AQ-8

Blue Transport Company

Blue Transport Company operates a Truck Rental Division (that rents trucks to individuals) and a Transportation Division (that transports goods from one city to another). Some division financial measures for the year are as follows:

	Truck Rental Division	Transportation Division
Total assets	$ 11,000,000	$ 9,500,000
Current liabilities	$ 2,200,000	$ 2,800,000
Operating Income	$ 825,000	$ 855,000
Required rate of return	12 %	12%

Required:

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. Tony Red, the Truck Rental Division manager, argues that the Transportation 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 Transportation Division. Comment on the result.

4. Blue, whose tax rate is 40%, has two sources of funds: long term debt with a market value of $9,000,000 at an interest rate of 10%, and equity capital with a market value of $6,000,000 and a cost of equity of 15%. Applying the same weighted average cost of capital to each division, calculate EVA for each division.

5. Use your preceding calculations to comment on the relative performance of each division.