Ella Manufacturing makes fashion products and competes on the basis of quality a
ID: 2559865 • Letter: E
Question
Ella Manufacturing makes fashion products and competes on the basis of quality and leading-edge designs. The company has two divisions, clothing and cosmetics. Ella has $5,000,000 invested in assets in its clothing division. After-tax operating income from sales of clothing this year is $1,000,000.The cosmetics division has $12,500,000invested in assets and an after-tax operating income this year of $2,000,000.The weighted-average cost of capital for Ella is 6%.The CEO of Ella has told the manager of each division that the division that "performs best" this year will get a bonus.
The CEO of Ella Manufacturing has recently heard of another measure similar to residual income called EVA. The CEO has the accountant calculate adjusted incomes for clothing and cosmetics, and finds that the adjusted after-tax operating incomes are $634,200 and $2,181,600, respectively. Also, the clothing division has $470000 of current liabilities, while the cosmetics division has only $380,000 of current liabilities
Requirement 1. Calculate the ROI and residual income for each division of
EllaElla
Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each measure?
Begin by selecting the formula to calculate ROI, then compute the ROI for each division.
Measure of income
/
Measure of investment
=
ROI
Clothing Division
$1,000,000
/
$5,000,000
=
20
%
Cosmetics Division
$2,000,000
/
$12,500,000
=
16
%
Now select the formula to calculate RI, then compute the RI for each division.
Measure of income
-
Imputed cost of investment
=
RI
Clothing Division
$1,000,000
-
$300,000
=
$700,000
Cosmetics Division
$2,000,000
-
$750,000
=
$1,250,000
If Ella Manufacturing uses ROI, then the manager of the clothing division will get the bonus. If Ella Manufacturing uses RI, then the manager of the
cosmetics division will get the bonus.
What are the advantages and disadvantages of each measure?
First, match each measure with its advantage.
ROI
This measure is easy to calculate and easy to understand. It combines revenue, cost, and investment into a single number, so that managers can clearly see what can be changed to increase returns.
RI
This measure has the advantage of goal congruence because any investment that earns more than the required capital charge increases the measure and thereby increases the managers' performance evaluations.
Now match each measure with its disadvantage.
RI
This measure is not as easy to measure because it requires the company to determine the amount of capital and the cost of capital for each business unit.
ROI
Managers who are evaluated based on this measure have incentives to reject investments that, from the viewpoint of the company as a whole, should be accepted.
Requirement 2. Using the information given calculate EVA, and discuss which division manager will get the bonus.
Begin by calculating the revised ROI for each division using the EVA definition of operating income and assets. (Round your answers to two decimal places, X.XX%.)
ROI
Clothing Division
%
Cosmetics Division
%
Measure of income
/
Measure of investment
=
ROI
Clothing Division
$1,000,000
/
$5,000,000
=
20
%
Cosmetics Division
$2,000,000
/
$12,500,000
=
16
%
Explanation / Answer
EPV means Economic Value Added, it is a measure of a companys financial performance based on the residual income
it can be calculated by deducting cost of capital on investemnt from operating profit after tax
If EVA is negative means the division is not generating the vaue from the funds invested into the business
if EVA is positive means the division is generating rturns in excess of required mnimum return.
so cosmetics division manager will get the bonus
CLOTHING COSMETICS Net Profit After tax 1000000 2000000 Investment 50000000 12500000 Cost of capital 6% 6% Investment*COC 3000000 750000 EVA -2000000 1250000Related Questions
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