Pleasanton Studios

Karen Brown, the CEO of Pleasanton Studios, is having a tough week. All three of her top management level employees have dropped in with problems. One executive is making questionable decisions, another is threatening to quit, and the third is reporting losses (again). Karen is hoping to find answers to all her difficulties. She is asking you (her accountant) for some advice on how to proceed.

Pleasanton Studios owns and operates three decentralized divisions--Entertainment, Streaming, and Parks. The decentralized organizational structure means that each division operates as an investment center. Division managers meet with the CEO at least once annually to review their performance, measured by their division's return on investment (ROI). Each division manager receives an annual bonus equal to 10% of their base salary for every ROI percentage point above the cost of capital.

The Entertainment division manager, Joe Freeman, was the first to knock on Karen's door this morning. Entertainment, Pleasanton Studios' first business endeavor, produces movies for the big screen. Entertainment has been in operation since 1965. Last month, Joe had mentioned a proposal to build a new animation studio. The build would have an initial cost of $4,920,000 with an estimated life of 20 years, no salvage value and would allow Entertainment to start producing animated movies. Animated movies were projected to bring in an additional $1,210,000 in revenues each year but would increase annual production costs by $574,000. Joe had dropped in to let Karen know he had decided not to move forward with the animation studio. This surprised Karen. Her quick mental calculation indicated that the studio would have a reasonable payback period--much shorter than the expected life of the studio. Knowing that there are multiple ways to evaluate an investment, Karen needed to get some numbers from her accountant before resuming the discussion with Joe.

Next to Karen's door was the manager of Streaming, Angela Imanah. Streaming produces short-form episodes (30 minute to one hour) in addition to streaming the movies developed by Entertainment. Revenue is earned in the form of subscriptions to the service, which have been growing steadily at 20% each year since 2018. Angela's complaint is that, based on the current bonus payout schedule, Joe Freeman's bonus is significantly higher than hers, though Streaming is experiencing rapid growth under her management. She says that her division is being punished under the current bonus structure for having opened so recently (her division's assets were acquired more recently than those in Entertainment). She currently has an employment offer from another company and stated that she will accept the offer unless she feels her performance is being appropriately acknowledged and compensated. Karen thanks her for her candid feedback and asks for a little time to analyze the situation. She is unsure why newer assets might penalize the Streaming division and needs more information before she finishes the discussion with Angela.

Parks is a theme park based on the movies from Entertainment and the series from Streaming. For many years it was a popular year-round destination with characters, rides, and a hotel. The park has lost popularity in recent years, and has been 'in the red' for the past two years. If the park is not profitable this year, Karen will need to decide whether Pleasanton Studios would be better off permanently closing the division. Included in the 'Fixed COGS' for Parks is an annual $1,680,000 mortgage payment on the land and buildings for the park, which would still need to be paid if the park is closed. Incidentally, Karen recently had a conversation with a Marriott Hotels executive, who would like to expand into the area. If she decides to close Parks, she is fairly certain that the hotel facilities could be leased to Marriott for $650,000 annually.

A report containing part of this year's financial results for Pleasanton Studios can be found in Table 1 below. The 'Selling and admin costs' listed in Table 1 are direct to each division (not allocated), and are fixed (that is, they do not change with increased/decreased production). In addition to the current year data in Table 1, there are $2,000,000 in corporate costs that should be allocated evenly between the three divisions (the allocation may seem odd, but go with it). These costs are primarily due to employee benefits costs, which are billed at the corporate level. If the Parks division is closed, the decreased employee base would reduce the $2,000,000 allocated corporate costs to $1,500,000. Pleasanton Studios has a cost of capital and required rate of return 12% and income is subject to a 25% income tax rate.

Before she can make any decisions, Karen needs some answers. She schedules a Zoom meeting with you, the company's accountant.

Table 1: Pleasanton Studios current year data

	Entertainment	Streaming	Parks
Revenues	$54,583,520	$30,184,570	$7,564,270
Fixed COGS	$3,356,850	$4,074,530	$3,159,430
Variable COGS	$40,257,310	$22,020,695	$3,698,928
# of customers	15,264,200	1,420,060	30,240
# of employees	11,562	1,954	1,378
Average net operating assets	$29,014,000	$19,252,000	$420,000
Selling and admin costs	$3,259,520	$944,620	$231,900

1. How do I summarize the company's performance by preparing a segmented income statement?

	Entertainment	Streaming	Parks	Overall
Sales
COGS
Gross Margin
Allocated overhead
Selling and administrative
Operating Income
Tax expense
Divisional income

1. How do I calculate current ROI, residual income and EVA for the three divisions?
2. How do I calculate NPV and IRR and use them to evaluate Entertainment's decision not to invest in the new animation studio?
3. How do I perform a basic differential analysis showing the effect on operating income if Parks is shut down?

	Current	Parks Closed	Difference
Marriott Revenue
CM
Fixed COGS
Selling and Admin
Allocated Corporate
Operating Income