Division
Current titles out of stock (internal process) could influence Customer
satisfaction (customer).
Internet Division
Number of times the Web site is down could influence the percent of Web site
visits that translate into sales.
P 12-18. Comparing Performance Evaluation Methods
a. Division B has the highest net income, followed by Division C and then Division A.
An advantage of rewarding managers based on net income is that
managers are clearly motivated to increase profitability of the firm. But a
disadvantage is that evaluation in terms of profit can lead managers to make
investments that earn a return less than the cost of capital. Hence, they may
overinvest in assets.
b.
Division A
Net income
Division B
Division C
$102,000
$1,040,000
$780,000
Plus interest
30,000
1,100,000
700,000
Less tax effect of Interest
12,000
440,000
280,000
NOPAT
$120,000
$1,700,000
$1,200,000
Total assets
$530,000
$10,700,000
$6,375,000
30,000
1,250,000
$500,000
$9,450,000
24%
18%
Less noninterest-bearing
current liabilities
Investment
ROI
600,000
$5,775,000
21%
Division A has the highest ROI, followed by Division C and then Division B. An
advantage of using ROI to reward managers is that managers would have an
incentive to increase the profitability of their division. However, a disadvantage
is that managers could delay the purchase of modern equipment needed to
stay competitive. New equipment tends to significantly raise the level of
investment and reduce ROI. Managers may fear that the decline in ROI will
lead to low ratings of their job performance.
c.
Division A
Division B
$102,000
$1,040,000
$780,000
Plus interest
30,000
1,100,000
700,000
Less tax effect of interest
12,000
440,000
280,000
Net income
Division C
NOPAT
$120,000
$1,700,000
$1,200,000
Total assets
$530,000
$10,700,000
$6,375,000
30,000
1,250,000
600,000
$500,000
$9,450,000
Less noninterest-bearing
current liabilities
Investment
0.12
$5,775,000
Cost of capital
0.10
0.14
Required NOPAT
50,000
1,134,000
808,500
Residual income
$70,000
$566,000
$391,500
Division B has the highest residual income, followed by Division C and then
Division A. An advantage of using residual income to evaluate managers is that it
does not give them an incentive to underinvest if a project will earn a return
greater than the cost of capital. On the other hand, managers will not have an
incentive to overinvest if a project will earn a return less than the cost of capital.
However, a disadvantage is that residual income rewards accomplishments of the
past and does not consider future benefits.