ROI, RI, EVA. 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 2008 are as follows:

1. Calculate return on investment (ROI) for each division using operating income as a measure of income and total assets as a measure of investment

2. Calculate residual income (RI) 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 eachdivision.

Transcribed Image Text:

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