Case Study 3

Struanski Limited (Struanski) is a holding company based in Scotland, which owns and controls the operations of its subsidiaries through the application of the Return on Investment method of assessing divisional performance. Every year, at the time of budget preparation and review, the CFO determines minimum targets for Return on Investment (ROI) for each of the subsidiaries. For the year ahead, the draft budgets of the three main operating companies include the following relevant data:

Budgeted Net Profit Net Book Value Replacement Costs of Assets 000 000 000 Pretty Properties 405 2,650 3,150 Enigma Engineering 300 1,100 1,450 Simple Software 425 900 600

However, subsequent to the preparation of these draft budgets, each of the companies has developed some new proposals, which they believe to be in the interests of the group as a whole to pursue. These new proposals comprise the following:

Pretty Properties (Pretty)

The commercial director of Pretty Properties has prepared a proposal to acquire an office block in central Aberdeen at a cost of 780,000. With annual operating costs estimated at 35,000, she believes that the properties will generate annual gross revenues of 60,000.

Enigma Engineering (Enigma)

The managing director of Enigma is particularly keen to enhance profitability by spending 350,000 to acquire a manufacturing licence for a new product aimed at the expanding oil industry. The sales director has estimated that annual sales should reach 550,000 with a contribution ratio of 40%. In addition, there will be extra specific fixed costs of 87,000 related to the introduction of the new product. However, there are machinery constraints within Enigmas existing premises, which will require to be addressed before the proposal can proceed. One possible solution is to release machinery capacity by the disposal of one of the current product lines, which currently contributes 102,000 to annual profits. If production of this current product is terminated, there will be savings of 21,000 in annual fixed costs. The CEO believes that the product line can be sold for a price that will recover the net book value of the related fixed assets (purchased for 202,000 three years ago, but with 7 an expected four-year useful lifetime) and recover the cost of the products stock of 22,500.

Simple Software (Simple)

The sales director has been approached by a customer that has offered to acquire one of Simples main software product lines for 280,000. It is expected that this product line will contribute 35,000 out of the budgeted net profit for the year. The following additional information is relevant:

1. The Struanski group uses a cost of capital of 12% as the base in assessing acceptable levels of divisional ROI, being the rate of interest it is receiving on its substantial short-term cash balances (which would be used to fund any of the investment proposals under consideration)

2. The divisional ROI is computed by using net profit for the year related to net assets at the beginning of the year (as given above). It is to be assumed that the proposals under consideration can be implemented by the start of next year.

3. All fixed assets are depreciated on a straight-line basis.

4. All proceeds from sale or disposal of current assets go direct to Struanski.

5. All gains on the sale of fixed assets also go direct to Struanski.

6. Ignore taxation.

Required: 1. Compute the ROI for each of the subsidiaries for next year based on the original draft budgets and then inclusive of the impact of the new proposals.

2. Evaluate each of the subsidiaries proposals and advise whether or not you would recommend them. Critique the proposals both from the subsidiarys viewpoint and from Struanskis viewpoint.

a: Budgeted Net Profit 000 Net Book Value L'000 Replacement Costs of Assets '000 405 300 425 2,650 1,100 900 3,150 1,450 600 to the preparation of these draft budgets, each of the companies lew proposals, which they believe to be in the interests of the group These new proposals comprise the following: a: Budgeted Net Profit 000 Net Book Value L'000 Replacement Costs of Assets '000 405 300 425 2,650 1,100 900 3,150 1,450 600 to the preparation of these draft budgets, each of the companies lew proposals, which they believe to be in the interests of the group These new proposals comprise the following