Question

TU-24 Evaluating segment performance (LO 3, 4) Hannalinn Corporation onor ates three divisions-Archer, Barrett, and Corvell. Division managers are evaluated based on the division's return on investment, and historically, the Corvell division has consistently outperformed the other two divisions. Hannalinn's senior management team has recently discovered that the Corvell Division manager has chosen not to invest in projects that would have been beneficial to the organization as a whole, and they are concerned that the current practice of evaluating the division managers' performance using return on investment may have contributed to these decisions. Therefore, the senior management team is considering the use of residual income or EVA to evaluate the division managers' performance. The following data is taken from the most recent year of operations. Archer Barrett Corvell Assets $30,000,000 $20,000,000 $8,000,000 Current liabilities 2,250,000 750,000 325,000 Operating income 4,200,000 3,200,000 1,520,000 Minimum rate of return 14% Weighted average cost of capital 8% 8% 8% Tax rate 30% Required a. Calculate the return on investment, residual income, and EVA for each division Comment on the expected results of switching performance evaluation made either residual income or EVA. 14% 14% 30% 30%

Answer 1

Part A

	Archer	Barrett	Corvell
Operating income (a)	4200000	3200000	1520000
Assets (b)	30000000	20000000	8000000
Return on investment (a / b)	14%	16%	19%

	Archer	Barrett	Corvell
Operating income (a)	4200000	3200000	1520000
Required rate of return (assets*14%) (b)	4200000	2800000	1120000
Residual income (a – b)	$0	$400000	$400000

Required rate of return = assets*14%

Archer = 30000000*14% = 4200000

Barrett = 20000000*14% = 2800000

Corvell = 8000000*14% = 1120000

	Archer	Barrett	Corvell
Income after tax (a)	2940000	2240000	1064000
Cost of capital (b)	2220000	1540000	614000
EVA   (a – b)	$720000	$700000	$450000

Income after tax = operation income *(1-30%)

Archer = 4200000*(1-30%) = 2940000

Barrett = 3200000*(1-30%) = 2240000

Corvell = 1520000*(1-30%) = 1064000

Cost of capital = (assets – current liabilities)* weighted average cost of capital

Archer = (30000000-2250000)*8% = 2220000

Barrett = (20000000-750000)*8% = 1540000

Corvell = (8000000-325000)*8% = 614000

Part B

The results of all method shows different divisions at the top position. It is better that instead of comparing divisions of different sizes, the performance of each division should be done over the period of time. Corvell Division manager should accept the projects achieves the prescribed minimum required rate of return. It is possible that project return may be lower than the division’s current average return on investment.