Questions -
Q1. Suburban Lifestyles, Inc. has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers' lots. Suburban Lifestyles expanded into the precut housing market when it acquired Fairmont Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers' lots for assembly. Suburban Lifestyles' management designated the Fairmont Division as an investment center. Suburban uses return on investment (ROI) as a performance measure with investment defined as average productive assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum return of 15 percent before income taxes. Fairmont's ROI has ranged from 19.3 to 22.1 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an estimated ROI of 18 percent. Fairmont's management decided against the investment because it believed the investment would decrease the division's overall ROI. The 20x1 income statement for Fairmont Division follows. The division's productive assets were $25,200,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year.
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FAIRMONT DIVISION Income Statement For the Year Ended December 31, 20x1 (in thousands)
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Sales Revenue
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$48,000.00
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Cost of Good Sold
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$31,600.00
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Gross Margin
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$16,400.00
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Operating expenses:
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Administrative
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$4,280.00
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Selling
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$7,200.00
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$11,480.00
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Income from operations before income taxes
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$4,920.00
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Required:
1. Calculate the following performance measures for 20x1 for the Fairmont Division.
a. Return on investment (ROI).
b. Residual income.
2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20x1 if residual income were used as a performance measure instead of ROI? Explain your answer.
Q2. Golden Gate Construction Associates, a real estate developer and building contractor in San Francisco, has two sources of long-term capital: debt and equity. The cost to Golden Gate of issuing debt is the after-tax cost of the interest payments on the debt, taking into account the fact that the interest payments are tax deductible. The cost of Golden Gate's equity capital is the investment opportunity rate of Golden Gate's investors, that is, the rate they could earn on investments of similar risk to that of investing in Golden Gate Construction Associates. The interest rate on Golden Gate's $90 million of long-term debt is 10 percent, and the company's tax rate is 40 percent. The cost of Golden Gate's equity capital is 15 percent. Moreover, the market value (and book value) of Golden Gate's equity is $135 million.
Required: Calculate Golden Gate Construction Associates' weighted-average cost of capital.
Q3. Refer to the data in the preceding exercise for Golden Gate Construction Associates. The company has two divisions: the real estate division and the construction division. The divisions' total assets, current liabilities, and before-tatx operating income for the most recent year are as follows:
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Division
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Total Assets
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Current Liabilities
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Before-Tax Operating Income
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Real Estate
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$150,000,000.00
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$9,000,000.00
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$30,000,000.00
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Construction
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$90,000,000.00
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$6,000,000.00
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$27,000,000.00
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Required: Calculate the economic value added (EVA) for each of Golden Gate Construction Associates' divisions. (You will need to use the weighted-average cost of capital, which was computed in the preceding exercise.)