Question
Hot Rod Auto Company operates a new car division (that sells high performance sports cars) and a performance parts division (that sells performance-improvement parts for
Hot Rod Auto Company operates a new car division (that sells high performance sports cars) and a performance parts division (that sells performance-improvement parts for family cars). Some division financial measures for 2017 are as follows:
Data Table:
New Car | Performance | |
| Division | Parts Division |
Total assets | $35,000,000 | $32,312,500 |
Current liabilities | $7,100,000 | $8,400,000 |
Operating income | $2,450,000 | $2,585,000 |
Required rate of return | 13% | 13% |
Requirements:
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. | William Abraham, the New Car Division manager, argues that the performance parts 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 performance parts division. Comment on the result. |
4. | Hot Rod Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a market value of $17,000,000 at an interest rate of 10%, and equity capital with a market value of $11,000,000 and a cost of equity of 16%. Applying the same weighted-average cost of capital (WACC) to each division, calculate EVA for each division. |
5. | Use your preceding calculations to comment on the relative performance of each division. |
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