Question

Tony's Tire and Auto Repair has two divisions split up by region—a Southern Division and a Northern Division. The following segmented income statement is for the most recent fiscal year ended December 31:

Tony's Tire and Auto Repair
Segmented Income Statements

	Southern Division	Northern Division
Sales	$5,250	$31,500
Cost of goods sold	1,575	13,650
Gross margin	3,675	17,850
Allocated overhead (from corporate)	300	1,827
Selling and administrative expenses	2,205	12,600
Operating income	1,170	3,423
Income tax expense (30% rate)	351	1,027
Net income	$819	$2,396

Tony's Tire and Auto Repair
Segmented Balance Sheet Statements

	Southern Division		Northern Division
	End balance	Beginning balance	End balance	Beginning balance
Assets
Cash	$1,155	$1,103	$4,400	$3,800
Accounts receivables	840	893	3,100	3,150
Inventory	2,100	2,205	7,500	7,650
Total current assets	4,095	4,201	15,000	14,600
Property, plant, and equipment (net)	5,775	6,090	26,000	28,000
Land (held for sale)	1,050	1,050	2,500	2,500
Total assets	10,920	11,341	43,500	45,100
Liabilities and owner's equity
Accounts payable	1,260	1,208	3,750	3,300
Other current liabilities	315	368	1,600	1,200
Total current liabilities	1,575	1,576	5,350	4,500
Long-term liabilities	0	0	0	0
Total liabilities	1,575	1,576	5,350	4,500
Total owner's equity	9,345	9,765	38,150	40,600
Total liabilities and owner's equity	$10,920	$11,341	$43,500	$45,100

1. Calculate average operating assets for each division. (Hint: Land held for sale is not an operating asset.)
2. Calculate ROI for each division.
3. What does the ROI tell you about each division at Tony's Tire and Auto Repair?
4. Assuming the cost of capital is 6%, calculate residual income (RI) for each division. How should this information be used to evaluate each division manager?
5. Assuming the cost of capital is still 6% and that management wants to make three adjustments to calculate EVA, apply the following adjustments:
   • Adjustment 1: Marketing costs will be capitalized and amortized over several years. On the balance sheet, average operating assets will increase by the unamortized amount of $73,500 for the Southern Division and $2,940,000 for the Northern Division. On the income statement, marketing expense for the year will be added back to operating income; marketing amortization expense for 1 year will be deducted. Assume that marketing amortization expense for the year is $31,500 for the Southern Division and $1,260,000 for the Northern Division. No adjustments will be made for previous years' marketing expenditures.
   • Adjustment 2: Land held for sale is not an operating asset and thus is deducted from average operating assets.
   • Adjustment 3: All current liabilities are noninterest bearing and thus are deducted from average operating assets.
6. Calculate EVA for each division.
7. What does the EVA show for each division?

Answer 1

Part 1: Calculation of Average Operating Assets:
Segmented Balance Sheet Statements
	Southern Division		Northern Division
	End balance	Beginning balance	End balance	Beginning balance
Assets
Cash	1,155	1,103	4,400	3,800
Accounts receivables	840	893	3,100	3,150
Inventory	2,100	2,205	7,500	7,650
Total current assets	4,095	4,201	15,000	14,600
Property, plant, and equipment (net)	5,775	6,090	26,000	28,000
Step 1: Total operating assets (Current Assets+Fixed Assets(except land)	9,870	10,291	41,000	42,600
Step 2: Average Operating assets (opening balance+closing balance)/2	10,081		41,800
Part 2: Calculation of ROI
Net profit………………(i)	819		2,396
Average Operating Assets …………(ii)	10,081		41,800
ROI= (i)/(ii)	8%		6%
ROI of southern division is greater than northern division. This explains that the performance of southern division is better than northern division. The southern division is more efficient than the northern division.
Part 3: Calculation of Residual Income
Net profit………………(i)	819		2,396
Cost of Capital……………..(ii)	6%		6%
Average Operating Assets ……….(iii)	10,081		41,800
Residual Income [(i)- (ii)*(iii)]	214		-112
Residual Income of southern division is greater than northern division. This explains that the performance of division manager of southern division is better than northern division. Also, its evident that the southern division is able to make minimum where as northern division unable to meet the cost of capital. It is feasible to shut down the northern division.