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Question: Performance Auto Company operates a New Car

Performance Auto Company operates a New Car Division (that sells high-performance sports cars) and a Performance Parts Division (that sells performance improvement parts for family cars). Some division financial measures for 2015 are as follows:
Performance Auto Company operates a New Car Division (that sells high-performance sports cars) and a Performance Parts Division (that sells performance improvement parts for family cars). Some division financial measures for 2015 are as follows:


Required:
1. Calculate return on investment for each division using operating income as a measure of income and total assets as a measure of investment.
2. Calculate residual income for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment.
3. William Abraham, the New Car Division manager, argues that the Performance Parts Division has “loaded up on a lot of short-term debt” to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the Performance Parts Division. Comment on the result.
4. Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a market value of $18,000,000 at an interest rate of 10%, and equity capital with a market value of $12,000,000 and a cost of equity of 15%. Applying the same weighted-average cost of capital (WACC) to each division, calculate EVA for each division.
5. Use your preceding calculations to comment on the relative performance of each division

Required: 1. Calculate return on investment for each division using operating income as a measure of income and total assets as a measure of investment. 2. Calculate residual income for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment. 3. William Abraham, the New Car Division manager, argues that the Performance Parts Division has “loaded up on a lot of short-term debt” to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the Performance Parts Division. Comment on the result. 4. Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a market value of $18,000,000 at an interest rate of 10%, and equity capital with a market value of $12,000,000 and a cost of equity of 15%. Applying the same weighted-average cost of capital (WACC) to each division, calculate EVA for each division. 5. Use your preceding calculations to comment on the relative performance of each division





Transcribed Image Text:

A В New Car Performance 1 Division Parts Division 2 Total assets 3 Current liabilities 4 Operating income 5 Required rate of return $33,000,000 $ 6,600,000 $ 2,475,000 12% $28,500,000 $ 8,400,000 $ 2,565,000 12%


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