Question

Rawhajpoutalah Intl., an Indian tobacco company, has two divisions, A and B, for which the figures are as follows:

	Division A	Division B
Capital employed	1000	1000
Expected return	15%	15%
Net Operating Income	50	300

A). What are the values for divisions A and B if you assume, for calculation purposes, that operating income is constant to perpetuity?

B) The company pays out 50 and so finances its investments for 300. The company invests everything in division B at the same return on capital employed (30%). How much value is created?

C) Same question if the 300 is invested in division A at the average rate of return of A (5%).

D) Same question if the 300 is divided equally between A and B.

E) What are your conclusions?

Answer 1

Answer A:

If operating income is constant to perpetuity:

Values for divisions A = Operating income / Expected return = 50 / 15% = $333.33

Values for divisions B = 300 / 15% = $2,000

Values for divisions A = $333.33

Values for divisions B = $2,000

Answer B:

Value of Division A remains unchanged.

If 300 is invested in Division B, Increase in operating capital = 300 * Return on capital employed = 300 * 30% = 90

Value created in division B = (90 / 15% - Investment) = 600 - 300 = 300

Value created = 300

Answer C:

Value of division B remains unchanged

Increase in operating income of division A = 300 * 5% = 15

Change in value of Division A = (15/ 15% - 300) = - 200

Hence there is reduction in value by 200

Value created = -200

Answer D:

Change in value of Division A = ((150 * 5%) / 15% -150) = - 100

Change in value of Division B = ((150 * 30%) / 15% -150) = 150

Hence total value created = -100 + 150 = 50

Value created = 50

Answer E:

Value is created when return on capital employed is higher than expected return or cost of capital. For optimal returns and higher value creation it is better to invest in division which delivers better return of capital employed rather than spreading investment budget across divisions.