Question

Stevens Company has two divisions, Helmet and Ball, that report on a decentralized basis. It is a decentralized organization and currently the division managers are evaluated on a variety of financial measures. Their results for 2019 were as follows: Helmet Ball Sales $150,000 $300,000 Operating Income $ 15,000 $ 45,000 Asset base $ 75,000 $150,000 Required: a. Compute the following amounts for each division, Helmet and Ball:

i. Return on investment (ROI).

ii. Residual income if the desired rate of return is 20 percent.

iii. Economic Value Added (EVA) when the Weighted Average cost of capital for Stevens Company is 12%.

iv. Operating Asset turnover

v. Operating Income Margin.

b. Firms use ROI, residual income and EVA to evaluate the performance of managers and the division. The use of these financial measures can result in myopic (or short-term focus) or dysfunctional behavior amongst managers. Briefly discuss how firms can evaluate performance of managers so as to discourage myopic or dysfunctional behaviour.

c. Identify and explain the shortcomings of the current approach at Stevens Company in evaluating divisional performance.

Answer 1

Particulars		DIVISIONS
		Helmet	Ball
Sales		150000	300000
Operating Expenses		135000	255000
Operating Income		15000	45000
Asset Base		75000	150000
i) ROI		20	30
OP Income/Asset
ii) Residual Income if the desired rate of return is 20%
Operating Income		15000	45000
Asset Base		75000	150000
Required rate of return		20%	20%
Residual Income (RI)		0	15000
RI=Operating Income-(Asset X Required rate of return)
iii) EVA when WACC is 12%
EVA=PAT-(Cost of Equity X Equity Capital)
PAT= Not available, hence Operating income is considered
Equity capital is not available, Asset is considered
Operating Income		15000	45000
Asset Base		75000	150000
Cost of capital (given)		12%	12%
EVA		6000	27000
iv) Operating Asset Turnover
Sales		150000	300000
Asset Base		75000	150000
Operating Asset Turnover		2	2
Op.Asset Turnover=Turnover/Asset
v) Operating Margin
Sales		150000	300000
Operating Income		15000	45000
Operating Margin		10	15
Operating Margin=Operating Income/Sales X100
B)
Whereas ROI, RI and EVA are used to evaluate the performanc of managers and the division which is short term
focus, Shareholder Value creation (SVC) takes a long term perspective and focuses on valuation.
The SVC approach is based on the assumption that a principal -agent relationship exists between shareholder
and the management. As a shareholder's agent , the management is charged with the responsibility of creating
wealth for shareholders. Therefore, all management actions and strategies should be guided by Shareholder
Value Creation . There is strong need for the adoption of SVC in evaluating all management actions, projects,
business strategies and overall strategic planning. At the business unit or divisional level, it is used to evaluate
the altrrnative competitive strategies, to identify the key business factors that impact SVC and to set
performance targets that are consistent with value creation.
C)
Shortcomings of current approach:
ROI, EVA provides focus on short term results and profitability, long term profitability focus is ignored
ROI considers current period's revenue and cost and do not pay attention to those investment that will impact
firms long term profitability. Managers using ROI may cut spending on productivity improvement, R& D, etc
Periodic EVA fails to estimate the value added to shareholders because of the inflation and other factors.