Question

You are the Vice President of Operations for Willowbrook Company, a decentralized company that makes several varieties of drinks (soft drinks, cider-based drinks, and coffee drinks). Each division is run as an investment center with the manager’s performance evaluation based on their division’s ROI. In addition to the information below, there are $320,000 in corporate costs, of which $190,000 are allocated to the divisions based on the number of units sold at each division. These costs are due to employee benefits, which are billed at the corporate level. The remaining $130,000 in corporate costs cannot reasonably be allocated to the divisions.

Willowbrook has the following data for this year:

	Soft Drinks Division	Cider Division	Coffee Division
Sales	$500,000	$1,300,000	$800,000
# of units sold	250,000	430,000	160,000
# of employees	540	200	360
Contribution margin	260,000	425,000	460,000
Direct fixed costs	59,520	377,620	231,900
Average net operating assets	$320,000	$800,000	$420,000

Willowbrook Company has a target annual rate of return of 22 percent, a weighted-average cost of capital 16%, and is subject to a 30% tax rate. The Soft Drinks Division was recently presented with an investment in a $205,000 piece of machinery that would save operating costs of $5,000 per year over a period of thirty years. The new machinery would replace a current piece of equipment that could be sold for $2,000 and has a book value of $50,000. The manager of the Soft Drinks Division, with full decision rights on the matter, decided against replacing the current equipment.

The CEO of Willowbrook, David Copperfield, heard about the investment opportunity and is confused about the outcome. From his initial conversations with the Soft Drinks Division’s manager, it sounded like a good investment.

Copperfield is also reconsidering its investment in cider-based drinks - in the three previous years, Cider has shown a net loss. When Copperfield launched the Cider product line four years ago, he gave the division manager until this year to come ‘out of the red’. 80% of the Cider division’s direct fixed costs could be avoided by discontinuing the product line. At this point, Willowbrook has not identified an alternate use for the Cider production space, and all three divisions are currently running below capacity.

Required:

a. Create a multilevel income statement, showing the three divisional incomes and the corporate net income (for Willowbrook overall).

b.   Calculate the annual ROI, residual income, and EVA for the new investment considered by the Soft Drinks Division (not for the division overall).

c. Provide a differential analysis of lifetime costs of the Soft Drinks Division’s investment, using the techniques learned in this class. Ignore tax effects in your analysis.

d. Did the Soft Drinks division manager make the ‘right’ decision (i.e., was it in Willowbrook’s overall best interest for the Soft Drinks division to reject the investment)? Explain your answer. Your answer from part b. should inform your evaluation.

e. Recreate the multilevel income statement from requirement (a) showing the overall effect on net income if Willowbrook were to discontinue the Cider product line. Provide a recommendation on whether to discontinue the Cider product line.

f.    Notice how the allocation of corporate overhead affects the Cider product line. Provide a recommendation on a different way to allocate corporate overhead.

**Please show all calculations! I am trying to understand how to do this, not just get an answer.** Thank you!

Answer 1

It may be noted that allocated corporate costs are not controllable by the divisions, and therefore they are not to be considered for decision making, as they are not relevant costs. Only the direct fixed cost will be considered in calculating the ROI.

a.

Total Income for 3 divisions: 475960

Less corporate costs: 320000

PBT. 155960

Less tax(30%). 46788

PAT. (Net income) $ 109172

b.

Cost of machinery $205000

Less: sale of old mach $. 2000

Less: tax benefit on loss of sale:* $ 33600

We get net investment cost= $169400

* ( loss on sale = 50000-2000=$ 48000. Tax benefit=48000*(1-tax rate) = 48000*(100%-30%) =48000*70%=$33,600 )

Annual ROI for the new machine = 5000x100/169400 = 2.95%

Residual income from the new machine = $2000x(1- tax rate)= 2000x70%=$1400

EVA for the new machine=(-169400 +1400 for 30 years discounted at 16%) =

-169400 + 1400/(1.16) + 1400/(1.16)²...+ 1400/(1.16)³⁰

^{=-169400 + 8648(calculation shown below) = -160762}

note:We multiply 1400 by 0.862069 to get 1206.897(which is 1/(1+r)ⁿ where r =0.16( or 16%) and n is the number of years

( n starts from 1 upto 30 )this is known as the discounting factor )

c) differential analysis is same as above

d) yes, the decision to reject the new soft drink project was a correct decision as the NPV was -160762.

it seems that the question is wrong - a gain of only $2000 for 30 years will never justify an investment of $200000)( it could be a

gain of $20000 per annum)

This is known as the discounting cash flow technique of evaluating projects, where the net Present Value is calculated and if it is positive, we accept otherwise reject