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, Vivian Bentley, 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, Vivian pointed to the positive results reflected on the income statement.

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

1) 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.

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

3) Summarize and explain your findings in parts 1 and 2 to the committee.

Tori's Fashion, Inc., sells clothing and accessories throughout North America. The company's compensation committee, made up of five members from the board of directors, is meeting to discuss the CEO's 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) Tori's Fashion, Inc. Income Statement Idollar amounts are in thousands Year 3 Year 2 Year 1 Sales $96,525 $71,500 $55,000 Cost of good sold 28.958 21450 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 1875 1650 Net income $5.157 $4.375 $3.850 Tori's Fashion, Inc. Balance Sheet Average Balance (dollar amounts are in thousands Year 3 Year 2 Year 1 Assets Average Balance Average Balance Average Balance Cash $11.776 $6,720 $5,200 Accounts receivable 10.752 8,320 4,600 Inventory 13.312 7.360 4200 Total current assets $35,840 $22.400 $14,000 Property, plant, and equipment (net) 38,400 24,000 15,000 Land (held for sale) 5,000 5,000 5,000 Total assets $79.240 $51.400 $34000 9,216 7.132 $16,348 3,600 3.700 $7,300 Liabilities and owners' equity Accounts payable Other current liabilities Total current liabilities Long-term liabilities Total Liabilities Total owner's equity Total liabilities and owners' equity 5,760 5.020 $10,780 o $10,780 40.620 $51400 $16,348 62892 $79.240 $7.300 26.700 $34.000 Assessment 2 Performance Evaluation Methods Since land held for sale is not an operating asset, it must be deducted from total assets to find average operating assets. (Dollar amounts are in thousands.) Sxx, XXX Sxx XXX Year 3 Year Year 1 Total average assets Sxx.xxx Sxx.xxx Less: Land held for sale (xxxx) Total average operating assets Sxxxxx $XXXXX Using average operating assets calculated above, calculate ROI: Year 3 Year 2 Year 1 Operating income $x xxx Sx.xxx Sx.xxx Average operating assets $xx xxx Sxx.xxx Sxx.xx Return on Investment x.xx% xxxx% XXXX% assets. Retum on investment = Operating income + Average operating For Year 3, x.xx% = $x,XXX + $xx,XXX. b. Operating income and average operating assets were calculated in part a. The cost of capital rate is XX percent. (Dollar amounts are in thousands.) The formula to calculate residual income is: Residual * Operating - Percent cost Average income income of capital operating assets Year 3 residual income = $x,XXX - (xx% x $XX.XXX) - Sx.xxx - Sx.xxx =(x.xxx) Year 2 residual income - SxxXx - (xx% x $XXXXX) = $x.xxx - Sx.xxx Year 1 residual income = $x,xxx-(xx% x Sxx,xxx) -SX.XXX-Sx.xxx = Sx XXX