Ready Products, Inc., operates two divisions, each with its own manufacturing facility. The accounting system reports the following data for 2010:

HEALTH CARE PRODUCTS DIVISION

Income Statement for the Year

Ended December 31, 2010 (000s)

Revenues ...............$600

Operating costs ............ 470

Operating income ...........$130

COSMETICS DIVISION

Income Statement for the Year

Ended December 31, 2010 (000s)

Revenues ................$600

Operating costs ............ 400

Operating income ...........$200

Ready estimates the useful life of each manufacturing facility to be 15 years. As of the end of 2010, the plant for the health-care division is four years old, while the manufacturing plant for the cosmetics division is six years old. Each plant had the same cost at the time of purchase, and both have useful lives of 15 years with no salvage value. The company uses straight-line depreciation and the depreciation charge is $70,000 per year for each division. The manufacturing facility is the only long-lived asset of either division. Current assets are $300,000 in each division. An index of construction costs, replacement cost, and liquidation values for manufacturing facilities for the period that Ready has been operating is as follows:

		Replacement	Liquidation Value
Year	Cost Index	Cost	Healthcare	Cosmetics
2004	80	$1,000,000	$800,000	$800,000
2005	82	1,000,000	800,000	800,000
2006	84	1,100,000	700,000	700,000
2007	89	1,150,000	600,000	700,000
2008	94	1,200,000	600,000	800,000
2009	96	1,250,000	600,000	900,000
2010	100	1,300,000	500,000	1,000,000

Required
1. Compute ROI for each division using the historical cost of divisional assets (including current assets) as the investment base. Interpret the results.
2. Compute ROI for each division, incorporating current-cost estimates as follows:
a. Gross book value (GBV) of long-lived assets, plus book value of current assets.
b. GBV of long-lived assets restated to current cost using the index of construction costs, plus book value of current assets.
c. Net book value of long-lived assets restated to current cost using the index of construction costs, plus book value of current assets.
d. Current replacement cost of long-lived assets, plus book value of current assets.
e. Current liquidation value of long-lived assets, plus book value of current assets.
3. Which of the measures calculated in requirement 2 would you choose to (a) evaluate the performance of each division manager, and (b) decide which division is most profitable for the overall firm. What are the strategic advantages and disadvantages to the firm of each measure for both (a) and(b)?

Transcribed Image Text:

3. a. The best measure for evaluating the manager is replacement cost, as it corresponds to the "going-concern" value of the investment. The objective is t identify a measure of investment that fairly reflects the productive capacity of the assets. Often, net book value falls much faster than the productive capability of the assets, and thus, the ROI with the older assets overstates the profitability of the unit. The use of gross book value or current cost can help reduce the bia favoring divisions with older assets. It is superior to net book value and gross book value which are not related to the current value of the investment. While th gross book value of the investment is superior to net book value (since it is not biased by the age of the assets), a direct measure of current value such a replacement cost is preferable. Liquidation value is not used because the divisions are not for sale, nor is sale of either division currently contemplated. The advantages of the replacement cost measure are fairness, since it avoids the age bias issues associated with the net book value measure, an motivation, since it reflects the current value of the asset and therefore what investment value the manager has to work with. The use of a construction cos index is a further improvement on gross book value, and is useful when a reasonably meaningful measure of replacement cost is not available because, fo example, the assets are very specialized and replacement costs would be extremely high. b. The evaluation of the division should use replacement cost for the same reasons as explained in (a) above. The only difference here is when either division might be sold or relocated, in which case the liquidation value is relevant. Top management can also look at the liquidation value based ROI as a direct measur of whether the business or division should be sold the division should earn a favorable return on liquidation value, and if not, then management should conside liquidation.