Question

Residual income, ROI, and EVA The following selected data pertain to Brannard Company's Construction Division for last year.

Sales $2,380,000

Variable costs $1,428,000

Traceable fixed costs $238,000

Average invested capital (assets) $3,570,000

Current liabilities $238,000

Required rate of return 15%

Marginal tax rate 36%

Weighted average cost of capital 12%

QN:
1. Calculate the residual income. $______

2. Calculate the return on investment. ______%

3. Calculate the economic value added. $______

Answer 1

Residual income, ROI, and EVA The following selected data pertain to Brannard Company's Construction Division for last year.

Sales $2,380,000

Variable costs $1,428,000

Traceable fixed costs $238,000

Average invested capital (assets) $3,570,000

Current liabilities $238,000

Required rate of return 15%

Marginal tax rate 36%

Weighted average cost of capital 12%

.:
1. Calculate the residual income. $214200

Residual income = Operating income - ( Average net Operating assets * Required rate of return )

Where,

Operating income = sales - variable cost - fixed cost = 2380000 - 1428000 - 238000 = 714000

Average net Operating assets = Average invested capital (assets) -Current liabilities = 3570000 - 238000 = 3332000

Required rate of return = 15%

.

Residual income = 714000 - ( 3332000 * 15% ) = 714000 - 499800 = 214200

.

2. Calculate the return on investment.  20%

Return on Investment (ROI ) = operating income / Average invested capital (assets)

Where,

operating income = 714000

Average invested capital (assets) = 3570000

.

ROI = 714000 / 3570000 = 0.2 = 20%

.

3. Calculate the economic value added. $57120

economic value added is an estimate of a entity economic profit, or the value created in excess of the required return of the company's shareholders which means WACC. EVA is the net profit less the capital charge for raising the firm's capital.

.

The formula is:

EVA = Net operating profit after tax - ( Average net Operating assets * Weighted average cost of capital )

Where,

Net operating profit after tax = Operating income * ( 1 -tax rate )

Net operating profit after tax = 714000 * ( 1 - 36% ) = 714000 * 0.64 = 456960

Average net Operating assets = Average invested capital (assets) -Current liabilities = 3570000 - 238000 = 3332000

Weighted average cost of capital = 12%

.

EVA = 456960 - ( 3332000 * 12% ) = 456960 - 399840 = $57120