Question

Ch The following data are available for two divisions of Solomons Company. Division operating profit Division investment North Division South Division $ 9,200,000 $ 42,000,000 46,000,000 336,000,000 The cost of capital for the company is 7 percent. Ignore taxes. Required: a-1. Calculate the ROI for both North and South divisions. a-2. If Solomons measures performance using ROI, which division had the better performance? b-1. Calculate the EVA for both North and South divisions. (The divisions have no current liabilities.) b-2. If Solomons measures performance using economic value added, which division had the better performance? c. Would your evaluation change if the company's cost of capital was 15 percent? 1. When evaluated by ROI? 2. When evaluated by EVA?

Answer 1

a-1. ROI = ( Division operating profit / Division investment ) * 100

ROI for North Division = ( $9,200,000 / $46,000,000 ) * 100 = 20%

ROI for South Division = ( $42,000,000 / $336,000,000 ) * 100 = 12.5%

a-2.If Solomons measures the performance using ROI, then the North Division had the better performance as its return on investment is 20% which is much better than the South Division which has ROI of 12.5%.

b-1. EVA = Net Operating profit after tax - ( Invested capital * Weighted average cost of capital )

EVA for North division = $9,200,000 - ( $46,000,000 * 7%) = $5,980,000.

EVA for South division = $42,000,000 - ( $336,000,000 * 7%) = $18,480,000.

b-2. As EVA for South division is much more than the North Division, therefore, the South division has performed better than the North Division.

c. 1. Cost of capital = 15%

1. If evaluation is done on the basis of ROI, then North division is performing better as it still has ROI more than the Cost of capital.

2. If evaluation is done by EVA

EVA for North division = $9,200,000 - ( $46,000,000 * 15%) = $2,300,000.

EVA for South division = $42,000,000 - ( $336,000,000 * 15%) = -$8,400,000

Here, the North division is performing better, as the South division has a negative EVA while the North Division still has a positive EVA.