Question

19-3

Heather Smith Cosmetics (HSC) manufactures a variety of products and is organized into three divisions (investment centers): soap products, skin lotions, and hair products. Information about the most recent year’s operations follows. The information includes the value of intangible assets, including research and development, patents, and other innovations that are not included on HSC’s balance sheet. Were these intangibles to be included in the financial statements (as they are for EVA®), the increase in the balance sheet and the increase in after-tax operating income would be as given below:

Division	Operating Income			Average Total Assets			Value of Intangibles			Intangibles’ Effect on Income
Soap products	$	3,240,500		$	59,990,500		$	1,490,500		$	990,500
Skin lotions		2,740,500			32,990,500			7,990,500			5,990,500
Hair products		4,990,500			54,990,500			990,500			690,500
Minimum desired rate of return		5.00	%
Cost of capital		4.00	%

Required:

1. Calculate the return on investment (ROI) for each division. (Round your answers to 2 decimal places. (i.e. .1234 = 12.34%))

2. Calculate the residual income (RI) for each division.

3. Calculate EVA^® for each division.

Answer 1

Solution:

1. The Return on Investment (ROI) is calculated using the formula:-

Return on Investment = Operating Income/Average total assets

ROI of Soap products

ROI = $3,240,500/59,990,500

ROI = 0.0540 or 5.40%

ROI of Skin lotions

ROI = $2,740,500/32,990,500

ROI = 0.0831 or 8.31%

ROI of Hair Products

ROI = $4,990,500/54,990,500

ROI = 0.0908 or 9.08%

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2. The residual income (RI) is calculated using the formula:-

RI = Operating Income - (Desired rate of return x Average total assets)

RI of Soap products

RI = $3,240,500 - (0.05 x 59,990,500)

RI = $240,975

RI of Skin lotions

RI = $2,740,500 - (0.05 x 32,990,500)

RI = $1,090,975

RI of Hair Products

RI = $4,990,500 - (0.05 x 54,990,500)

RI = $2,240,975

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c. The EVA is calculated using the formula given below

EVA = Operating Income + Intangibles effect on income - Cost of capital x (Average total assets + Value of intangibles)

EVA of soap products

EVA = $3,240,500 + $990,500 - 0.04 x ($59,990,500 + $1,490,500)

EVA = $1,771,760

EVA of skin lotions

EVA = $2,740,500 + $5,990,500 - 0.04 x ($32,990,500 + $7,990,500)

EVA = $7,091,760

EVA of Hair products

EVA = $4,990,500 + $690,500 - 0.04 x ($54,990,500 + $990,500)

EVA = $3,441,760