Problem - Performance Auto Company operates a new car division (that sells high- performance sports cars) and a performance parts division (that sells performance-improvement parts for family cars). Some division financial measures for 2017 are as follows:
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New Car Division
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Performance Parts Division
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Total assets
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$33,000,000
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$28,500,000
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Current liabilities
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$6,600,000
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$8,400,000
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Operating income
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$2,475,000
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$2,565,000
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Required rate of return
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12%
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12%
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1. Calculate return on investment (ROI) for each division using operating income as a measure of income and total assets as a measure of investment.
2. Calculate residual income (RI) for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment.
3. William Abraham, the new car division manager, argues that the performance parts division has "loaded up on a lot of short-term debt" to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the performance parts division. Comment on the result.
4. Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a market value of $18,000,000 at an interest rate of 10% and equity capital with a market value of $12,000,000 and a cost of equity of 15%. Applying the same weighted-average cost of capital (WACC) to each division, calculate EVA for each division.
5. Use your preceding calculations to comment on the relative performance of each division.