Question
Benson Ltd operates a Car Division (that sells high-performance sport cars) and a Parts Division (that sells performance-improvement parts for family cars). The companys required
Benson Ltd operates a Car Division (that sells high-performance sport cars) and a Parts Division (that sells performance-improvement parts for family cars). The companys required rate of return is 8%. Some divisional financial measures for the current quarter are as follows:
| Car Division | Parts Division |
---|---|---|
Total assets | $ 3,300,000 | $ 2,850,000 |
Current liabilities | $ 660,000 | $ 840,000 |
Operating profit | $ 247,500 | $ 256,500 |
Required:
(a) Calculate the return on investment (ROI) for each division using total assets as a measure of invested capital. (1 mark)
(b) Calculate the residual income (RI) for each division using total assets minus current liabilities as a measure of invested capital. (2 marks)
(c) The Car Division manager argues that the Parts Division has loaded up 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 divisions. Comment on the result. (3 marks)
(d) Benson Ltd has two sources of funds: long-term debt with a market value of $1,800,000 at an after-tax interest rate of 6%, and equity capital with a market value of $1,200,000 and a cost of equity of 12%. The company tax rate is 30%. Calculate the economic valued added (EVA) for each division. (3 marks)
(e) Are the measures above consistent in comparing the performance of the two divisions? (1 mark)
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