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ID: 2558600 • Letter: L
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Which of the three projects do you recommend Isabelle undertake?
Isabelle Abiassi operates a popular summer camp for elementary school children. Projections for the current year are as follows:Sales revenue $8,460,000 Operating income $750,750 Average assets $4,272,000
The camp’s weighted-average cost of capital is 11%, and Isabelle requires that all new investments generate a return on investment of at least 15%. 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 $ 4,080 $ 5,356 $ 2,808 Average total assets 27,200 41,200 15,600
Explanation / Answer
(a)Calculation the return on investment, residual income, and economic value added for each of the three projects
PLAYGROUND
1.Return on investment
=Incremental operating income / Average total assets
=$4080 / $27200 * 100
=15%
2.Residual Income
= $4080 – ($27200*15%)
=$4080 - $4080
= 0
3.Economic Value Added
=($4080*75%) – ($27200*11%)
= $3060 - $2992
= $68
SWIMMING POOL
1.Return on investment
=Incremental operating income / Average total assets
=$5356 / $41200 * 100
=13%
2.Residual Income
= $5356 – ($41200*15%)
=$5356 - $6180
= ($824)
3.Economic Value Added
=($5356*75%) – ($41200*11%)
= $4017 - $4532
= ($515)
GYM
1.Return on investment
=Incremental operating income / Average total assets
=$2808 / $15600 * 100
=18%
2.Residual Income
= $2808 – ($15600*15%)
=$2808 - $2340
= $468
3.Economic Value Added
=($2808*75%) – ($15600*11%)
= $2106 - $1716
= $390
(b)Which of the three projects do you recommend Isabelle undertake?
Both the Playground and the Gym meet or exceed the 14% ROI required by the camp, and both have positive residual income and EVA. The pool does not meet any of the thresholds, so the investment should not be made
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ALL THE BEST !!!
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