# 5 questions Due 3 hours

 1.The Caribbean Division of Mega-Entertainment Corporation just started operations. It purchased depreciable assets costing \$30.5 million and having a four-year expected life, after which the assets can be salvaged for \$6.1 million. In addition, the division has \$30.5 million in assets that are not depreciable. After four years, the division will have \$30.5 million available from these non-depreciable assets. This means that the division has invested \$61 million in assets with a salvage value of \$36.6 million. Annual depreciation is \$6.1 million. Annual operating cash flows are \$15.1 million. In computing ROI, this division uses end-of-year asset values in the denominator. Depreciation is computed on a straight-line basis, recognizing the salvage values noted. Ignore taxes.

 Required:

Compute ROI, using net book value and gross book value for each year. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

 ROI – Net book value (%) ROI – Gross book value (%) Year 1 Year 2 Year 3 Year 4

2.

 The Caribbean Division of Mega-Entertainment Corporation just started operations. It purchased depreciable assets costing \$24 million and having a 4-year expected life, after which the assets can be salvaged for \$4.8 million. In addition, the division has \$24 million in assets that are not depreciable. After four years, the division will have \$24 million available from these nondepreciable assets. This means that the division has invested \$48 million in assets with a salvage value of \$28.8 million. Annual depreciation is \$4.8 million. Annual operating cash flows are \$18 million. Depreciation is computed on a straight-line basis, recognizing the salvage values noted. Ignore taxes. Assume that the division uses beginning-of-year asset values in the denominator for computing ROI.

 Required:

Compute ROI, using net book value and gross book value. (Round your answers to 1 decimal place.)

 ROI – Net book value (%) ROI – Gross book value (%) Year 1 Year 2 Year 3 Year 4

3.

 Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has \$4,500,000 in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested \$3,500,000 in automated equipment for test machine assembly. The division’s expected income statement at the beginning of the year was as follows:

 Sales revenue \$ 18,000,000 Operating costs Variable 2,000,000 Fixed (all cash) 8,000,000 Depreciation New equipment 1,750,000 Other 1,250,000 Division operating profit \$ 5,000,000

 A sales representative from LSI Machine Company approached Oscar in October. LSI has for \$6,600,000 a new assembly machine that offers significant improvements over the equipment Oscar bought at the beginning of the year. The new equipment would expand division output by 10 percent while reducing cash fixed costs by 5 percent. It would be depreciated for accounting purposes over a 3-year life. Depreciation would be net of the \$600,000 salvage value of the new machine. The new equipment meets Pitt’s 20 percent cost of capital criterion. If Oscar purchases the new machine, it must be installed prior to the end of the year. For practical purposes, though, Oscar can ignore depreciation on the new machine because it will not go into operation until the start of the next year.

 The old machine, which has no salvage value, must be disposed of to make room for the new machine.

 Pitt has a performance evaluation and bonus plan based on ROI. The return includes any losses on disposal of equipment. Investment is computed based on the end-of-year balance of assets, net book value. Ignore taxes.

 Required:

 (a) What is Forbes Division’s ROI if Oscar does not acquire the new machine? (Round your answer to 1 decimal place.)

 (b) What is Forbes Division’s ROI this year if Oscar acquires the new machine? (Round your answer to 1 decimal place.)

 (c) If Oscar acquires the new machine and it operates according to specifications, what ROI is expected for next year? (Round your answer to 1 decimal place.)

4.

 Pharmaceutical firms, oil and gas companies, and other ventures inevitably incur costs on unsuccessful investments in new projects (e.g., new drugs or new wells). For oil and gas firms, a debate continues over whether those costs should be written off as period expense or capitalized as part of the full cost of finding profitable oil and gas ventures. For pharmaceutical firms, GAAP in the United States is clear that R&D costs are to be expensed when incurred. Pharm-It has been writing R&D costs off to expense as incurred for both financial reporting and internal performance measurement. However, this year a new management team was hired to improve the profit of Pharm-It’s Cardiology Division. The new management team was hired with the provision that it would receive a bonus equal to 10 percent of any profits in excess of base-year profits of the division. However, no bonus would be paid if profits were less than 20 percent of end-of-year investment. The following information was included in the performance report for the division:

 This Year Base Year Increase over Base Year Sales revenues \$ 21,000,000 \$ 20,500,000 Costs incurred R&D Expense 0 4,100,000 Depreciation and other amortization 3,650,000 3,500,000 Other costs 7,750,000 7,500,000 Division profit \$ 9,600,000 \$ 5,400,000 \$ 4,200,000 End-of-year investment \$ 40,500,000 a \$ 34,500,000

 a Includes other investments not at issue here.

 During the year, the new team spent \$5 million on R&D activities, of which \$4,500,000 was for unsuccessful ventures. The new management team has included the \$4,500,000 in the current end-of-year investment base because “You can’t invent successful drugs without missing on a few unsuccessful ones.”

 Required:

 (a) What is the ROI for the base year and the current year? Ignore taxes. (Round your answers to 1 decimal place.)

 (1) If R&D is expensed:

 (2) If R&D is capitalized:

 (b) What is the amount of the bonus that the new management team is likely to claim? (Enter your answer in dollars and not in millions.)

(c)

If you were on Pharm-It’s board of directors, how would you respond to the new management’s claim for the bonus?

 [removed] The board should reject the request for a bonus. [removed] The board should accept the request for a bonus.

5.

 Biddle Company uses EVA to evaluate the performance of division managers. For the Wallace Division, after-tax divisional income was \$450,000 in year 3. The company adjusts the after-tax income for advertising expenses. First, it adds the annual advertising expenses back to after-tax divisional income. Second, the company managers believe that advertising has a three-year positive effect on the sale of the company’s products, so it amortizes advertising over three years. Advertising expenses in year 1 will be expensed 55 percent, 30 percent in year 2, and 15 percent in year 3. Advertising expenses in year 2 will be expensed 55 percent, 30 percent in year 3, and 15 percent in year 4. Advertising expenses in year 3 will be amortized 55 percent, 30 percent in year 4, and 15 percent in year 5. Third, unamortized advertising expenses become part of the divisional investment in the EVA calculations. Wallace Division had incurred advertising expenses of \$120,000 in year 1 and \$220,000 in year 2. It incurred \$260,000 of advertising in year 3. Before considering the unamortized advertising, the Wallace Division had total assets of \$4,250,000 and current liabilities of \$610,000 at the beginning of year 3. Biddle Company calculates EVA using the divisional investment at the beginning of the year. The company uses a 13.0 percent cost of capital to compute EVA.

 Required:

 Compute the EVA for the Wallace Division for year 3. (Negative amount should be indicated by a minus sign. Round your final answer to the nearest dollar amount.)

Is the division adding value to shareholders?

 [removed] No [removed] Yes