Chapter 14, Problem 50P

 ROI, EVA, and Different Asset Bases

 Hy’s is a nationwide hardware and furnishings chain. The manager of the Hy’s Store in Boise is evaluated using ROI. Hy’s headquarters requires an ROI of 8 percent of assets For the coming year, the manager estimates revenues will be $4,680,000, cost of goods sold will be $2,934,000, and operating expenses for this level of sales will be $468,000. Investment in the store assets throughout the year is $3,375,000 before considering the following proposal.

  A representative of Ace Appliances approached the manager about carrying Ace’s line of appliances. This line is expected to generate $1,350,000 in sales in the coming year at Hy’s Boise store with a merchandise cost of $1,026,000. Annual operating expenses for this additional merchandise line total $153,000. To carry the line of goods, an inventory investment of $990,000 throughout the year is required. Ace is willing to floor-plan the merchandise so that the Hy store will not have to invest in any inventory. The cost of floor planning would be $121,500 per year. Hy’s marginal cost of capital is 8 percent. Ignore taxes.

Required

1. a.      What is Hy’s Boise stores expected ROI for the coming year if it does not carry Ace’s appliances?
2. b.      What is the store’s expected ROI if the manager invests in Ace’s inventory and carries the appliance line?
3. c.       What would the store’s expected ROI be if the manager elected to take the floor plan option?
4. d.      Would the manager prefer (a), (b), or (c)? Why?
5. e.       Would your answers to any of the above change if EVA was used to evaluate performance? For purposes of this problem, assume no current liabilities.

To determine

Calculate store B’s ROI for the coming year if it does not carry A’s appliances.

Answer to Problem 50P

The return on investment is 37.87% if the store does not carry A’s appliances.

Explanation of Solution

Return on investment:

Return on investment is the amount of total profit earned by a division with its assets. The return on investment is used to check the efficiency of the unit. It shows the efficiency of the unit to utilize its assets to generate the profit.

Calculate the ROI if the store does not carry A’s appliances:

$\begin{array}{c}\text{Return on investment = }\frac{\text{After-tax divisonal income}}{\text{Divisonal asstes}}\\ =\frac{\$1,278,000\text{ (1)}}{\$3,375,000}\\ =\text{ 37}\text{.87\%}\end{array}$

Thus, the return on investment is 37.87%.

Working note 1:

Calculate the operating profit of division B:

Particulars	Division B
Sales	$4,680,000
Less: cost of sales	2,934,000
Gross margin	$1,746,000
Less: operating expenses	$468,000
Operating income	$1,278,000

Table: (1)

To determine

Calculate store B’s ROI for the coming year if it carries A’s appliances.

Answer to Problem 50P

The return on investment is 33.20% if the store carries A’s appliances.

Explanation of Solution

Divisional ROI:

Divisional ROI is the return on investment for a division of a business. It is calculated by dividing the operating profit of the division from the divisional assets.

Calculate the ROI if the store carries A’s appliances:

$\begin{array}{c}\text{Return on investment = }\frac{\text{After-tax divisonal income}}{\text{Divisonal asstes}}\\ =\frac{\$1,449,000\text{ (2)}}{\$4,365,000\text{ (3)}}\\ =\text{ 33}\text{.20\%}\end{array}$

Thus, the return on investment is 33.20%.

Working note 2:

Calculate the operating profit of division B:

Particulars	Division B	Appliances	Total
Sales	$4,680,000	$1,350,000	$6,030,000
Less: cost of sales	$2,934,000	$1,026,000	$3,960,000
Gross margin	$1,746,000	$324,000	$2,070,000
Less: operating expenses	$468,000	$153,000	$621,000
Operating income	$1,278,000	$171,000	$1,449,000

Table: (2)

Working note 3:

Calculate the divisional assets:

$\begin{array}{c}\text{Divisional assets = Division B assets +}\text{}\text{Appliances assets}\\ \text{= }\$3,375,000\text{ + }\$990,000\\ =\$4,365,000\end{array}$

To determine

Calculate the ROI if the manager opts for the floor plan option.

Answer to Problem 50P

The return on investment is 39.33% if store opts floor option.

Explanation of Solution

Return on investment:

Return on investment is the amount of total profit earned by a division with its assets. The return on investment is used to check the efficiency of the unit. It shows the efficiency of the unit to utilize its assets to generate the profit.

Calculate the ROI if store opts floor option:

In the case of floor option, there will be an additional floor charge, and the investment base will remain the same.

$\begin{array}{c}\text{Return on investment = }\frac{\text{After-tax divisonal income - Floor charges}}{\text{Divisonal asstes}}\\ =\frac{\$1,449,000\text{ (2) - }\$121,500}{\$3,375,000}\\ =\text{ 39}\text{.33\%}\end{array}$

Thus, the return on investment is 39.33%.

To determine

Comment which option should be considered by the manager.

Explanation of Solution

Investment in the project:

The investment in the project is a very important decision. Before selecting the project, the management should consider the profitability of the project with the help of present value, IRR, ROI, etc.

Selection of the option by the manager:

The manager should select the floor plan. The ROI of the first option, second option and third option is 37.87%, 33.20%, and 39.33%.

Division B has the highest ROI in case of floor option, so the company should consider the third option (floor plan).

To determine

Calculate the EVA of the division in all cases and which should be opted.

Answer to Problem 50P

The company should opt a second plan (carrying A’s appliances). The EVA is a case of carrying A’s appliances is highest out of three options.

Explanation of Solution

Economic Value Added:

Economic Value Added is the value left after the deduction of the cost of capital from the after-tax profit of the unit. EVA adjusts the profit and capital to eliminate the accounting distortion. Capitalizing the expenditure that would be recorded as an expense in the books of the unit is the example of adjustment in the EVA

Calculate the EVA of the division in all three cases:

Calculate EVA if the store does not carry A’s appliances:

$\begin{array}{c}\text{EVA =}\left(\begin{array}{l}\text{After-tax (adjusted) operating profits -}\\ \text{ (cost of capital }\times \text{adjusted capital employed)}\end{array}\right)\\ \text{= }\$1,278,000\text{ (1) }-\text{ (8\% }\times \$3,375,000\text{)}\\ \text{= \$1,008,000}\end{array}$

Calculate EVA if store carries A’s appliances:

$\begin{array}{c}\text{EVA =}\left(\begin{array}{l}\text{After-tax (adjusted) operating profits -}\\ \text{ (cost of capital }\times \text{adjusted capital employed)}\end{array}\right)\\ \text{= }\$1,449,000\text{ (2) }-\text{ (8\% }\times \$4,365,000\text{ (3})\text{)}\\ \text{= \$1,099,800}\end{array}$

Calculate EVA if store opts floor plan:

$\begin{array}{c}\text{EVA =}\left(\begin{array}{l}\text{After-tax (adjusted) operating profits -}\\ \text{ (cost of capital }\times \text{adjusted capital employed)}\end{array}\right)\\ \text{= }\$1,327,500-\text{ (8\% }\times \text{ \$3,375,000)}\\ \text{= \$1,057,500}\end{array}$

Thus, the company should opt for a second plan (carrying A’s appliances). The EVA is a case of carrying A’s appliances is highest out of three options.