Question

Tony's Tire and Auto Repair has two divisions split up by region—a Southern Division and a Northern Division. The following segmented income statement is for the most recent fiscal year ended December 31:

Tony's Tire and Auto Repair

Segmented Income Statements

Southern Division

Northern Division

Sales

$5,250

$31,500

Cost of goods sold

1,575

13,650

Gross margin

3,675

17,850

Allocated overhead (from corporate)

300

1,827

Selling and administrative expenses

2,205

12,600

Operating income

1,170

3,423

Income tax expense (30% rate)

351

1,027

Net income

$819

$2,396

Tony's Tire and Auto Repair

Segmented Balance Sheet Statements

Southern Division

Northern Division

End balance

Beginning balance

End balance

Beginning balance

Assets

Cash

$1,155

$1,103

$4,400

$3,800

Accounts receivables

840

893

3,100

3,150

Inventory

2,100

2,205

7,500

7,650

Total current assets

4,095

4,201

15,000

14,600

Property, plant, and equipment (net)

5,775

6,090

26,000

28,000

Land (held for sale)

1,050

1,050

2,500

2,500

Total assets

10,920

11,341

43,500

45,100

Liabilities and owner's equity

Accounts payable

1,260

1,208

3,750

3,300

Other current liabilities

315

368

1,600

1,200

Total current liabilities

1,575

1,576

5,350

4,500

Long-term liabilities

0

0

0

0

Total liabilities

1,575

1,576

5,350

4,500

Total owner's equity

9,345

9,765

38,150

40,600

Total liabilities and owner's equity

$10,920

$11,341

$43,500

$45,100

Calculate average operating assets for each division. (Hint: Land held for sale is not an operating asset.)

Calculate ROI for each division.

What does the ROI tell you about each division at Tony's Tire and Auto Repair?

Assuming the cost of capital is 6%, calculate residual income (RI) for each division. How should this information be used to evaluate each division manager?

Assuming the cost of capital is still 6% and that management wants to make three adjustments to calculate EVA, apply the following adjustments:

Adjustment 1: Marketing costs will be capitalized and amortized over several years. On the balance sheet, average operating assets will increase by the unamortized amount of $73,500 for the Southern Division and $2,940,000 for the Northern Division. On the income statement, marketing expense for the year will be added back to operating income; marketing amortization expense for 1 year will be deducted. Assume that marketing amortization expense for the year is $31,500 for the Southern Division and $1,260,000 for the Northern Division. No adjustments will be made for previous years' marketing expenditures.

Adjustment 2: Land held for sale is not an operating asset and thus is deducted from average operating assets.

Adjustment 3: All current liabilities are noninterest bearing and thus are deducted from average operating assets.

Calculate EVA for each division.

What does the EVA show for each division?

Answer 1

Hi, since there are multiple sub parts asked, I will answer the first 4 subparts. Kindly repost the remaining questions separately in order to be answered.

1.Computation of average operating assets:

Excel spread sheet:

Excel workings:

2. Computation of ROI:

Excel spread sheet:

Excel workings:

3. The Southern division has the highest ROI at 11.1% where as the Northern division’s ROI is 8.19%. This specifies that the Southern division is making high profitable usage of its assets than the Northern division.

4.

Computation of residual income:

Excel spreadsheet:

Excel workings:

Even though the Northern division has more RI than the Southern division, it is not sufficient to decision that the Northern division manager is doing better than the Southern division manager.

The aim for each manager is mainly to constantly increase RI over time. Thus, Tony's Tire and Auto Repair need to compare RI for each division to former periods and then reward division managers for vital increases from one period to the other.