Workshop solution

Ch 13

EXERCISE 13.28 (25 minutes) ROI and EVA®: service firm

Equipment Rental Truck Rental
Division Division

1 ROI Invested capital ($750 000 – 80 000) = $670 000 ($3 000 000 – 250 000) = $2 750 000

ROI $45 000 / $670 000 $110 000 / $2 750 000

= 0.0672 or 6.72% = 0.04 or 4.0%

2 EVA® $45 000 – ($670 000  0.06) $110 000 – ($2 750 000  0.06)
= $45 000 – 40 200 = $110 000 – 165 000
= $4 800 = $(55 000)

3 Ready Rentals’ Equipment Rental Division (ERD) has performed better than the Truck Rental Division
(TRD) under both measures. TRD has a much higher profit figure, but when the invested capital is brought
into consideration, the high investment base of TRD leads to a lower ROI. TRD’s profit of $110 000 is
2.44 times that of ERD ($45 000), whereas TRD’s invested capital of $2 750 000 is 4.1 times that of the
$670 000 invested in ERD. The ROI for TRD is less than the WACC of 6 per cent but ERD exceeds the
WACC.

TRD has a negative EVA®. This indicates that the weighted average cost of capital of 6 per cent is greater
than its rate of the return calculated under ROI. With its ROI exceeding the WACC, ERD’s EVA® is
positive.
While at this stage ERD is the better performing division, the firm would gain better insight into the
performance of each division if comparisons were made with other firms in the same business. At the same
time, TRD may have invested large amounts of capital in the short term with a view to improving long term
performance and this highlights the dangers of single-period measurements.

PROBLEM 13.31 (35 minutes) ROI and performance evaluation: manufacturer

1 Return on sales: $810 000 ÷ $10 800 000 = 7.5%
Investment turnover: $10 800 000 ÷ $13 500 000 = 80%
Return on investment: $810 000 ÷ $13 500 000 = 6%, or
7.5% × 80% = 6%
2 Strategy (1) Profit will be reduced to $675 000 because of the loss, and invested capital will fall to $13
365 000 from the disposal. ROI = $675 000 ÷ $13 365 000, or 5.05 per cent. This strategy should be
rejected, since it reduces Fletcher Industries’ performance.
Strategy (2) In terms of ROI, this strategy neither hurts nor helps. The acceleration of overdue receivables
increases cash and decreases accounts receivable by the same amount, producing no effect on invested
capital. Of course, it is possible that the newly acquired cash could be invested in activities or assets that
would provide a positive return for the firm.

3 The effect of this strategy would be to increase profits by $337 500. If it had happened in the last quarter,
profit would have increased to $1 147 500 and ROI to 8.5 per cent. However, the reduction in expenses
could have a negative impact on future performance. A drastic cutback in advertising could lead to a loss
 of customers and a reduced market share. This could translate into reduced profits over the long term. With
respect to repairs and maintenance, reduced outlays could prove costly by unintentional shortening of the
useful lives of plant and equipment. Such action could result in an accelerated asset replacement program.
In the short term, if lack of maintenance leads to a major breakdown of equipment next quarter the profits
could decrease.

4 Andrews’ ROI: ($6 750 000 – $5 400 000) ÷ $11 250 000 = 12%
Brown’s ROI: ($10 125 000 – $9 270 000) ÷ $10 687 500 = 8%
Both investments appear attractive, as their ROIs are higher than the division’s current ROI of
6 per cent. However, if Fletcher Industries desires to maximise its ROI, it should acquire only Andrews;
the return from Andrews plus Brown will lie between 12 per cent and 8 per cent. The risk is that the financial
characteristics that are reported for the two companies may not be typical of future financial results. Of
course, when making decisions to acquire other companies the impact on a company’s ROI is only one of
many factors that would be considered!

Current Current + Current +

Andrews Andrews +
Brown

Profit $810 000 $2 160 000 $3 015 000

Invested capital 13 500 000 24 750 000 35 437 500

ROI 6% 8.73% 8.51%