Evaluating the

performance of

business segments

Cost, Profit, and Investments Centers

Cost Center A segment whose

manager has control over

costs, but not over

revenues or investment funds.

Cost, Profit, and Investments Centers

Profit Center A segment whose

manager has control over both

costs and revenues,

but no control over investment funds.

RevenuesSalesInterestOther

CostsMfg. costsCommissionsSalariesOther

Cost, Profit, and Investments Centers

Investment Center

A segment whose manager has

control over costs, revenues, and investments in

operating assets.

Division Headquarters

Cost, Profit, and Investments Centers

ResponsibilityCenter

ResponsibilityCenter

CostCenterCost

CenterProfit

CenterProfit

CenterInvestment

CenterInvestment

Center

Cost, profit,and investmentcenters are allknown asresponsibilitycenters.

Three popular approaches to the measurement of investment center performance are:

1. Return on assets (ROI)

2. Residual income (RI)

3. Economic value added (EVA)

Return on Investment (ROI) Formula

ROI = ROI = Net operating incomeNet operating incomeoperating assets operating assets

Cash, accounts receivable, inventory,plant and equipment, and other operating assets.

Cash, accounts receivable, inventory,plant and equipment, and other operating assets.

Net Operating IncomeNet Operating Income

Return on Investment (ROI) Formula

ROI = ROI = Net operating incomeNet operating incomeoperating assets operating assets

Margin = Margin = Net operating incomeNet operating incomeSales Sales

Turnover = Turnover = SalesSalesoperating assets operating assets

ROI = ROI = Margin Margin Turnover Turnover

Assume the following:

Operating income = $30,000

Assets = $200,000

Sales = $500,000

Determine the company’s return on sales (ROS). asset turnover, and

ROI.

Return on Investment (ROI) Formula

$30,000 $500,000

× $500,000$200,000

ROI =

6% 6% 2.5 = 15% 2.5 = 15%ROI =

ROI = ROI = Margin Margin Turnover Turnover

Net operating income Sales

Sales operating assets×ROI =

Return on Investment (ROI) Formula

$30,000 $500,000

× $500,000$200,000

ROI =

6% 6% 2.5 = 15% 2.5 = 15%ROI =

ROI = ROI = Margin Margin Turnover Turnover

Net operating income Sales

Sales operating assets×ROI =

Question: Is a 15% ROI good or bad? What is a suitable benchmark?

Controlling the Rate of Return

Three ways to improve ROI . . .Three ways to improve ROI . . .

IncreaseIncreaseSalesSales

ReduceReduceExpensesExpenses ReduceReduce

AssetsAssets

Residual Income - Another Measure of Performance

Net operating incomeabove some minimum

return on operatingassets

Residual Income

Operating assets 100,000$ Required rate of return × 20%Required income 20,000$

Operating assets 100,000$ Required rate of return × 20%Required income 20,000$

Actual income 30,000$ Required income (20,000) Residual income 10,000$

Actual income 30,000$ Required income (20,000) Residual income 10,000$

Residual Income

Operating assets 100,000$ Required rate of return × 20%Required income 20,000$

Operating assets 100,000$ Required rate of return × 20%Required income 20,000$

Actual income 30,000$ Required income (20,000) Residual income 10,000$

Actual income 30,000$ Required income (20,000) Residual income 10,000$

Question: Is a $10,000 RI good or bad? What is a suitable benchmark?

ROI and RI measures require meaningful measures of the

operating assets of the business segments, and a realistic gauge of the cost of capital percentage for each of

the business segments.

Consider the following areas of concern in measuring assets and

costs of capital at the divisional level.

Issues in identifying and valuing divisional assets:

Issues in identifying and valuing divisional assets:

What items should be included in a comprehensivelisting of divisional assets? Should assets that are

not typically included in financial accountingbalance sheets be included (e.g., advertising projects,

research and development spending, humanresource expenditures)?

Issues in identifying and valuing divisional assets:

What items should be included in a comprehensivelisting of divisional assets? Should assets that are

not typically included in financial accountingbalance sheets be included (e.g., advertising projects,

research and development spending, humanresource expenditures)?

How should divisional assets be valued (e.g. athistorical costs, inflation-adjusted costs, disposal

values, replacement costs)?

Issues in identifying and valuing divisional assets:

What items should be included in a comprehensivelisting of divisional assets? Should assets that are

not typically included in financial accountingbalance sheets be included (e.g., advertising projects,

research and development spending, humanresource expenditures)?

How should divisional assets be valued (e.g. athistorical costs, inflation-adjusted costs, disposal

values, replacement costs)?

How should leased assets be treated?

How are ROI and RI related? In what circumstances are these two measures likely to provide different rankings of the performance

of business segments?

How is the firm’s cost of capital relevant to ROI and/or RI calculations? How is the

appropriate cost of capital determined for a specific business segment?

Other issues in measuring and using ROI and RI:

Economic Value Added (EVA) is a recent modification of the RI measure, and is

computed as follows:

Economic value added (EVA®)

= After-tax operating income

– [Weighted-average cost of capital

× (Total assets – current liabilities)]

= Economic value added

Economic value added (EVA®) is a recent modification of the RI formula, and is

measured as follows:

Economic Value Added

Economic value added (EVA®) uses thefollowing specific measures::

1. Income equal to after-tax operating income

2. A required rate of return equal to theweighted-average after-tax cost of capital

3. Investment equal to total assets minuscurrent liabilities

Economic Value Added Example

Assume that Relax Inns has two sources oflong-term funds:

1. Long-term debt with a book value of $3,600,000 and a market value of $4,800,000 issued at an interest rate (before tax) of 10%

2. Equity capital that also has a market value of$4,800,000, a book value of $2,200,000 and an

after-tax cost of 14%.Tax rate is 30%.

Economic Value AddedWhat is the after-tax cost of debt capital?

0.10 × (1 – Tax rate) = 0.07, or 7%

Economic Value AddedWhat is the after-tax cost of debt capital?

0.10 × (1 – Tax rate) = 0.07, or 7%

Assume that Relax Inns’ cost ofequity capital is 14%.

What is the weighted-average cost of capital?

The weights based on market values are multiplied by the after-tax capital costs

and summed, as follows:WACC% = (4.8/9.6) 7% + (4.8/9.6) 14%

= 10.5%

Assume that Relax Inn has total assets of$7,000,000 and current liabilities of

$1,000,000.The company reports pre-tax income of

$2,000,000 and is taxed at 30%.Determine the company’s EVA.

EVA = After-tax income – Capital charge= $1,400,000 – (10.5% x $6,000,000)

= $770,000

Assume that Relax Inn has total assets of$7,000,000 and current liabilities of

$1,000,000.The company reports pre-tax income of

$2,000,000 and is taxed at 30%.Determine the company’s EVA.

Issues in the use of EVA or RI

How does the measurement of EVA differ from RI?

Which measure is more consistent with the concept of “controllability?”

How do we specify the appropriate costof capital?

ROI, RI and EVA performance evaluations may create incentives for managers that are not optimal for the company. The following issues are often pertinent:

Capital spending proposals with positive net present valuesmay be discarded because they fail to meet a target ROI.

Because operating leases are usually not included in the measurement of segment operating assets, managers may

prefer to lease rather than to purchase assets.

Financial accounting standards for the recognition and measurement of assets may make comparisons difficult.

Reliance on historical costs, and the presence of uncapitalized intangibles, are especially troublesome factors.

Handout 15 (f):Multiple Choice items

1. Kop Corporation has provided the following data:

Kop Corporation's residual income is: A. $1,800 B. $5,400 C. $2,700 D. $3,600

1. Kop Corporation has provided the following data:

Kop Corporation's residual income is: A. $1,800 B. $5,400 C. $2,700 D. $3,600

2. Spar Company has calculated the following ratios for one of its investment centers:

What is Spar's return on investment for this investment center? A. 50.0% B. 12.5% C. 15.0% D. 25.0%

2. Spar Company has calculated the following ratios for one of its investment centers:

What is Spar's return on investment for this investment center? A. 50.0% B. 12.5% C. 15.0% D. 25.0%

3. Mike Corporation uses residual income to evaluate the performance of its divisions. The company's minimum required rate of return is 14%. In January, the Commercial Products Division had average operating assets of $970,000 and net operating income of $143,700. What was the Commercial Products Division's residual income in January? A. $7,900 B. -$20,118 C. $20,118 D. -$7,900

3. Mike Corporation uses residual income to evaluate the performance of its divisions. The company's minimum required rate of return is 14%. In January, the Commercial Products Division had average operating assets of $970,000 and net operating income of $143,700. What was the Commercial Products Division's residual income in January? A. $7,900 B. -$20,118 C. $20,118 D. -$7,900

Handout 15 (c):ROI, RI and EVA

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

(a) Residual income, West Division (assume a cost of capital of 10 percent)

RI = OI- (r%)(TA) = $400m – (.10)($2.0mil) = $200,000

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

(a) Residual income, West Division (assume a cost of capital of 10 percent)

RI = OI- (r%)(TA) = $700m – (.10)($4.0mil) = $300,000

RI = OI- (r%)(TA) = $400m – (.10)($2.0mil) = $200,000

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

(a) Residual income, West Division (assume a cost of capital of 10 percent)

(c) Cost of capital at which the East Division would have

residual income equal to zero

RI = OI- (r%)(TA) = $700m – (.10)($4.0mil) = $300,000

RI = OI- (r%)(TA) = $400m – (.10)($2.0mil) = $200,000

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

(a) Residual income, West Division (assume a cost of capital of 10 percent)

(c) Cost of capital at which the East Division would have

residual income equal to zero

RI = OI- (r%)(TA) = $700m – (.10)($4.0mil) = $300,000

RI = OI = (r%)(TA) 0 = $400m – (r%)($2.0mil) r% = 20%

RI = OI- (r%)(TA) = $400m – (.10)($2.0mil) = $200,000

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

(a) Residual income, West Division (assume a cost of capital of 10 percent)

(c) Cost of capital at which the East Division would have

residual income equal to zero

RI = OI- (r%)(TA) = $700m – (.10)($4.0mil) = $300,000

RI = OI = (r%)(TA) 0 = $400m – (r%)($2.0mil) r% = 20%

RI = OI- (r%)(TA) = $400m – (.10)($2.0mil) = $200,000

(d) Cost of capital at which the East and West Divisions would have equal amounts of residual income

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Required: Determine the following: (a) Residual income, East Division (assume a cost of capital of 10 percent)

(a) Residual income, West Division (assume a cost of capital of 10 percent)

(c) Cost of capital at which the East Division would have

residual income equal to zero

RI = OI- (r%)(TA) = $700m – (.10)($4.0mil) = $300,000

RI = OI = (r%)(TA) 0 = $400m – (r%)($2.0mil) r% = 20%

RI = OI- (r%)(TA) = $400m – (.10)($2.0mil) = $200,000

(d) Cost of capital at which the East and West Divisions would have equal amounts of residual income

$400m – (r%)($2.0mil) = $700m – (r%)($4.0mil) r% = 15%

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Assume that the Divide Company is financed by long-term debt with a book value of $7 million and a market value of $20 million and an interest rate (before tax) of 10%, and equity capital with a book value of $5 million and a market value of $60 million at a cost of equity (after tax) of 15%. Divide Company’s income tax rate is 40%. Determine the following amounts for purposes of evaluating the each division’s economic value added (EVA):

(a) Divide Company’s weighted average after-tax cost of capital percent:

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Assume that the Divide Company is financed by long-term debt with a book value of $7 million and a market value of $20 million and an interest rate (before tax) of 10%, and equity capital with a book value of $5 million and a market value of $60 million at a cost of equity (after tax) of 15%. Divide Company’s income tax rate is 40%. Determine the following amounts for purposes of evaluating the each division’s economic value added (EVA):

(a) Divide Company’s weighted average after-tax cost of capital percent: Market

value Weight

Rate after tax

WACC%

Debt $20 mil .25 .06 .0150 Equity $60 mil .75 .15 .1125 Total $80 mil 1.00 .1275

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Assume that the Divide Company is financed by long-term debt with a book value of $7 million and a market value of $20 million and an interest rate (before tax) of 10%, and equity capital with a book value of $5 million and a market value of $60 million at a cost of equity (after tax) of 15%. Divide Company’s income tax rate is 40%. Determine the following amounts for purposes of evaluating the each division’s economic value added (EVA):

(a) Divide Company’s weighted average after-tax cost of capital percent: Market

value Weight

Rate after tax

WACC%

Debt $20 mil .25 .06 .0150 Equity $60 mil .75 .15 .1125 Total $80 mil 1.00 .1275

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Assume that the Divide Company is financed by long-term debt with a book value of $7 million and a market value of $20 million and an interest rate (before tax) of 10%, and equity capital with a book value of $5 million and a market value of $60 million at a cost of equity (after tax) of 15%. Divide Company’s income tax rate is 40%. Determine the following amounts for purposes of evaluating the each division’s economic value added (EVA):

(a) Divide Company’s weighted average after-tax cost of capital percent: Market

value Weight

Rate after tax

WACC%

Debt $20 mil .25 .06 .0150 Equity $60 mil .75 .15 .1125 Total $80 mil 1.00 .1275

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Assume that the Divide Company is financed by long-term debt with a book value of $7 million and a market value of $20 million and an interest rate (before tax) of 10%, and equity capital with a book value of $5 million and a market value of $60 million at a cost of equity (after tax) of 15%. Divide Company’s income tax rate is 40%. Determine the following amounts for purposes of evaluating the each division’s economic value added (EVA):

(a) Divide Company’s weighted average after-tax cost of capital percent: Market

value Weight

Rate after tax

WACC%

Debt $20 mil .25 .06 .0150 Equity $60 mil .75 .15 .1125 Total $80 mil 1.00 .1275

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

Assume that the Divide Company is financed by long-term debt with a book value of $7 million and a market value of $20 million and an interest rate (before tax) of 10%, and equity capital with a book value of $5 million and a market value of $60 million at a cost of equity (after tax) of 15%. Divide Company’s income tax rate is 40%. Determine the following amounts for purposes of evaluating the each division’s economic value added (EVA):

(a) Divide Company’s weighted average after-tax cost of capital percent: Market

value Weight

Rate after tax

WACC%

Debt $20 mil .25 .06 .0150 Equity $60 mil .75 .15 .1125 Total $80 mil 1.00 .1275

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

(a) Dollar amount of the East Division’s capital charge

Cap. Charge = WACC% (TA – CL) = (.1275)($2mil - .8mil) = $153,000

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

(a) Dollar amount of the East Division’s capital charge

(b) Dollar amount of the West Division’s capital charge:

Cap. Charge = WACC% (TA – CL) = (.1275)($2mil - .8mil) = $153,000

Cap. Charge = WACC% (TA – CL) = (.1275)($4mil - 1mil) = $382,500

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

(a) Dollar amount of the East Division’s capital charge

(b) Dollar amount of the West Division’s capital charge:

(c) Dollar amount of the East Division’s EVA

Cap. Charge = WACC% (TA – CL) = (.1275)($2mil - .8mil) = $153,000

Cap. Charge = WACC% (TA – CL) = (.1275)($4mil - 1mil) = $382,500

Divide Company East Division West Division Total Assets $ 2,000,000 $ 4,000,000 Current Liabilities $ 800,000 $ 1,000,000 Operating Income (before tax) $ 400,000 $ 700,000

(a) Dollar amount of the East Division’s capital charge

(b) Dollar amount of the West Division’s capital charge:

(c) Dollar amount of the East Division’s EVA

(d) Dollar amount of the West Division’s EVA

Cap. Charge = WACC% (TA – CL) = (.1275)($2mil - .8mil) = $153,000

Cap. Charge = WACC% (TA – CL) = (.1275)($4mil - 1mil) = $382,500

EVA = OIAT – Cap.Charge = ($400,000)(.6) - $153,000 = $87,000

EVA = OIAT – Cap.Charge = ($700,000)(.6) - $382,500 = $37,500

At what cost of capital do both divisions have the same EVA?

At what cost of capital do both divisions have the same EVA?

EVA(East) = EVA(West)

240,000 – R (1,200,000) = 420,000 – R (3,000,000)

R = 10%

EVA = $120,000

Handout 15 (d):Investment biasesin using ROI and RI

Monolith Enterprises, Special Metals Casting Division Monolith Enterprises is highly decentralized, with most divisions being structured as investment

centers. Both return on assets (ROA) and residual income (RI) are used in evaluating the operating

performance of divisional managers. Lex Luther, currently serving a probationary period as

manager of the Special Metal Casting division, will be evaluated based on his ability to improve

the operating performance of the division over the relatively short-term future. Presently the

division’s operating income is $ 1.2 million, and total divisional assets are $ 12.5 million. Luther

currently is evaluating a capital expenditure proposal with the following projected cash flows:

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

Required: (Ignore income taxes in addressing the following questions. Assume that divisional

assets and operating income will remain at current levels in future years if the above capital project

is not adopted. For simplicity, use beginning of the year asset balances for calculating performance

measures.)

(1) Determine the division’s current return on assets (ROA) and residual income (RI) assuming

that the project is not adopted.

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

Required: (Ignore income taxes in addressing the following questions. Assume that divisional

assets and operating income will remain at current levels in future years if the above capital project

is not adopted. For simplicity, use beginning of the year asset balances for calculating performance

measures.)

(1) Determine the division’s current return on assets (ROA) and residual income (RI) assuming

that the project is not adopted.

ROA = $1.2mil / $12.5mil = 9.6% RI = $1.2mil – (10%)($12.5mil) = ($50,000) Currently the division’s ROA is below the cost of capital, and the RI is negative.

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

Required: (Ignore income taxes in addressing the following questions. Assume that divisional

assets and operating income will remain at current levels in future years if the above capital project

is not adopted. For simplicity, use beginning of the year asset balances for calculating performance

measures.)

(1) Determine the division’s current return on assets (ROA) and residual income (RI) assuming

that the project is not adopted.

(2) Evaluate the project’s net present value and internal rate of return. Does the proposed

investment seem economically beneficial to Monolith Enterprises?

ROA = $1.2mil / $12.5mil = 9.6% RI = $1.2mil – (10%)($12.5mil) = ($50,000) Currently the division’s ROA is below the cost of capital, and the RI is negative.

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

Required: (Ignore income taxes in addressing the following questions. Assume that divisional

assets and operating income will remain at current levels in future years if the above capital project

is not adopted. For simplicity, use beginning of the year asset balances for calculating performance

measures.)

(1) Determine the division’s current return on assets (ROA) and residual income (RI) assuming

that the project is not adopted.

(2) Evaluate the project’s net present value and internal rate of return. Does the proposed

investment seem economically beneficial to Monolith Enterprises?

ROA = $1.2mil / $12.5mil = 9.6% RI = $1.2mil – (10%)($12.5mil) = ($50,000) Currently the division’s ROA is below the cost of capital, and the RI is negative.

NPV = (PVAF10,10%)(ACF) – Cost = (6,145)($1,000,000) - $5,650,000 = $495,000IRR = 12% (because the PVAF10,12% is 5.650)The project has a positive NPV and the IRR exceeds the cost of capital.

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

(1) Determine the dollar amount of operating income expected in each year of the project’s life

(in each year, measure income as operating cash flows less depreciation expense).

(2) Determine the expected ROA and RI in the first, second and last year of the project’s life.

Based on these measures, would Lex Luther be likely to approve the project proposal?

The annual operating cash flow is $1,000,000 and straight-line depreciation is $565,000 ($5,650,000 / 10yrs.), so the annual operating income is $435,000.

Project cost: $ 5,650,000 Annual cash flow $ 1,000,000 Estimated useful life: 10 years Estimated salvage value: None Other pertinent information: Risk-adjusted cost of capital 10% Borrowing rate, long-term debt 6% Depreciation method Straight line

(1) Determine the dollar amount of operating income expected in each year of the project’s life

(in each year, measure income as operating cash flows less depreciation expense).

(2) Determine the expected ROA and RI in the first, second and last year of the project’s life.

Based on these measures, would Lex Luther be likely to approve the project proposal?

The annual operating cash flow is $1,000,000 and straight-line depreciation is $565,000 ($5,650,000 / 10yrs.), so the annual operating income is $435,000.

The beginning book values of the asset are $5,650,000, $5,085,000 and $565,000 in the first, second and last year of the project. The annual income is $435,000 in each year. Consequently, the ROA and RI are as follows:

Yr 1 Yr 2 Yr10 ROA 7.7% 8.6% 77.0% RI ($130,000) ($73,500) $378,500

Because Luther is being evaluated based on a short-term horizon, it is unlikely that he would accept a project that reduces the division’s performance measures in the initial years.

(1) Assume that Luther has tentatively decided not to fund the proposed project. The

manufacturer of the equipment required for the project offers to lease rather than sell the

equipment to Special Metals Casting under the following lease terms:

Lease term: 10 years Annual lease rental: $ 900,000

The prospective lessor provides the following analysis to demonstrate the economic advantages of the lease, and its expected favorable impact on Luther’s performance measures:

Annual operating cash flow $1,000,000 Less: Lease rental payments $ 900,000 Operating income (and net annual cash flow) $ 100,000 Present value factor, ten years at 10% x 6.145 = $614,500 positive NPV ROA impact: Return on assets will increase, because the leased asset will not be included on the division’s balance sheet, and operating income will increase by $100,000 in each year. RI impact: Residual income will increase by $100,000 each year, because the leased asset will not affect the amount of the division’s capital charge.

(1) Evaluate the impact of the proposed lease arrangement on the division’s ROA and

RI. Is Luther likely to approve the lease agreement? Is it economically beneficial to

Monolith Enterprises to lease rather than to purchase the required equipment?

Determine the dollar amount of the economic advantage (or disadvantage) of the

lease arrangement. (Hint: Interpret the lease payments as serial redemption debt

payments. Discount these payments at the company’s borrowing rate, and compare

the present value of the debt payments to the purchase cost of the equipment.)

The division’s ROA would increase because operating income increases by $100,000 each year, and the denominator (total assets) does not include operating (non-capitalized) leases. The division’s RI would increase because operating income is higher, and the capital charge is unaffected by operating leases. Luther would be likely to approve the lease arrangement.In order to determine whether leasing is preferable to purchase, we compare the purchase cost of the asset to the present value of the lease payments. The lease is interpreted as serial-repayment debt, and is evaluated at the company’s borrowing rate of 6%.

Present value of lease payments = (PVAF10,6%)(Lease pay’t)

= (7.360)($900,000) = $6,624,000

The present value of the lease payments is $6,624,000 and exceeds the $5,650,000 purchase cost by $974,000.This amount represents the financial disadvantage of leasing versus purchase of the asset.

(1) Explain how the lessor was able to show a positive NPV for the lease arrangement,

given the amount of advantage (or disadvantage) that you have determined above.

(1) Explain how the lessor was able to show a positive NPV for the lease arrangement,

given the amount of advantage (or disadvantage) that you have determined above.

The evaluation of the original project shows a positive NPV of $495,000. If the asset is leased rather than purchased, the NPV is reduced by $974,000 so the present value of the leased asset is a negative $479,000 ($495,000 - $974,000). The lessor’s analysis, however, shows a positive NPV of $614,500. This implies that the lessor has overstated the value of the project by $1,093,500 ($479,000 + $614,500). How did this occur?

The evaluation of the original project shows a positive NPV of $495,000. If the asset is leased rather than purchased, the NPV is reduced by $974,000 so the present value of the leased asset is a negative $479,000 ($495,000 - $974,000). The lessor’s analysis, however, shows a positive NPV of $614500. This implies that the lessor has overstated the value of the project by $1,093,500 ($479,000 + $614,500). How did this occur?

The lessor’s overstatement is due to the fact that the present value of the lease payments has been understated (and the value of the project has been overstated) because the lease payments have been discounted at 10%, the company’s cost of capital, rather than at the correct rate of 6%, the company’s borrowing rate. The impact is shown below: PV(L) at 6%: ($900,000)(7.360) = $6,624,000 PV(L) at 10%: ($900,000)(6.145) = $5,530,500 Difference: $1,093,500

(1) Suppose that the lease is structured as a “capital lease” for financial reporting

purposes, i.e., the present value of the lease is capitalized as an asset and is

systematically amortized over the life of the lease. In addition, the lease

payments are recognized as serial repayments of debt, with an implicit interest

rate of six percent per annum (the firm’s borrowing rate). Determine how this

arrangement would affect Luther’s ROA and RI in the first year of the lease

term. (Note that the implicit interest expense would not be reported on the

divisional income statement, because ROA is compared to capital costs as a

benchmark, and RI already includes a charge for capital employed by the

division.)

The lease would be capitalized at its present value of $6,624,000. Assuming straight-line amortization of the leased asset, each year would report operating income of $337,600 ($1,000,000 - $662,400). ROA in the initial year would be 5.1%. RI in the first year would be a negative $ 324,800 ($337,600 – 10% x $6,624,000). Note that these amounts are lower than those for the purchase of the equipment, and reflect the fact that the lease is not an economical method of obtaining the asset.

(1) Discuss the underlying reasons why a capital project having a positive NPV,

and an internal rate of return that exceeds the project’s risk-adjusted required

return, would have negative impacts on ROA and RI. (Hint: Consider the

income pattern that would be reported if the investment described above was

a financial asset, e.g. a serial debt instrument with a cost of $5,650,000 and

annual cash receipts of $1,000,000.)

When capital projects are evaluated using discounting methods such as NPV and/or IRR, the implied income pattern is the same as would result from a financial instrument with similar cash flows. Conventional accounting methods for depreciation and amortization, however, are not based on compound interest concepts, and generally result in higher depreciation/amortization charges in the earlier years of asset use. This feature may bias managers against economically beneficial asset investments, or may bias the financing of assets towards operating lease arrangements.

Transfer Transfer PricingPricing

Transfer PricingTransfer Pricing

Value or amount recorded in a firm’s accounting records when one business unit sells (transfers) a good or service to another business unit

Cost to the buying unit

Revenue to the selling unit

Transfer price

Price that leads both division managers, who act in their own self-interest, to make decisions that are in the firm’s best interest

Managers are evaluated on performance and both division managers want to maximize revenues and minimize costs.

The transfer price is revenue to the seller division and cost to the buyer division. As a result, divisional comparisons are affected.

The outside market for an intermediate product

The inside market for an intermediate product

Seller division Buyer division

Outside supplier Outside buyer

The outside market for an intermediate product

The inside market for an intermediate product

Seller division Buyer division

Outside supplier Outside buyer

General Guidelines

Minimum transfer price= Incremental costs per unit incurred

up to the point of transfer+ Opportunity costs per unit to the selling division

Case: Supplier division operates at full capacity.Transfer price: external market price (i.e., variable

cost plus contribution margin)

Case: Supplier division has excess capacity.Transfer price: variable costs of production.

Transfer-Pricing Methods

Market-based transfer prices: prices charged by competing suppliers, sometimes reduced for internal efficiencies.

Cost-based transfer prices: Variable cost Variable cost plus markup Full cost Full cost plus markup

Negotiated transfer prices

Dual transfer prices

Transfer pricing systems often have additional objectives:

Transfer pricing systems often have additional objectives:

Minimize global income tax burdens

Transfer pricing systems often have additional objectives:

Minimize global income tax burdens

Repatriate profits to avoid exchange controls

Transfer pricing systems often have additional objectives:

Minimize global income tax burdens

Repatriate profits to avoid exchange controls

Provide advantages in contract negotiations (e.g., union contracts)

Transfer pricing systems often have additional objectives:

Minimize global income tax burdens

Repatriate profits to avoid exchange controls

Provide advantages in contract negotiations (e.g., union contracts)

>Discourage competition in profitable markets.

Handout 15 (a):Transfer Pricing

General Rule

Multilateral Company includes two divisions, Hexagon and Octagon, which are organized as profit centers. The Hexagon Division produces circuit boards at a variable cost per unit of $16.00. These items may be either sold to outside customers for $20.00 per unit, or transferred to the Octagon Division at a negotiated transfer price. The Octagon Division incurs additional variable unit costs of $14.00 per unit in producing a product for outside customers that sell for $33.00.

Multilateral Company includes two divisions, Hexagon and Octagon, which are organized as profit centers. The Hexagon Division produces circuit boards at a variable cost per unit of $16.00. These items may be either sold to outside customers for $20.00 per unit, or transferred to the Octagon Division at a negotiated transfer price. The Octagon Division incurs additional variable unit costs of $14.00 per unit in producing a product for outside customers that sell for $33.00.

(a) Assume that the Hexagon Division currently has substantial unused capacity. What is the lowest transfer price that the division should accept for its circuit boards? At that price, what would be the total contribution per unit earned by Quadrilateral Company? How would that profit be apportioned between the two divisions? What is the highest price that the Octagon Division would pay for the circuit boards? At that price, what would be the total contribution per unit earned by Quadrilateral Company? How would that profit be apportioned between the two divisions?

Multilateral Company includes two divisions, Hexagon and Octagon, which are organized as profit centers. The Hexagon Division produces circuit boards at a variable cost per unit of $16.00. These items may be either sold to outside customers for $20.00 per unit, or transferred to the Octagon Division at a negotiated transfer price. The Octagon Division incurs additional variable unit costs of $14.00 per unit in producing a product for outside customers that sell for $33.00.

(a) Assume that the Hexagon Division currently has substantial unused capacity. What is the lowest transfer price that the division should accept for its circuit boards? At that price, what would be the total contribution per unit earned by Quadrilateral Company? How would that profit be apportioned between the two divisions? What is the highest price that the Octagon Division would pay for the circuit boards? At that price, what would be the total contribution per unit earned by Quadrilateral Company? How would that profit be apportioned between the two divisions?

The lowest acceptable transfer price is Hexagon’s variable cost of $16 per unit. There is no opportunity cost given slack capacity. The company would earn a contribution of $3 per unit ($33 – $16 - $14) that would be reported by Octagon only. The highest price that Octagon would pay is $19 ($33 - $14). At that price, the company would earn a contribution of $3 per unit that would be reported by Hexagon only.In concept, Hexagon’s variable cost is the optimal transfer price because it reflects the marginal cost to Quadrilateral Company. In practical cases, the transfer price would usually be above the marginal cost.

(b) Assume instead that the Hexagon Division is operating at full capacity, and can sell its entire output in the external market at a unit price of $20.00. What is the lowest transfer price that the division should accept for its circuit boards? If the divisional managers act rationally, what is the total contribution per unit earned by Quadrilateral Company? How would that profit be apportioned between the two divisions?

(b) Assume instead that the Hexagon Division is operating at full capacity, and can sell its entire output in the external market at a unit price of $20.00. What is the lowest transfer price that the division should accept for its circuit boards? If the divisional managers act rationally, what is the total contribution per unit earned by Quadrilateral Company? How would that profit be apportioned between the two divisions?

The external market price of $20 should be the transfer price, because it reflects the variable cost and the opportunity cost of sales in the external market (each unit transferred forgoes sales proceeds of $20). At this price, Octagon would not buy internally, Hexagon would sell to external customers, and the company would earn $4 per unit ($20 - $16).

Handout 15 (b):Transfer Pricing

Multiple Objectives

The Numero Company is vertically integrated, and consists of three divisions. The Uno Division fabricates component parts; the Duo Division assembles the components into household appliances; and the Tres Division performs a range of distribution activities including transportation, warehousing, and operation of wholesale and retail outlets. The divisions are organized as profit centers. Divisional managers aim to maximize profits, and have the discretion to use outside suppliers and also to sell to outside customers. Relevant cost and revenue information is provided below:

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

(a) Variable production costs incurred in the division, excluding transfer costs from other divisions.

(b) Price per unit paid to sister divisions for intra-company purchases (c) Current market prices to outside customers for division’s products or services. (d) Current market prices from outside suppliers for division’s purchase requirements

Sketch these relations on the board.

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

(1) Assume that the Uno and Dos divisions both have substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

(1) Assume that the Uno and Dos divisions both have substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

With idle capacity in both Uno and Dos, all transfers should be made at variable unit costs. The price from Uno to Dos should be $20, and the price from Dos to Tres should be $36 ($16 + $20). Tres will incur additional variable costs of $14, and the unit contribution will be $50 ($100 - $36 - $14). Tres would report all of this contribution.

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

(1) Assume that the Uno and Dos divisions both have substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

With idle capacity in both Uno and Dos, all transfers should be made at variable unit costs. The price from Uno to Dos should be $20, and the price from Dos to Tres should be $36 ($16 + $20). Tres will incur additional variable costs of $14, and the unit contribution will be $50 ($100 - $36 - $14). Tres would report all of this contribution.

(2) Assume that the Uno Division can sell all of its production to outside customers, so that any internal transfers would displace outside sales. The Dos Division has substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

(1) Assume that the Uno and Dos divisions both have substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

With idle capacity in both Uno and Dos, all transfers should be made at variable unit costs. The price from Uno to Dos should be $20, and the price from Dos to Tres should be $36 ($16 + $20). Tres will incur additional variable costs of $14, and the unit contribution will be $50 ($100 - $36 - $14). Tres would report all of this contribution.

(2) Assume that the Uno Division can sell all of its production to outside customers, so that any internal transfers would displace outside sales. The Dos Division has substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

Uno should transfer to Dos at the outside sales price of $30. Dos has idle capacity and should transfer to

Tres at $46 ($30 + $16). Tres will report a contribution of $40 ($100 - $46 - $14). Uno will report a profit of $10 ($30 - $20). Total company profit will be $50 ($10 + $40).

(3) Assume that the Dos Division can sell all of its production in the outside market, so that any internal transfers would displace outside sales. The Uno Division has substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

(3) Assume that the Dos Division can sell all of its production in the outside market, so that any internal transfers would displace outside sales. The Uno Division has substantial idle capacity. Determine the appropriate transfer prices from Uno to Dos, and from Dos to Tres. At those transfer prices, what will be the total unit contribution earned by Numero Company? How will that total contribution be apportioned to each of the three divisions?

Uno should transfer to Dos at the variable cost of $20. Dos should transfer to Tres at the outside sales price of $48. Tres will report a contribution of $38 ($100 - $14 - $48). Dos will report a profit of $12 ($48 - $20 - $16). Total company profit will be $50 ($12 + $38).

Numero Company Divisions Uno Dos Tres Variable unit costs (a) $ 20.00 $ 16.00 $ 14.00 Transfer costs (b) 0 ? ? Sales price, external market (c) $ 30.00 $ 48.00 $ 100.00 Purchase price, external market (d) --- $ 30.00 $ 48.00

Note: The following questions are for discussion purposes, and do not require specific numerical answers. (4) You have been informed that the Uno and Tres divisions are in relatively high tax

rate jurisdictions that impose gross receipts and ad valorem taxes on local business operations. The Duo division, in contrast, is taxed based on local real estate assessments that are not directly related to operating results. How would these tax differences affect your suggested transfer pricing recommendations?

Note: The following questions are for discussion purposes, and do not require specific numerical answers. (4) You have been informed that the Uno and Tres divisions are in relatively high tax

rate jurisdictions that impose gross receipts and ad valorem taxes on local business operations. The Duo division, in contrast, is taxed based on local real estate assessments that are not directly related to operating results. How would these tax differences affect your suggested transfer pricing recommendations?

In order to minimize the tax burden, the profits reported by Uno and Tres should be minimized. The transfer price from Uno to Dos should be as low as possible, and the transfer price from Dos to Tres should be as high as possible. For practical purposes, including the likelihood of oversight by local taxing authorities, the transfer price from Uno will not be lower than Uno’s variable cost, and the transfer price to Tres will not be higher than the external market price for Dos’s output.

Note: The following questions are for discussion purposes, and do not require specific numerical answers. (4) You have been informed that the Uno and Tres divisions are in relatively high tax

rate jurisdictions that impose gross receipts and ad valorem taxes on local business operations. The Duo division, in contrast, is taxed based on local real estate assessments that are not directly related to operating results. How would these tax differences affect your suggested transfer pricing recommendations?

In order to minimize the tax burden, the profits reported by Uno and Tres should be minimized. The transfer price from Uno to Dos should be as low as possible, and the transfer price from Dos to Tres should be as high as possible. For practical purposes, including the likelihood of oversight by local taxing authorities, the transfer price from Uno will not be lower than Uno’s variable cost, and the transfer price to Tres will not be higher than the external market price for Dos’s output.

(5) You have been informed that the Duo division is located in a foreign nation that has very strict foreign exchange controls, and does not permit companies to repatriate profits to their home countries without onerous penalties. Currently, Duo’s operating cash flows are substantially higher than Numero requires for local re-investment. How would the existence of these restrictions affect your suggested transfer pricing recommendations?

Note: The following questions are for discussion purposes, and do not require specific numerical answers. (4) You have been informed that the Uno and Tres divisions are in relatively high tax

rate jurisdictions that impose gross receipts and ad valorem taxes on local business operations. The Duo division, in contrast, is taxed based on local real estate assessments that are not directly related to operating results. How would these tax differences affect your suggested transfer pricing recommendations?

In order to minimize the tax burden, the profits reported by Uno and Tres should be minimized. The transfer price from Uno to Dos should be as low as possible, and the transfer price from Dos to Tres should be as high as possible. For practical purposes, including the likelihood of oversight by local taxing authorities, the transfer price from Uno will not be lower than Uno’s variable cost, and the transfer price to Tres will not be higher than the external market price for Dos’s output.

(5) You have been informed that the Duo division is located in a foreign nation that has very strict foreign exchange controls, and does not permit companies to repatriate profits to their home countries without onerous penalties. Currently, Duo’s operating cash flows are substantially higher than Numero requires for local re-investment. How would the existence of these restrictions affect your suggested transfer pricing recommendations?

In this case Duo’s contribution should be minimized. The transfer price from Uno should be set as high as possible (but no higher than the external market price for Uno’s output), and the transfer price to Tres should be set as low as possible (but no lower than Duo’s variable cost plus the transfer price from Uno).