Stella Manufacturing makes fashion products and competes on the basis of quality and leading-edge designs. The company has two divisions, clothing and cosmetics. Stella has $2,800,000 invested in assets in its clothing division. After-tax operating income from sales of clothing this year is $700,000. The cosmetics division has $8,500,000 invested in assets and an after-tax operating income this year of $1,700,000. The weighted-average cost of capital for Stella is 10%. The CEO of Stella has told the manager of each division that the division that "performs best" this year will get a bonus. Read the requirements. Requirement 1. Calculate the ROI and residual income for each division of Stella Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each measure? Begin by selecting the formula to calculate ROI, then compute the ROI for each division. Measure of income Clothing Division Cosmetics Division $ $ 700,000 1,700,000 Measure of investment = ROI $ $ 2,800,000 8,500,000 = 25 % 20 % Measure of income Now select the formula to calculate RI, then compute the RI for each division. Imputed cost of investment RI Clothing Division Cosmetics Division $ $ 700,000 $ 280,000 = $ 420,000 1,700,000 $ 850,000 = $ 850,000 If Stella Manufacturing uses ROI, then the manager of the clothing division will get the bonus. If Stella Manufacturing uses RI, then the manager of the cosmetics division will get the bonus. What are the advantages and disadvantages of each measure? First, match each measure with its advantage. ROI RI This measure is easy to calculate and easy to understand. It combines revenue, cost, and investment into a single number, so that managers can clearly see what can be changed to increase returns. This measure has the advantage of goal congruence because any investment that earns more than the required capital charge increases the measure and thereby increases the managers' performance evaluations. Now match each measure with its disadvantage. RI ROI This measure is not as easy to measure because it requires the company to determine the amount of capital and the cost of capital for each business unit. Managers who are evaluated based on this measure have incentives to reject investments that, from the viewpoint of the company as a whole, should be accepted. Requirement 2. The CEO of Stella Manufacturing has recently heard of another measure similar to residual income called EVA. The CEO has the accountant calculate adjusted incomes for clothing and cosmetics, and finds that the adjusted after-tax operating incomes are $506,000 and $1,092,260, respectively. Also, the clothing division has $500,000 of current liabilities, while the cosmetics division has only $98,000 of current liabilities. Using the preceding information, calculate the EVA for each division and discuss which division manager will get the bonus. Begin by calculating the revised ROI for each division using the EVA definition of operating income and assets. ROI Clothing Division % Cosmetics Division %