Cornerstone Exercise 12-14: Calculating Residual I

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Calculate residual income and economic value added for various divisions and investment scenarios based on provided income statements, asset values, and required rates of return. Assess division performance, investment decisions, and managerial evaluations using ROI and residual income metrics.

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The concept of residual income and economic value added (EVA) plays a crucial role in corporate performance measurement, particularly in evaluating the profitability and efficiency of divisions and investment projects. These metrics provide deeper insights than traditional accounting measures, helping managers and stakeholders assess value creation relative to the minimum required returns and overall company objectives.

Residual income (RI) is defined as the operating income earned beyond the minimum required return on operating assets. It effectively measures absolute value added by a division or project, reflecting whether the utilization of assets generates sufficient returns to cover the cost of capital. Calculating residual income involves determining the minimum acceptable operating income, which is derived by multiplying operating assets by the required rate of return. The residual income formula is expressed as:

Residual Income = Operating Income - (Operating Assets × Required Rate of Return)

In the first case, Pelican Manufacturing’s residual income is computed after establishing the average operating assets and applying the minimum rate of return. The average operating assets are calculated by averaging the beginning and ending asset balances. Using Pelican’s data, this calculation looks like: (Beginning Assets + Ending Assets) / 2, which results in (390,000 + 460,000)/2 = 425,000. The minimum required return equates to 10% of this average, i.e., 42,500. Since the operating income of 66,550 exceeds this, residual income is 66,550 - 42,500 = 24,050, signifying value creation.

The residual income becomes a vital indicator for managerial performance evaluation, aligning managerial incentives with shareholder value creation. Unlike ROI, which can sometimes discourage investments that lower overall ROI but increase value, residual income encourages managers to undertake projects that generate returns above the cost of capital.

Similarly, East Mullett Manufacturing's EVA calculation follows the same principle but emphasizes net income relative to total capital employed and the cost of capital, typically expressed as:

Economic Value Added (EVA) = Net Operating Profit After Taxes (NOPAT) - (Capital Employed × Cost of Capital)

Given the company's data, the estimated EVA indicates whether the company is earning returns exceeding its capital costs. With an actual cost of capital at 8%, calculating EVA involves deducting 8% of total capital employed ($389,000) from the net income figure provided. A positive EVA reveals value creation, while a negative outcome indicates value destruction.

The case of Schipper Company's Home Products Division illustrates residual income at division level, emphasizing the importance of comparative performance measures. With an operating income of 112,400 and operating assets of 750,000, the minimum return at 10% results in a required income of 75,000. Subtracting this from operating income yields a residual income of 37,400, demonstrating effective value addition beyond the minimum expectations.

The analysis of Leslie Blandings's investment scenario in the weather radio project demonstrates the use of ROI and residual income in investment decision-making. ROI measures the percentage return relative to investment size, calculated as:

ROI = Operating Income / Operating Assets

For the division without the new project, ROI is, therefore, 725,000 / 3,625,000 = 20%. When considering the project, the additional income ($640,000) and investment ($4,000,000) modify this metric. The ROI for the project alone is 640,000 / 4,000,000 = 16%, which is less than the division's overall ROI, but the overall division ROI increases if the project is undertaken.

Residual income analysis considers whether the project or division earns more than the minimum required of 12%. The residual income for each scenario compares the operating income against the capital employed multiplied by this rate, leading to insights about the value potentially added or destroyed by accepting the project. A positive residual income indicates the investment surpasses the threshold for value addition, guiding managerial decisions.

The consideration of multiple investments, like the air conditioner and turbocharger projects, involves calculating their respective ROIs and residual incomes, then evaluating their alignment with strategic financial metrics and company paradigms. The manager’s decision hinges on whether these investments generate sufficient returns above the minimum threshold, especially under varied required rates of return, such as 14% or 10%. The ROI and residual income analyses often produce differing recommendations because ROI focuses on relative measures, whereas residual income emphasizes absolute value creation.

In conclusion, residual income and EVA are indispensable tools for corporate finance and managerial decision-making, providing balanced perspectives on divisional performance and investment viability. They address limitations inherent in ROI, such as discouraging potentially beneficial investments, and promote value-maximizing decisions aligned with shareholder wealth enhancement. Ultimately, integrating both measures facilitates more comprehensive evaluations, enabling managers to prioritize investments and operational strategies that foster sustainable corporate growth and profitability.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2019). Essentials of Corporate Finance. McGraw-Hill Education.
  • Rappaport, A. (1986). Creating shareholder value: The new standard for measuring corporate performance. The Free Press.
  • Stewart, G. B. (1991). The quest for value: A guide for weighing the options on Wall Street and in corporate America. HarperBusiness.
  • Larcker, D. F., & Rusticus, T. (2010). Financial Statement Analysis and Valuation. Sage Publishing.
  • Young, S. M., & O'Byrne, S. F. (2001). EVA and Value-Based Management: A Practical Guide to Implementation. McGraw-Hill.
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