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ACCT 502

Homework Problems

Adapted from Horngren, Datar and Rajan, 14^th edition

Problem 1 (Eva Manufacturing)

Eva Manufacturing makes fashion products and competes on the basis of quality and leading-edge designs.  The company has $3,000,000 invested in assets in its clothing manufacturing division.  After-tax operating income from sales of clothing this year is $600,000.  The cosmetics division has $10,000,000 invested in assets and an after-tax operating income this year of $1,600,000.  Income for the clothing division has grown steadily over the last few years.   The weighted average cost of capital for Eva is 10% and the previous period’s after-tax return on investment for each division was 15%.  The CEO of Eva has told the manager of each division that the division that “performs best” this year will get a bonus.

1) Calculate the ROI and residual income for each division of Eva Manufacturing, and briefly explain which manager will get the bonus.  What are the advantages and disadvantages of each measure?

2) For purposes of calculating EVA, the CEO finds that the adjusted after-tax operating incomes for clothing and cosmetics, respectively, are $720,000 and $1,430,000.  Also, the clothing division has $400,000 of current liabilities, while the cosmetics division has only $200,000 of current liabilities.  Using the preceding information, calculate EVA, and discuss which division manager will get the bonus.

Problem 2 (Summit Equipment)

Summit Equipment specializes in the manufacture of medical equipment, a field that has become increasingly competitive.  Approximately two years ago, Ben Harrington, president of Summit, decided to revise the bonus plan (based, at the time, entirely on operating income) to encourage division manager to focus on areas that were important to customers and that added value without increasing cost.  In addition to a profitability incentive, the revised plan includes incentives for reduced rework costs, reduced sales returns, and on-time deliveries.  Bonuses are calculated and awarded semiannually on the following basis: A base bonus is calculated at 2% of operating income; this amount is then adjusted as follows:

a. (i) Reduced by excess of rework costs over and above 2% of operating income

(ii) No adjustment if rework costs are less than or equal to 2% of operating income

b. (i) Increased by $5,000 if more than 98% of deliveries are on time, and by $2,000 if

96% to 98% of deliveries are on time

(ii) No adjustment in on-time deliveries are below 96%

c. (i) Increased by $3,000 if sales returns are less than or equal to 1.5% of sales

(ii) Decreased by 50% of excess of sales returns over 1.5% of sales

Note: If the calculation of the bonus results in a negative amount for a particular period, the manager simply receives no bonus and the negative amount is not carried forward to the next period.

Results for Summit’s Charter division and Mesa division for the current year, the first year under the new bonus plan, follow.  Last year, under the old bonus plan, the Charter division manager earned a bonus of $27,060 and the Mesa division manager, a bonus of $22,440.

	Charter Division		Mesa Division
	Jan. – June	June – Dec.	Jan. – June	June – Dec.
Revenues	$4,200,000	$4,400,000	$2,850,000	$2,900,000
Operating income	$462,000	$440,000	$342,000	$406,000
On-time delivery	95.4%	97.3%	98.2%	94.6%
Rework costs	$11,500	$11,000	$6,000	$8,000
Sales returns	$84,000	$70,000	$44,750	$42,500

1.  Why did Harrington need to introduce these new performance measures?  That is, why does Harrington need to use these performance measures in addition to the operating-income numbers for the period?

2. Calculate the bonus earned by each manager for each six-month period.

3. What effect did the change in the bonus plan have on each manager’s behavior?  Did th new bonus plan achieve what Harrington desired?  What changes, if any, would you make to the new bonus plan?

Problem 3 (Century Lab)

Century Lab plans to purchase a new centrifuge machine for its New Hampshire facility.  The machine costs $137,500 and is expected to have a useful life of eight years, with a terminal disposal value of $37,500.  Savings in cash operating costs are expected to be $31,250 per year.  However, additional working capital is needed to keep the machine running efficiently.  The working capital must continually be replaced, so an investment of $10,000 needs to be maintained at all times, but this investment is fully recoverable (will be “cashed in”) at the end of the useful life.  Century Lab’s required rate of return is 14%.  Ignore income taxes in your analysis.  Assume all cash flows occur at year-end except for initial investment amounts.  Century Lab uses straight-line depreciation for its machines.

1. Calculate net present value

2. Calculate internal rate of return

3. Calculate accrual accounting rate of return based on initial investment

4. Calculate accrual accounting rate of return based on average investment

5. You have the authority to make the purchase decision.  Why might you be reluctant to base your decision on the DCF methods?

Problem 4 (Mornay Company)

The Mornay Company manufactures telecommunications equipment at its plant in Toledo, Ohio.  The company has marketing divisions throughout the world.  A Mornay marketing division in Vienna, Austria, imports 10,000 units of Product 4A36 from the United States.  The following information is available:

U.S. income tax rate on the U.S. division’s operating income       35%

Austrian income tax rate on the Austrian division’s operating income       40%

Austrian import duty       15%

Variable manufacturing cost per unit of Product 4A36 $   550

Full manufacturing cost per unit of Product 4A36 $   800

Selling price (net of marketing and distribution costs) in Austria $1,150

Suppose the United States and Austrian tax authorities only allow transfer prices that are between the full manufacturing cost per unit of $800 and a market price of $950, based on comparable imports into Austria.  The Austrian import duty is charged on the price at which the product is transferred into Austria.  Any import duty paid to the Austrian authorities is a deductible expense for calculating Austrian income taxes due.

1. Calculate the after-tax operating income earned by the United States and Austrian divisions from transferring 10,000 units of Product 4A36 (a) at full manufacturing cost per unit and (b) at market price of comparable imports. (Income taxes are not included in the computation of the cost-based transfer prices.)

2. Which transfer price should the Mornay Company select to minimize the total of company import duties and income taxes?  Explain your reasoning.

Suppose that the U.S. division could sell as many units of Product 4A36 as it makes at $900 per unit in the U.S. market, net of all marketing and distribution costs.

3. From the perspective of the Mornay Company as a whole, would after-tax operating income be maximized if it sold the 10,000 units of Product 4A36 in the U.S. or in Austria?

4. Suppose division managers act autonomously to maximize their division’s after-tax operating income.  Will the transfer price computed in requirement 2 result in the U.S. division managers taking the actions determined to be optimal in requirement 3?  Explain?

5. What is the minimum transfer price that the U.S. division manager would agree to?  Does this transfer price result in the Mornay Company as a whole paying more import duty and income tax than the answer to part 2?  If so, by how much?

Problem 5 (Ridgecrest Corporation)

Ridgecrest Corporation manufactures corrugated cardboard boxes.  It competes and plans to grow by selling high-quality boxes at a low price and by delivering them to customers quickly after receiving customers’ orders.  There are many other manufacturers who produce similar boxes.  Ridgecrest believes that continuously improving its manufacturing processes and having satisfied employees are critical to implementing its strategy in the next year.

Kearney Corporation, a competitor of Ridgecrest, manufactures corrugated boxes with more designs and color combinations than Ridgecrest at a higher price.  Kearney’s boxes are of high quality but require more time to produce and so have longer delivery times.

Draw a strategy map for Ridgecrest.  You should have one or two strategic objectives for each balanced scorecard perspective.  For each strategic objective indicate a measure that you would expect to see in Ridgecrest’s balanced scorecard for next year.

Problem 6 (Dream Rider)

Dream Rider produces car seats for children from newborn to two years old.  The company is worried because one of its competitors recently came under public scrutiny because of product failure.  Historically, Dream Rider’s only problem with its care seats was stitching in the straps.  The problem can usually be detected and repaired during an internal inspection.  The cost of the inspection is $4 and the repair cost of $0.75.  All 250,000 car seats were inspected last year and 9% were found to have problems with the stitching in the straps during the internal inspection.  Another 3% of the 250,000 car seats had problems with the stitching, but the internal inspection did not discover them.  Defective units that were sold and shipped to the customers needed to be shipped back to Dream Rider and repaired.  Shipping costs are $7, and repair costs are $0.75.  However, the out-of-pocket costs (shipping and repair) are not the only costs of defects not discovered in the internal inspection.  For 20% of the external failures, negative word of mouth will result in a loss of sales, lowering the following year’s profits by $300 for each of the 20% of units with external failures.

1. Compute the total cost of quality.

2. Dream rider is considering an alternative inspection plan that will cost of $1.00 per car seat inspected.  Instead of finding 9/12 of the defective seats (as above), it will find only 5/12.  What are the total costs of quality for the alternative inspection plan?

3. What other factors should Dream Rider consider before changing inspection plans?

Solution to Problem 1 (Eva Manufacturing)

1. ROI and residual income:

	Clothing	Cosmetics
Operating income after tax	$   600,000	$  1,600,000
Net assets	$3,000,000	$10,000,000
ROI ($600,000 ÷ $3,000,000; $1,600,000 ÷ $10,000,000)	20.00%	16.00%
RI ($600,000 − 10% × 3,000,000; $1,600,000− 10% × $10,000,000)	$   300,000	$     600,000

The choice of measure used to evaluate performance will determine which division gets the bonus.  If the firm uses ROI, then the Clothing Division will get the bonus.  However, the Cosmetics Division has much larger absolute and residual income.  If the firm evaluates performance based on residual income, then the Cosmetics Division will get the bonus.

The advantages of ROI are that it is easy to calculate and easy to understand.  It combines revenue, cost, and investment into a single number, so that managers can clearly see what can be changed to increase returns. But ROI has limitations. Managers who are evaluated based on ROI have incentives to reject investments with ROIs below their divisions’ current average ROI, even when the investments have positive net present values.

Residual income has the advantage of goal congruence because any investment that earns more than the required capital charge increases RI, and thereby increases the managers’ performance evaluations.  The measure is not subject to the “cutoff” problems that occur when managers compare a new investment’s ROI to the average ROI being earned on existing investments.  However, RI is not as easy to measure because it requires the company to determine the amount of capital and the cost of capital for each business unit.

2.

	Clothing	Cosmetics
Adjusted operating  income	$   720,000		$1,430,000
Net assets less current liabilities	$2,600,000		$9,800,000
Revised ROI ($720,000 ÷ $2,600,000; $1,430,000  ÷ 9,800,000)	27.69%		14.59%
EVA ($720,000 − 10% × $2,600,000; $1,430,000  − 10% × $9,800,000)	$   460,000		$   450,000

Clothing Division will get the bonus because both EVA and ROI (using EVA’s definition of operating income and assets) are higher than those of the Cosmetics Division.

Solution to Problem 2 (Summit Equipment)

1. Operating income is a good summary measure of short-term financial performance. By itself, however, it does not indicate whether operating income in the short run was earned by taking actions that would lead to long-run competitive advantage. For example, Summit’s divisions might be able to increase short-run operating income by producing more product while ignoring quality or rework. Harrington, however, would like to see division managers increase operating income without sacrificing quality. The new performance measures take a balanced scorecard approach by evaluating and rewarding managers on the basis of direct measures (such as rework costs, on-time delivery performance, and sales returns). This motivates managers to take actions that Harrington believes will increase operating income now and in the future. The nonoperating income measures serve as surrogate measures of future profitability.

2. The semiannual installments and total bonus for the Charter Division are calculated as follows:

Charter Division Bonus Calculation

For Year Ended December 31, 2012

January 1, 2012 to June 30, 2012
Profitability	(0.02 ´ $462,000)	$   9,240
Rework	(0.02 ´ $462,000) – $11,500	(2,260)
On-time delivery	No bonus—under 96%	0
Sales returns	[(0.015 ´ $4,200,000) – $84,000] ´ 50%	(10,500)
Semiannual installment Semiannual bonus awarded		$  (3,520) $          0
July 1, 2012 to December 31, 2012
Profitability	(0.02 ´ $440,000)	$  8,800
Rework	(0.02 $440,000) – $11,000	(2,200)
On-time delivery	96% to 98%	2,000
Sales returns	[(0.015 ´ $4,400,000) – $70,000] ´ 50%	(2,000)
Semiannual installment Semiannual bonus awarded		$  6,600 $  6,600
Total bonus awarded for the year		$  6,600

The semiannual installments and total bonus for the Mesa Division are calculated as follows:

Mesa Division Bonus Calculation

For Year Ended December 31, 2012

January 1, 2012 to June 30, 2012
Profitability Rework On-time delivery Sales returns	(0.02 $342,000) (0.02 $342,000) – $6,000 Over 98% [(0.015 $2,850,000) – $44,750] 50%	$  6,840 0 5,000 (1,000)
Semiannual bonus installment Semiannual bonus awarded		$10,840 $10,840
July 1, 2012 to December 31, 2012
Profitability Rework On-time delivery Sales returns	(0.02 $406,000) (0.02 $406,000) – $8,000 No bonus—under 96% [(0.015 $2,900,000) – $42,500] which is greater than zero, yielding a bonus	$  8,120 0 0 3,000
Semiannual bonus installment Semiannual bonus awarded		$11,120 $11,120
Total bonus awarded for the year		$21,960

3. The manager of the Charter Division is likely to be frustrated by the new plan, as the division bonus has fallen by more than $20,000 compared to the bonus of the previous year. However, the new performance measures have begun to have the desired effect––both on-time deliveries and sales returns improved in the second half of the year, while rework costs were relatively even. If the division continues to improve at the same rate, the Charter bonus could approximate or exceed what it was under the old plan.

The manager of the Mesa Division should be as satisfied with the new plan as with the old plan, as the bonus is almost equivalent. On-time deliveries declined considerably in the second half of the year and rework costs increased. However, sales returns decreased slightly. Unless the manager institutes better controls, the bonus situation may not be as favorable in the future. This could motivate the manager to improve in the future but currently, at least, the manager has been able to maintain his bonus with showing improvement in only one area targeted by Harrington.

Ben Harrington’s revised bonus plan for the Charter Division fostered the following improvements in the second half of the year despite an increase in sales:

· An increase of 1.9% in on-time deliveries.

· A $500 reduction in rework costs.

· A $14,000 reduction in sales returns.

· However, operating income as a percent of sales has decreased (11% to 10%).

The Mesa Division’s bonus has remained at the status quo as a result of the following effects:

· An increase of 2.0 % in operating income as a percent of sales (12% to 14%).

· A decrease of 3.6% in on-time deliveries.

· A $2,000 increase in rework costs.

· A $2,250 decrease in sales returns.

This would suggest that revisions to the bonus plan are needed. Possible changes include:

· increasing the weights put on on-time deliveries, rework costs, and sales returns in the performance measures while decreasing the weight put on operating income;

· a reward structure for rework costs that are below 2% of operating income that would encourage managers to drive costs lower;

· reviewing the whole year in total.  The bonus plan should carry forward the negative amounts for one six-month period into the next six-month period incorporating the entire year when calculating a bonus; and

· developing benchmarks, and then giving rewards for improvements over prior periods and encouraging continuous improvement.

Solution to Problem 3 (Century Lab)

1.   Present value of annuity of savings in cash operating costs

($31,250 per year for 8 years at 14%):  $31,250 ´ 4.639 $144,969

Present value of $37,500 terminal disposal price of machine at

end of year 8:  $37,500 ´ 0.351 13,163

Present value of $10,000 recovery of working capital at

end of year 8:  $10,000 ´ 0.351 3,510

Gross present value 161,642

Deduct net initial investment:

Centrifuge machine, initial investment $137,500

Additional working capital investment 10,000 147,500

Net present value $  14,142

2. The sequence of cash flows from the project is:

For a $147,500 initial outflow, the project now generates $31,250 in cash flows at the end of each of years one through seven and $78,750 (= $31,250 + $37,500) at the end of year 8.

Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 16.51%.

3. Accrual accounting rate of return based on net initial investment:

Net initial investment = $137,500 + $10,000

= $147,500

Annual depreciation

($137,500 – $37,500) ÷ 8 years =   $12,500

Accrual accounting rate of return = =  12.71%.

4. Accrual accounting rate of return based on average investment:

Net terminal cash flow = $37,500 terminal disposal price

+ $10,000 working capital  recovery

= $47,500

Average investment = ($147,500 + $47,500) / 2

= $97,500

Accrual accounting rate of return = =  19.23%.

5. If your decision is based on the DCF model, the purchase would be made because the net present value is positive, and the 16.51% internal rate of return exceeds the 14% required rate of return. However, you may believe that your performance may actually be measured using accrual accounting. This approach would show a 12.71% return on the initial investment, which is below the required rate. Your reluctance to make a “buy” decision would be quite natural unless you are assured of reasonable consistency between the decision model and the performance evaluation method.

Solution to Problem 4 (Mornay Company)

1.

Division Incomes of U.S. and Austrian Divisions from Transferring 10,000 Units of Product 4A36

Method A Internal Transfers at Full Manufacturing Cost