Question

In: Accounting

An auto parts Company produces various extra additions to motor cars. It has just discovered an...

An auto parts Company produces various extra additions to motor cars. It has just discovered an opportunity to invest in producing air conditioners for the back seats of vans and minibuses. The investment project will cost $925,000 and will generate an estimated additional operating income of $95,500.

Without the investment, the company will have average assets for the coming year of $29.5 million and expected operating income of $4.535 million.

Required:

  1. What is the ROI of the new investment project alone? Is it higher or lower than the existing ROI of the company?

  1. What will be the ROI of the company after accepting the new investment?

  1. Assuming that the managers are evaluated and rewarded on the basis of ROI performance, should a rational manger make the new investment? Why?

  1. Suppose that the company sets a minimum required rate of return to 11%. What will be the ‘Residual Income’ of the company after accepting the new investment? Is it higher or lower than the Residual Income without the investment?

  1. What will be the Economic value Added (EVA) of the company after making the new investment if corporate tax rate is 30% and the actual cost of capital of the company is 10%?

Solutions

Expert Solution

1.

ROI = Operating income / average assets

ROI of the new investment project alone

ROI = 95500 / 925000 = 0.1032 or 10.32%

existing ROI = 4.535 million / 29.5 million = 0.1537 or 15.37%

* The ROI of the new investment project alone is lower than the existing ROI

2.

ROI of the company after accepting the new investment

ROI = ( 4535000 + 95500 ) / ( 29500000 + 925000 ) = 0.1522 or 15.22%

3.

Assuming that the managers are evaluated and rewarded on the basis of ROI performance, should a rational manger make the new investment? Why?

No, because it is decrease the overall ROI of the company will decreased.

4.

Suppose that the company sets a minimum required rate of return to 11%. What will be the ‘Residual Income’ of the company after accepting the new investment? Is it higher or lower than the Residual Income without the investment?

RI = Operating income - ( Investment * Required rate )

RI after accepting new opportunity

Operating income = 4535000 + 95500   =4630500

Investment = 29500000 + 925000 = 30425000

required rate of return to 11%

RI = 4630500 - ( 30425000 * 11% ) = 4630500 - 3346750 = 1283750

RI without new opportunities

Operating income = 4535000

Investment = 29500000

required rate of return to 11%

RI = 4535000 - ( 29500000 * 11% ) = 1290000

* RI after accepting new investment is lower than the Residual Income without the investment

5.

What will be the Economic value Added (EVA) of the company after making the new investment if corporate tax rate is 30% and the actual cost of capital of the company is 10%?

EVA = operating income after tax - ( Investment * cost of capital )

After new investment

operating income after tax = 4535000 + 95500   =4630500 - 30% = 3241350

Investment = 29500000 + 925000 = 30425000

Cost of capital = 10%

EVA = 3241350 - ( 30425000 * 10% )

EVA = 3241350 - 3042500 = 198850

ekkarill92 answered 2 weeks ago
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