Question

Poseidon Corporation manufactures a variety of gear for water sports. Poseidon has three divisions: Lake, River, and Ocean. Each division is managed as an investment center. During the current year, the Ocean division experienced the following transactions:

1. A special order was accepted at a selling price significantly less than the ordinary selling price. The sale will not impact other sales because this was a one-time order and Ocean has excess capacity. The selling price was in excess of total variable costs.
2. One of three production managers in the Ocean Division submitted his resignation. The position will not be filled due to current efficiencies experienced in the production department.
3. Due to the popularity of open-ocean swimming during the Olympics, the company experienced a surge in sales during the summer months. Sales returned to their normal level for the remainder of the year.
4. Equipment costing $500,000 was purchased to replace fully depreciated, obsolete equipment.
5. The company’s after-tax cost of capital increased from 8 percent to 10 percent, with no effect on the minimum required rate of return.
6. The company’s effective tax rate decreased from 35 percent to 30 percent.

Required:

Determine the impact on return on investment, residual income, and economic value added. Use the table below to organize your answers. Use (I) for increase, (D) for decrease, (N) for no effect, to determine the impact of the transaction. Each transaction should be treated independently.

Transaction	Return on Investment	Residual Income	Economic Value Added
a.
b.
c.
d.
e.
f.

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Answer 1

ROI(Return on investment) is the net earnings for the organization measured with respect to the amount invested. It is a performance measure to compare the efficiency of one investment with another.
Residual income(RI) is net earnings in excess of the investor's expected minimum return.
EVA(Economic value-added) is the post-tax operating profits netted with the charges for using operating capital (i.e., Operating capital*Cost of capital). This is to assess the investment's performance efficiency.
EVA = NOPAT - (Operating capital * Cost of capital)
Sl no.	ROI(Return on investment)	Residual income(RI)	EVA(Economic value-added)	Explanation
a.	Increase	Increase	Increase	Revenues Increase
b.	Increase	Increase	Increase	Cost (Salary expense) decrease
c.	Increase	Increase	Increase	Increased revenues for a part of the year
d.	Decrease	Decrease	Decrease	The capital asset and depreciation expense increase
e.	No Change	No Change	Decrease	Increase in cost of capital leads to a decrease in the economic value added
f.	Increase	Increase	Increase	Total Tax expense decreases

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