ROI, Residual Income, and Net Present Value (L.O.4): Sound Enterprises is a conglomerate located on the shore
Question:
ROI, Residual Income, and Net Present Value (L.O.4): Sound Enterprises is a conglomerate located on the shore of the Gulf of Siam. Sound invested $800,000 in Container Shipping in 1984. Due to a glut in the availability of ships. Container Shipping had no positive cash flows until 1990. At that time, Container obtained a five-year charter for its entire fleet. The charter provides Container with annual before-tax cash flows of $400,000. Since Container believes that the ships will have no value after that date, Container is depreciating the $800,000 over the five years using the straight-line method and no salvage value starting in 1990. Sound Enterprises became impatient with the problems at its shipping subsidiary. In 1988, it formed Herring Fisheries, S.A., and invested $1.2 million to acquire fishing rights and to charter ships. Herring Fisheries began operations in 1990. Cash flows are $450,000 per year and are expected to continue for five years. At the end of five years, the fishing rights and charters will expire. Hence, the investment cost of $1.2 million is being depreciated straight-line over a five-year period starting in 1990. The company evaluates divisions on the basis of return on initial investment. (that is, annual before-tax net income divided by $800,000 for Container Shipping and $1.2 million for Herring). The cost of capital (before-tax) is 15 percent.
Required:
a. Which subsidiary's project has the greater net present value?
b. Which subsidiary has the greater ROI and RI?
c. If the rankings differ, how is this explained?
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