Comparing Performance Evaluation Methods [LO 4,5,6] Top management of the Gates

ID: 2668425 • Letter: C

Question

Comparing Performance Evaluation Methods [LO 4,5,6]

Top management of the Gates Corporation is trying to construct a performance evaluation system to use to evaluate each of its three divisions. This past year’s financial data are as follows:

Division A Division B Division C
Total assets $520,000 $10,400,000 $6,030,000
Non interest-bearing current liabilities 29,000 1,180,000 560,000
Net income 102,000 1,040,000 750,000
Interest expense 29,900 1,140,000 690,000
Tax rate 40% 40% 40%
Required rate of return 9.30% 11.50% 15.60%

How would the divisions be ranked (from best to worst performance) if the evaluation were based on net income?

Net Income Rank
Division A $ 102,000 Rank 3
Division B $ 1,040,000 Rank 1
Division C $ __________ Rank 2

How would the divisions be ranked (from best to worst performance) if the evaluation were based on ROI? (Enter answer to 2 decimal places, e.g. 5.25.)

ROI Rank
Division A ____% Rank 1
Division B ____% Rank 3
Division C ____% Rank 2

How would the divisions be ranked (from best to worst performance) if the evaluation were based on residual income? (Round calculations and final answer to 0 decimal places, e.g. 5,025.)

Residual Income Rank
Division A $ _________ _______
Division B $ _________ ________
Division C $ _________ ________

Explanation / Answer

Division A

Division B

Division C

Total Assets

$520,000

$10,400,000

$6,030,000

Non interest-bearing current liabilities

$29,000

$1,180,000

$560,000

Net Income

$102,000

$1,040,000

$750,000

Interest expenses

$29,900

$1,140,000

$690,000

Tax Rate

40%

Required Rate of Return

9.30%

11.50%

15.60%

How would the divisions be ranked (from best to worst performance) if the evaluation were based on Net Income?

Net Income Rank:

Division A $102,000 Rank 3

Division B $1,040,000 Rank 1

Division C $750,000 Rank 2

How would the divisions be ranked (from best to worst performance) if the evaluation were based on ROI?

ROI (Return on Investment) = [Return / Investment]

Total Assets = [Long-term Liabilities + Capital Investment]

Division A:

$520,000 = [$29,000 + Capital Investment]

$520,000 - $29,000 = Capital Investment

Capital Investment of Division A = $491,000

Division B:

$10,400,000 = [$1,180,000 + Capital Investment]

[$10,400,000 - $1,180,000] = Capital Investment

Capital Investment of Division B = $9,220,000

Division C:

$6,030,000 = [$560,000 + Capital Investment]

[$6,030,000 - $560,000] = Capital Investment

Capital Investment of Division C = $5,470,000

ROI of Division A = [$102,000 / $491,000]

ROI of Division A = 0.2077 (or) 20.77%

ROI of Division B = [$1,040,000 / $9,220,000]

ROI of Division B = 0.1128 (or) 11.28%

ROI of Division C = [$750,000 / $5,470,000]

ROI of Division C = 0.1371 (or) 13.71%

ROI Rank:

Division A 20.77% Rank 1

Division B 11.28% Rank 3

Division C 13.71% Rank 2

How would the divisions be ranked (from best to worst performance) if the evaluation were based on residual income?

= Net Operating Profit After taxes – (Cost of Capital * [Total Assets – Non-interest bearing current liabilities]

Net Operating Profit of Division A = [($102,000 / 0.60) + $29,900]

Net Operating Profit of Division A = $199,900

Net Operating Profit after taxes of Division A = [$199,900 – ($199,900 * 40%)]

Net Operating Profit after taxes of Division A = [$199,900 - $79,960]

Net Operating Profit after taxes of Division A = $119,940

Residual Income of Division A = [$119,940 – (9.30% * {$520,000 - $29,000}]

Residual Income of Division A = [$119,940 – (9.30% * $491,000)]

Residual Income of Division A = [$119,940 - $45,663]

Residual Income of Division A = $74,277

Net Operating Profit of Division B = {($1,040,000 / 0.60) + $1,140,000]

Net Operating Profit of Division B = $2,873,333.33

Net Operating Profit after taxes of Division B = [$2,873,333.33 – ($2,873,333.33 * 40%)]

Net Operating Profit after taxes of Division B = [$2,873,333.33 - $1,149,333.33]

Net Operating Profit after taxes of Division B = $1,724,000

Residual Income of Division B = [$1,724,000 – (11.50% * {$10,400,000 - $1,180,000}]

Residual Income of Division B = [$1,724,000 - $1,060,300]

Residual Income of Division B = $663,700

Net Operating Profit of Division C = [($750,000 / 0.60) + $690,000]

Net Operating Profit of Division C = $1,940,000

Net Operating Profit after taxes of Division C = [$1,940,000 – ($1,940,000 * 40%)]

Net Operating Profit after taxes of Division C = [$1,940,000 - $776,000]

Net Operating Profit after taxes of Division C = $1,164,000

Residual Income of Division C = [$1,164,000 – (15.60% {$6,030,000 - $560,000)]

Residual Income of Division C = [$1,164,000 - $853,320]

Residual Income of Division C = $310,680

Residual Income Rank:

Division A $74,277 Rank 3

Division B $663,700 Rank 1

Division C $310,680 Rank 2