Question

For fiscal year 2018, Hiroole Department Store had net income of $6,060,000. Interest expense was $2,272,500, and the company’s tax rate on income was 40 percent. Total assets were $80,827,000, and noninterest-bearing current liabilities were $7,188,000. The company’s cost of capital (required rate of return) is 10 percent. Calculate NOPAT, invested capital, and residual income for Hiroole Department Store. (Enter negative answers preceding either - sign, e.g. -45 or in parentheses, e.g. (45).) NOPAT $ Invested capital $ Residual income $ Comment on the company’s profitability. The company appears .

Answer 1

Calculation of NOPAT, invested capital, and residual income for Hiroole Department Store

Given Details;

Net income of $6,060,000

Interest expense was $2,272,500

Company’s tax rate on income = 40 %

Total assets = $80,827,000

Noninterest-bearing current liabilities = $7,188,000

Company’s cost of capital (required rate of return) = 10 %

i.NOPAT (Net Operating Income After Taxes)

                 NOPAT = Net Income + Interest expense * (1 – Tax rate)

                               = $6,060,000 + $2,272,500 * (1-40%)

                               = $8,332,500 *(1-0.40)

                              = $8,332,500 *0.60

                 NOPAT   = $4,999,500

Explanation; NOPAT is a profitability measurement that calculates the amount of profits that a company makes from its operations after taxes. So, this will consider the “Operating Income” for the calculation. Operating Income indicates the operating efficiency of the company but Net Income is a measure of overall profitability of a company.

For arriving the Operating Income, we will add back “Interest Expenses” to “Net Income” since the “Interest expenses” has been initially subtracted to determine Net income. Because of this, Net income on which a company calculates its Income tax would be larger.

ii. Invested Capital

      Invested capital = Total assets – Noninterest-bearing current liabilities

                                        = $80,827,000 - $7,188,000

                       Invested capital      = $ 73,639,000

Explanation; Invested Capital is an important factor in profitability measurement that takes all “Assets “which bears Interest (Financing cost). So all other “non-interest bearing “assets will be reduced from the “Asset”. These “free financing cost” assets in called Noninterest-bearing current liabilities. In other words, Invested Capital represents the Assets which has only “cost of capital”.

iii. Residual Income

            Residual Income =NOPAT – Required profit

                                          = NOPAT – (Cost of capital * Invested capital)

                                      

                                             = $ 4,999,500 – (10%*$73,639,000)

                                             = $4,999,500 - $7,363,900

     Residual Income           = $ (2,364,400)

Explanation; The residual income is a method of measuring performance of investment center is meeting its minimums. If the Residual Income positive, the department is making more than its minimum. If the Residual Income is negative, on the other hand, the department is not meeting its minimums.

Calculation of Hiroole Department Store’s profitability.

Return On Investment (ROI) = NOPAT / Invested Capital*100

                                              = $4,999,500/ $73,639,000*100

Return On Investment (ROI)   = 6.79%

Therefore, Hiroole Department Store is generated about 6.79% of profit for of assets tied up. This means this company is having “Low Profitability”. Since the company has required rate of return on invested capital equal to 10% and the company is earning only 6.79%, the company is not as profitable as it is required to be.

Explanation; ROI indicates the percent of profit earned for each dollar of invested assets. In other words, it measures the ability of an investment center to generate profit using the assets invested in the division.

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