Question

Jenny is the president of the West division of Courland Inc. In December she reviews the division’s projected accounting statements for the year. If she does nothing, she expects the division to have $5 million in revenue, $2.4 million in variable costs, and $1.6 million in fixed costs, on volume of 100,000 units. The division has $6 million in assets. Courland has a cost of capital of 12%.

a) Calculate the projected value of the West division’s ROI and RI.

b) Jenny will receive a $100,000 bonus if she can achieve an ROI of 18%. Clearly, she would like to do that. She considers the following schemes to earn the bonus. Answer the question provided for each of these schemes.

I) West division could ship a lot of extra product to customers at year-end (called channel stuffing). Assume the extra products sell at the typical price and have the typical variable cost. How many extra units would West division need to sell to reach the ROI target?

II) West division could defer some of its costs (such as maintenance) until next year. This would decrease fixed costs this year. How much fixed cost would need to be deferred to reach the ROI target?

III) West division could hide some of its assets from the year-end balance sheet. There are several ways to do that (e.g., repurchase agreements, special purpose entities, or early pay down of operating liabilities). How much assets would need to be hidden to reach the ROI target?

Answer 1

Solution a:

Projected operating income = Projected revenue - variable expenses - fixed expenses = $5,000,000 - $2,400,000 - $1,600,000 = $1,000,000

Invested Assets = $6,000,000

Projected ROI = Opearating income / Operating assets = $1,000,000 / $6,000,000 = 16.67%

Minimum required return = $6,000,000*12% = $720,000

Residual Income = $1,000,000 - $720,000 = $280,000

Solution b-I:

Required net income to achieve 18% ROI = $6,000,000 * 18% = $1,080,000

Project net income = $1,000,000

Additional net income required = $1,080,000 - $1,000,000 = $80,000

Current selling price per unit = $5,000,000 / 1000000 = $50 per unit

Variable cost per unit = $2,400,000/100000 = $24 per unit

Contribution margin per unit =$50 - $24 = $26 per unit

Extra unit required to be sell to acheive 18% ROI = Required additional income / contribution margin per unit

= $80,000/$26 = 3077 units

Solution b-II:

Additional income required to achieve desired ROI = $80,000

Therefore $80,000 of fixed cost should be deferred to reach ROI target.

Solution b-III:

Existing income = $1,000,000

Required operating assets to show ROI of 18% = $1,000,000/18% = $5,555,556

Assets need to be hidden to reach ROI target = $6,000,000 - $5,555,556 = $444,444