The following data are available for two divisions of Solomons Company. North Division South Division Division operating profit $ 6,000,000 $ 40,000,000 Division investment 30,000,000 320,000,000 The cost of capital for the company is 8 percent. Ignore taxes. Required: a-1. Calculate the ROI for both North and South divisions. a-2. If Solomons measures performance using ROI, which division had the better performance? b-1. Calculate the EVA for both North and South divisions. (The divisions have no current liabilities.) b-2. If Solomons measures performance using economic value added, which division had the better performance? c. Would your evaluation change if the company's cost of capital was 16 percent? 1. When evaluated by ROI? 2. When evaluated by EVA?

a-1. Calculate the ROI for both North and South divisions.

ROI North Division = net profit / cost of investment = $6,000,000 / $30,000,000 = 20% ROI South Division = net profit / cost of investment = $30,000,000 / $320,000,000 = 9.38%

a-2. If Solomons measures performance using ROI, which division had the better performance?

North Division, since its ROI is much higher

b-1. Calculate the EVA for both North and South divisions. (The divisions have no current liabilities.)

North Division EVA = (net investment) x (actual return on investment - percentage cost of capital) = $30,000,000 x (20% - 8%) = $3,600,000 South Division EVA = (net investment) x (actual return on investment - percentage cost of capital) = $320,000,000 x (9.38% - 8%) = $4,416,000

b-2. If Solomons measures performance using economic value added, which division had the better performance?

It should choose South Division because its EVA is higher.

c. Would your evaluation change if the company's cost of capital was 16 percent?

1. When evaluated by ROI?

No it would not change because ROI doesn't consider cost of capital.

2. When evaluated by EVA?

Yes it would change because South Division's EVA would be negative, while North Division's will decrease but remain positive.

North Division EVA = (net investment) x (actual return on investment - percentage cost of capital) = $30,000,000 x (20% - 16%) = $1,200,000

South Division EVA = (net investment) x (actual return on investment - percentage cost of capital) = $320,000,000 x (9.38% - 16%) = - 21,184,000

Solomons Company

North and South Divisions

North/South Divisions:

Operating Profit = $6,000,000/$40,000,000

Investment = $30,000,000/$320,000,000

Cost of Capital (WACC) = 8%

a-1) ROI for both North and South Divisions:

ROI = Return on Investment

= Operating Profit/Investment x 100

North's ROI = 6/30 x 100 = 20%

South's ROI = 40/320 x 100 = 12%

a-2) If Solomons measures performance using ROI, the North division had the better performance.

b-1) Calculation of EVA for both North and South divisions:

EVA = Economic Value Added.

EVA = Net Operating Profit After Taxes minus (Invested Capital x WACC)

North's EVA = $6,000,000 - ($30,000,000 x 8%) = 6m - 2.4m = $3,600,000

South's EVA = $40,000,000 - ($320,000,000 x 8%) = 40m - 25.6m = $14,400,000

b-2) If Solomons measures performance using economic value added, the South division had the better performance.

c) 1. When ROI is evaluated using 16% cost of capital, the North division had a better performance. So the evaluation changes based on the 16% cost of capital. Whereas, North makes 20% ROI as against 16% cost of capital, the South manages 12% ROI as against 16% cost of capital.

c) 2. When performances are evaluated by EVA with 16% cost of capital:

North's EVA = $6,000,000 - ($30,000,000 x 16%) = 6m - 4.8m = $1,200,000

South's EVA = $40,000,000 - ($320,000,000 x 16%) = $40m - $51.2m = ($11,200,000)

When evaluated by EVA using 16% cost of capital, my evaluation would favour the North instead of the South.

Explanation:

ROI or Return on Investment is a financial performance measure which measures the profitability of an investment in a simple way. It compares the return on an investment relative to its cost. It is expressed as a percentage.

EVA or Economic Value Added is also a financial performance measure which subtracts the cost of capital from the operating profit in order to gauge in dollars terms the value created by the firm.