978-0133058789 Chapter 10 Part 2

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10-38 (25 min.)

1. The two separate components highlight certain features of profitability that are

not revealed by the single calculation.

a. The importance of capital turnover as a key to profits is stressed.

2. Company

Adam Basil Collin

Return on sales 9% 12% .6%

Turnover on capital × 2.7 × .125 × 2.4

Return on investment 23.9% 1.5% 1.5%

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investment simply by increasing its return on sales. In contrast, Collin’s

management should concentrate on increasing the return on sales.

3. Basil has a high return on sales and a low capital turnover strategy and probably

10-39 (15-20 min.)

1. (a) Entertainment $210 ÷ $1,050 = 20%

Publishing/Information 140 ÷ 700 = 20%

Consumer/Commercial Finance 265 ÷ 1,060 = 25%

2. This requirement can lead to a lengthy discussion of what causes differences in

the three measures computed in requirement 1. The obvious difference is the

segments.

10-40 (25 – 30 min.) Amounts in thousands.

Economic

Economic Value

Profit Added

1. Year 2 EVA = $4,463 – $3,569 – $292 – (11.5% × $2,854) = $274

Year 1 EVA = $4,510 – $3,615 – $255 – (11.5% × $2,689) = $331

2. EVA decreased from $331 million to $274 million. The decrease was caused by

1. Weighted-average cost of capital:

55% × 10% = 5.50%

2. Holt’s EVA of $3.8 billion means that Holt generated $3.8 billion of value for its

shareholders above the cost of capital, the weighted average of the normal return

10-43 (20-30 min.) Dollar amounts are in thousands.

Tools Appliances Lighting

Historical Cost:

Average net assets $15,000 $44,000 $27,000

Operating income 2,600 6,750 5,000

2. The following rankings exist:

Rate of Return Economic Profit

On On On On

3. In this case, if historical cost is the base, the use of rate of return on net assets

ranks Lighting first, whereas economic profit ranks Appliances first. Used

indiscriminately, each method has its drawbacks, regardless of whether historical

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Replacement costs are more helpful than historical costs as indicators of the

relative profitability of divisions because they are usually good approximations

of the current economic sacrifice being made to conduct such operations. As for

managers, their ability to meet budgeted goals, however measured, is paramount.

Students, professors, and managers have disagreements regarding which asset

base is preferable.

10-44 (50-60 min.)

2. Some major companies, including du Pont and Monsanto Chemical, have used

gross assets as an investment base. One reason often cited for using

undepreciated cost is that it partially compensates for the impact of the changing

price level on historical cost. However, if a company desires to use replacement

cost as a base, it should not try to tailor historical costs to the measurement

measured by depreciation.) To count original cost plus the cash accumulation as a

part of the investment base (column 10) is duplication; it does not provide as

useful a base as net assets. In contrast, a plant manager’s or division manager’s

performance often is best analyzed by using gross assets as the investment base

(column 6). The reinvestment of the cash accumulation in the amount of

Accumu- Net Average On Total Gross Assets Net Assets

lated Value, Book Annual On Average Cash Average***

Gross Depreci- End Value Net Gross Book Accumu- Cash Rate of Rate of

Year Cost ation of Year for Year* Income Cost Value lation** for Year Base Return Base Return

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)

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The proponents of using net book value as a base maintain that it is less confusing

because (a) it is consistent with the total assets shown on the conventional balance

sheet and (b) it is consistent with net income computations, which include

deductions for depreciation. Using net book value prevents duplication of the

same asset in the base and shows a constantly rising rate of return on plant

performance. See column 7. Note that the inclusion of the cash accumulation and

gross fixed assets duplicates the same item, so that the total fixed and current

10-45 (30-40 min.)

The issues in this problem are covered briefly in a section in the chapter. This

problem was originally used on a final examination. In particular, note that the quotation

is dealing with how to evaluate performance, as distinguished from decisions to buy,

1. Economic values are the best for performance measurement.

3. Market (exit) value is inherently less than or equal to (usually the former)

economic value for a given asset.

5. Replacement value will facilitate the evaluation of the division’s performance

more easily than the division manager’s performance.

The statement correctly establishes economic value as the “ideal” measure of an asset’s

value. The statement fails to disclose the characteristics of economic value that make it

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in the future and (b) the appropriate discount rate to be applied to those flows in the

present value process.

The statement presents a reasonable case in favor of replacement value over exit

value.

Some remarks might be made about the fact that replacement costs of highly

specialized assets may be more difficult to obtain than a direct approximation of their

economic values via discounted cash flow techniques.

The biggest defect of the commentary is its failure to mention the cost and value

of information tradeoffs in deciding whether some “current” value basis for evaluation of

performance is superior to continuing to use historical cost.

10-46 (20-30 min.)

The rule to be used is that goods and services should be transferred at a price

equivalent to that prevailing in an outside market at the time of transfer. Where the

internal division meets these selling prices, the buying division must purchase internally.

10-47 (30 min.)

$42.70 price is met. If the shocks and struts division does not sell to the

automotive division, 70% of the strut assembly volume will disappear, and gross

margin will fall to $2,550,000 as follows:

Sales, 300,000 at $61 $18,300,000

Variable costs, at $38.50 $11,550,000

2. Yes, the division should reject intracompany sales and concentrate on outside

sales since the gross margin would be $8,300,000, whereas the gross margin if

automotive division business were accepted would be $5,490,000. The gross

10-48 (30 min.)

1. The U.S. Division should not supply the Australian Division with the sound

system for the $7.00 per unit price. The U.S. Division is operating at capacity and

for $62.00. Assuming that the $10.00 per unit for fixed overhead and

administration is an allocation of costs the Australian Division incurs regardless

3. In the short run there is an advantage to Samtech Electronics of transferring the

sound system at the $7.00 price and thus selling the Game Box for at least $62.00.

To make this happen, Samtech Electronics could overrule the decision of the U.S.

$56.60. As long as the Australian Division has excess capacity, its profit would

increase by at least $5.40 (i.e., $62.00 – $56.60) per Game Box. Therefore, both

10-49 (20-25 min.)

1. The Eugene Division manager would not buy the lumber for $70 and would not

produce the chairs. The division would lose $4 on each chair produced at that

price:

Revenue per chair $95

Division cost per chair:

2. When there is no idle capacity at the Shasta Mill, transferring lumber to the

Eugene Division causes the Mill to pass up sales to outside customers. Compare

the total contribution from selling the lumber to the total contribution from using

the lumber to build chairs and selling the chairs: