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Case 7.1 : Investment center Problems (A)
The ABC Company has three division (A,B,C). Division A eclusively a marketing division. Division B exclusively a manufacturing division and Division C is both a manufacturing aand marketing division. The following are the financial facts for each of these divisions:
Current Assets Fixed Assets Total Assets Profit befor depreciation and market development cost Division A $ 100.000 $ $ 100.000 $ 200.000 Division B $ 100.000 $ 1.000.000 $ 1.100.000 $ 200.000 Division C $ 100.000 $ 500.000 $ 600.000 $ 200.000
Assume that the ABC Company depreciates fixed assets on a SLM over 10 years. To maintain its market and productive facilities, it has to invest $100,000 per year in market development in Division A and $50,000 per year in Division C. This is written off as an expense. It also has to replace 10% of its productive facilities each year. Under this equilibrium conditions, what are the annual rates of return earned by each of the division? Answer:
A 200.000 0 100.000 100.000 100.000 100,00% Division B 200.000 100.000 100.000 1.100.000 9,09% C 200.000 50.000 50.000 100.000 600.000 16,67% Total $ 600.000 $ 150.000 $ 150.000 $ 300.000 $ 1.800.000 16,67%
Profit befor depreciation and market development cost Less: Depreciation Less: Mrket Development Cost Net Profit Total Assets ROI = (Net Profit/Total Assets)*100
$ $ $ $
$ $ $ $ $
$ $ $ $ $
Current Assets Fixed Assets Total Assets Gross Profit From Sales
Gross profit from sales Less: Operating Expense Net Profit Total Assets ROI = (Net Profit/Total Assets)*100
$ $ $ $
$ $ $
Equity
$ $ $
Total Equities
Sales Cost Other than those list below Depreciation Allocated Share of Corporate expense Income before income tax
There are many methods to evaluate the performance of each division. We can use profitability ratios, liquidity ratio and debt ratio and so on to do the measurement. Just like many big company in the world, ROI, the indicator of money gained or lost on an investment relative to the amount of money invested, is the most popular way to do the measurement. However, in my opinion, EVA or RI should be a better method to evaluate the performance of each division separately. Let use EVA to explain the reason of EVA being a better approach. EVA is net operating profit after taxes less the money cost of capital. If the company uses ROI to measure the performance, it cannot maximize the shareholders value. When there is a project which will increase the value of the company but will decrease the ROI result, the manager will cancel it. But if