Question

Colonial Pharmaceuticals is a start-up small firm specializing in new medications. It is organized into two divisions, which are based on the products they produce. AC Division is smaller and the life of the products it produces tend to be shorter than those produced by the larger SO Division. Selected financial data for the past year is shown below. Colonial Pharmaceuticals uses a 9 percent cost of capital for divisional performance analysis.

Business Unit	AC Division	SO Division
Sales revenue	$8,000,000	$20,000,000
After-tax operating profit	$1,200,000	$4,800,000
R&D expenditures	$2,000,000	$3,600,000
Divisional assets	$9,000,000	$80,000,000
Divisional current liabilities	$800,000	$4,000,000

R&D is assumed to have a two-year life in the AC Division and a nine-year life in the SO division. All R&D expenditures are spent at the beginning of the year. Since Colonial is a start-up, we can assume that no R&D expenditures had taken place before this year.

Required

1. Calculate ROI (using the DuPont formula) for the two divisions.
2. Compute residual income for the two divisions.
3. Compute EVA for the two divisions.
4. Briefly assess the financial performance of the two divisions based on your analysis.

Answer 1

A. ROI = Profit/Invested capital

		Division AC	Division SO
A	Profit	1200000	4800000
B	Invested capital [Asset - Current liabilities]	8200000	7600000
	ROI [A/B]	14.63%	63.16%

B. Residual income = Operating income - [Total assets*Target rate of return]

		Division AC	Division SO
A	Operating income	1200000	4800000
B	Minimum required rate of return	0.09	0.09
C	Operating assets	9000000	8000000
D	Required return [B*C]	810000	720000
E	Residual income [A-D]	390000	4080000

C. EVA = Net Operating Profit After Taxes (NOPAT) - Invested Capital * Weighted Average Cost of Capital (WACC)

		Division AC	Division SO
A	NOPAT	1200000	4800000
B	Unamorised research expenditure	1000000	3200000
		[2000000/2]	[3600000/9 * 8]
C	NOPAT for EVA [ A+B]	2200000	8000000
D	Invested capital [Asset - Current liabilities]	8200000	7600000
E	WACC	9%	9%
	EVA	1462000	7316000

d. Division SO has performed better than AC division on all fronts.

It has a high ROI of 63.16% while division AC has a ROI of 14.63%.

Similarly, it has a very high residual income and EVA in contrast to that of division AC.

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