Question 1

Joseph Ltd operates two divisions Alpha and Omega Divisions. The company has two sources of funds: a long-term debt with a market value of $12 million at an interest rate of 10% and equity capital with a market value of $35 million at cost of equity of 7.5%. The company applies the same weighted average cost of capital to both divisions as the two divisions face similar risks.

The following information relates to the year 2021.

Non-current assets Current assets Current liabilities Profit before interest and tax

Alpha Division $000 17,900 3,100

1,000 4,000

Omega Division $000 45,100 10,300

2,800 5,000

The 2021 profits included restructuring expenses of $990,000 in Alpha Division and $4,800,000 in Omega Division that will benefit the company for an average of three years.

Average tax rate 17%. Assume the economic and accounting depreciation is the same. Use total assets minus current liabilities as investments for the performance measures. Required: (a) Calculate for each of the divisions, the following:

1. (i) Return on Investment.

2. (ii) Economic Value Added (EVA)

(b) Compare and briefly explain the performance of the two divisions based on the

performance measures computed in parts (a)(i) and (ii).

(c) The divisional managers are considering investing in new machinery: $3,500,000 in Alpha Division that is estimated to add $420,000 to pre-tax profits and Omega division was considering the investment of an additional $4,900,000 in machinery that will add $550,000 to the divisions pre-tax profits in the next year.

Compute the next years expected ROI and EVA of each of the divisions (assume all other figures unchanged except for the additional profits and investment costs of the new machinery) and assess whether the divisional managers are likely to embark on the new investments next year if the divisions performance are measured by ROI or EVA.

(d) Compare and contrast the ROI performance measure with the EVA. Which performance measurement is better to evaluate the divisional performances?