Performance Evaluation Methods. Fredas Footwear, Inc., sells shoes and accessories throughout North America. The companys compensation committee, made up of five members from the board of directors, is meeting to discuss the CEOs contract, which expires next month. The committee is currently reviewing financial information for the three most recent fiscal years: year 3 (most recent), year 2, and year 1 (shown as follows).

The income statement indicates sales increased 30 percent from year 1 to year 2 and 35 percent from year 2 to year 3. Net income increased 14 percent from year 1 to year 2 and 18 percent from year 2 to year 3. One member on the committee, Dante Bertini, would like to offer the CEO a multiyear extension with a significant bump in salary and thousands of shares of stock options. When questioned why, Dante pointed to the positive results reflected on the income statement.

Another committee member, Kim Quan, agrees with Dante that income statement trends look great, but she would like to review other measures of performance as well. Kim has asked you to come up with two measures of performance that go beyond simply looking at the income statement.

Freda's Footwear Income Statement (dollar amounts are in thousands)
	Year 3		Year 2		Year 1
Sales	$	96,525	$	71,500	$	55,000
Cost of goods sold		28,958		21,450		16,500
Gross margin	$	67,567	$	50,050	$	38,500
Selling and administrative expenses		60,200		43,800		33,000
Operating income	$	7,367	$	6,250	$	5,500
Income tax expense (30% rate)		2,210		1,875		1,650
Net income	$	5,157	$	4,375	$	3,850

Freda's Footwear Balance Sheet Average Balance (dollar amounts are in thousands)
	Year 3		Year 2		Year 1
	Average Balance		Average Balance		Average Balance
Assets
Cash	$	10,752	$	6,720	$	4,200
Accounts receivable		11,776		7,360		4,600
Inventory		13,312		8,320		5,200
Total current assets	$	35,840	$	22,400	$	14,000
Property, plant and equipment (net)		38,400		24,000		15,000
Land (held for sale)		3,500		3,500		3,500
Total assets	$	77,740	$	49,900	$	32,500
Liabilities and owners' equity
Accounts payable	$	9,216	$	5,760	$	3,600
Other current liabilities		5,632		3,520		2,200
Total current liabilities	$	14,848	$	9,280	$	5,800
Long-term liabilities		0		0		0
Total liabilities	$	14,848	$	9,280	$	5,800
Total owners' equity		62,892		40,620		26,700
Total liabilities and owners' equity	$	77,740	$	49,900	$	32,500

Required:

Calculate return on investment for each of the three years. Note that balance sheet amounts presented for each year are already average balances (i.e., no need to calculate average balances). Assume land held for sale is not an operating asset.

Calculate residual income for each of the three years assuming the companys cost of capital rate is 12 percent.

Prepare a written report to the compensation committee summarizing and explaining your findings in requirements a and b.