Question

Return on Investment and Economic Value Added Calculations with Varying Assumptions

Knitpix Products is a division of Parker Textiles Inc. During the coming year, it expects to earn income of $310,000 based on sales of $3.45 million. Without any new investments, the division will have average operating assets of $3 million. The division is considering a capital investment project—adding knitting machines to produce gaiters—that requires an additional investment of $650,000 and increases net income by $57,500 (sales would increase by $575,000). If made, the investment would increase beginning operating assets by $650,000 and ending operating assets by $430,000. Assume that the actual cost of capital for the company is 10%.

Required:

1. Compute the ROI for the division without the investment. Round your answer to two decimal places.
%

2. Compute the margin and turnover ratios without the investment. Show that the product of the margin and turnover ratios equals the ROI computed in Requirement 1. Round your answers to two decimal places.

Margin	%
Turnover
ROI	%

3. Conceptual Connection: Compute the ROI for the division with the new investment. Round your answer to one decimal place.
%

Do you think the divisional manager will approve the investment?

4. Conceptual Connection: Compute the margin and turnover ratios for the division with the new investment. Round your answers to two decimal places. How do these compare with the old ratios?

Margin	%
Turnover

5. Conceptual Connection: Compute the EVA of the division with and without the investment.

EVA without the investment	$
EVA with the investment	$

Should the manager decide to make the knitting machine investment?

Answer 1

SOLUTION

1. ROI = Income / Average operating assets

= $310,000 / $3,000,000 = 10.33%

2. Margin = Income / Sales

= $310,000 / $3,450,000 = 8.99%

Turnover = Sales / Average operating assets

= $3,450,000 / $3,000,000 = 1.15

ROI = Margin * Turnover

= 8.99% * 1.15 = 10.34%

3. Revised net income = $310,000 + $57,500 = $367,500

Average operating assets = ($650,000 + $430,000) / 2 = $540,000

Revised Average operating assets = $3,000,000 + $540,000 = $3,540,000

ROI = $367,500 / $3,540,000 = 10.38%

In this analysis the ROI with the investment is higher than the ROI without the investment so manager will approved the investment.

4. Margin = Income / Sales

= ($310,000 + $57,500) / ($3,450,000 + $575,000)

= $367,500 / 4,025,000 = 9.13%

Turnover = Sales / Average operating assets

= ($3,450,000 + 575,000) / ($3,000,000 + 540,000)

= 4,025,000 / 3,540,000 = 1.15

In this analysis Turnover will be the same and Margin will increased.

5. EVA without investment = $310,000 - (10%*$3,000,000)

= $310,000 - 300,000 = $10,000

EVA with investment = $367,500 - (10% * $3,540,000)

= $367,500 - 354,000 = 13,500

With the investment EVA will be increased so the manager will aprove the investment.