LINK TO TEXT LINK TO TEXT LINK TO VIDEO LINK TO VIDEO Isabelle Abiassi operates
ID: 2557815 • Letter: L
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Isabelle Abiassi operates a popular summer camp for elementary school children. Projections for the current year are as follows:Sales revenue $7,980,000 Operating income $704,750 Average assets $4,016,000
The camp’s weighted-average cost of capital is 10%, and Isabelle requires that all new investments generate a return on investment of at least 14%. The camp’s current tax rate is 25%.
At last week’s advisory board meeting, Isabelle told the board that she had up to $50,000 to invest in new facilities at the camp and asked them to recommend some projects. Today the board’s president presented Isabelle with the following list of three potential investments to improve the camp facilities.
Playground Swimming Pool Gym Incremental operating income $ 3,696 $ 4,752 $ 2,664 Average total assets 26,400 39,600 14,800
Explanation / Answer
Answer a.
Playground:
Return on Investment = Incremental Operating Income / Average Total Assets
Return on Investment = $3,696 / $26,400
Return on Investment = 14%
Residual Income = Incremental Operating Income - Return on Investment * Average Total Assets
Residual Income = $3,696 - 14% * $26,400
Residual Income = $0
Economic Value Added = Incremental Operating Income*(1-tax) - WACC*Average Total Assets
Economic Value Added = $3,696*(1-0.25) - 0.10*$26,400
Economic Value Added = $132
Swimming Pool:
Return on Investment = Incremental Operating Income / Average Total Assets
Return on Investment = $4,752 / $39,600
Return on Investment = 12%
Residual Income = Incremental Operating Income - Return on Investment * Average Total Assets
Residual Income = $4,752 - 14% * $39,600
Residual Income = -$792
Economic Value Added = Incremental Operating Income*(1-tax) - WACC*Average Total Assets
Economic Value Added = $4,752*(1-0.25) - 0.10*$39,600
Economic Value Added = -$396
Gym:
Return on Investment = Incremental Operating Income / Average Total Assets
Return on Investment = $2,664 / $14,800
Return on Investment = 18%
Residual Income = Incremental Operating Income - Return on Investment * Average Total Assets
Residual Income = $2,664 - 14% * $14,800
Residual Income = $592
Economic Value Added = Incremental Operating Income*(1-tax) - WACC*Average Total Assets
Economic Value Added = $2,664*(1-0.25) - 0.10*$14,800
Economic Value Added = $518
Answer b.
Playground and Gym both have ROI equal to or greater than 14%.
Playground and Gym both have positive Residual Income.
Playground and Gym both have positive EVA.
So, Playground and Gym should be selected
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