Question No. 2

Pacific Textiles has a knitwear division called Atlantic Knitting. In the coming year Atlantic Division expects a total sales of $3.45 million and an Operating income of $310 000. The division currently has average operating assets of $3 million. Atlantic Division is planning to add some overlocking machines with an additional initial investment of $600 000 with an ending balance of $400 000. This additional investment is expected to generate an additional sales of $ 595 000 and increase net operating income by $62 500. The minimum required rate of return of the company is 10% and actual cost of capital is 8%. The company is asking you to if the idea of expansion is a good idea or not. In particular they have asked you to do the following:

Required:

a.What is the ROI of the division without the additional investment?

b.Compute the net profit margin and turnover ratios before the new investment. Show that the margin ratio multiplied by turnover is equal to the ROI you have calculated in (a) above.

c.What would be the ROI of the division after the new investment? Do you think the divisional manager will approve the new investment? Why?

d.Calculate the margin and turnover ratios after the new investment and compare with the old ratios and comment on them.

e.Calculate the Residual Income before and after the new investment and comment.

f.Compute the EVA of the division before and after the new investment. On the basis of EVA alone should the new investment be accepted? Why?