Renewal Resorts, Inc. operates health spas in Key West, Florida; Phoenix, Arizona; and Carmel,

California. The Key West spa was the company's first and opened in 1996. The Phoenix spa

opened in 2006, and the Carmel spa opened in 2015. Renewal Resorts currently evaluates

divisional managers based on return on investment (ROI), but the company is considering

changing their performance evaluation system to an EVA approach. Data for 2019 are as

follows:

Key West Spa

Phoenix Spa

Carmel Spa

Total

Revenues

$ 3,900,000

$ 4,150,000

$ 3,130,000

$ 11,180,000

Leasing and other costs

2,300,000

2,830,000

1,655,000

6,785,000

Advertising costs

575,000

305,000

830,000

1,710,000

Operating income

1,025,000

1,015,000

645,000

2,685,000

Interest and taxes

462,600

494,200

437,000

1,393,800

Net income

562,400

520,800

208,000

1,291,200

Net book value at 2019 year-end:

Current assets

$ 1,280,000

$ 850,000

$ 600,000

$ 2,730,000

Long-term assets

5,375,000

5,862,000

6,535,000

17,772,000

Total assets

6,655,000

6,712,000

7,135,000

20,502,000

Current liabilities

330,000

265,000

84,000

679,000

Long-term debt

4,600,000

5,200,000

5,500,000

15,300,000

Stockholders' equity

1,725,000

1,247,000

1,551,000

4,523,000

Total liabilities and equity

6,655,000

6,712,000

7,135,000

20,502,000

Weighted average cost of capital

(WACC)

9%

Accumulated depreciation

2,220,000

1,510,000

220,000

Interest costs on long-term debt are 7% per year.

Renewal Resorts pays a 20% tax rate on income.

Renewal believes that advertising provides benefits over 2 years and therefore for EVA purposes

should be amortized on a straight-line basis over a 2-year useful life (beginning with the year of

the expenditure). Advertising for 2019 is shown in the table above. Advertising for 2018 for the

Key West, Phoenix, and Carmel spas was $550,000, $775,000, and $450,000, respectively.

Required:

1.) For each of the spas, calculate 2019 ROI using operating income as the numerator measure of

income and total assets as the denominator measure of investment.

2.) Suppose that Renewal Resorts is considering adding new saunas from Finland. For each spa,

the new saunas would cost $425,000 and would be expected to result in an incremental

increase in operating income of $50,000.

a) What is the incremental ROI and what effect would the addition of the saunas at the Key

West spa have on 2019 ROI for Key West? If performance evaluation is based on ROI,

would the Key West manager have an incentive to accept or reject this project? Explain your

answer.

b) Would the Phoenix spa manager have an incentive to accept or reject addition of saunas?

Would the Carmel spa manager? Briefly explain.

3.) a) Assume that Renewal did not add the saunas in question 2. Calculate 2019 EVA for each

of the spas.

b) The board of directors is struggling to decide how to set the parameters of a performance

evaluation system based on EVA. In the interest of fairness, they are considering setting the

target EVA for all three spas at the same level, $50,000. Write a brief paragraph (no more

than 5 or 6 sentences) to advise the board on the proposed target EVA. (3 points)

4.) Refer back to the information and assumptions in question 2. For each spa, explain whether

the manager has an incentive to add the new saunas if they are evaluated based on EVA

instead of ROI. Assume that the managers receive incentive compensation equal to 10% of

EVA.

5.) Would you recommend that Renewal Resorts change their performance evaluation system to

focus on EVA or continue to focus on ROI for evaluating the performance of the three spas?