Question

Consider the following facts: Divisin A in a firm has generated $847,000 of profits on $24 million worth of sales, using $32 million worth of dedicated assets. The cost for this firm is 9%, and the firm has invested %7.3 million in this division. A. Calculate the return on sales and return on Assets of Divisin A. If the hurdle rate for ROS and ROA in this firm are, respectively, 0.06 and 0.04, has the division performed well? B. Calculate the EVA of Division A (with the assumption that reported profits have already been adjusted) . Based on this EVA, has this division performed well? C. Suppose you were CEO of this firm, how would you choose between ROS/ROA and EVA for evaluating this division?

Answer 1

Given,

Firm’s generated Profit= $847,000

Total Sales= $24 Million = $24,000,000

The cost of capital of firm = 9%

Capital Invested = 7.3 million = $7,300,000

Firm’s Total Assets = $32,000,000

A) Calculation of the Return on Sales (ROS) & Return on Assets (ROA) for Division A

The Return on Sales (ROS) for Division A:

ROS = Net Profit / Total Sales

ROS = $847,000 / $24,000,000

ROS = 0.0352

The Return on Assets (ROA) for Division A:

ROA = Net Income / Total Assets

ROA = $847,000 / $32,000,000

ROA = 0.0264

From the above, we can get that both ROS & ROA, which are lower than their hurdle rate of 0.06 & 0.04 respectively. Therefore, this shows that the project is not running well and should be stopped.

B) Calculation of EVA of Division A:

Economic Value added (EVA) = Net Operating Profit – (Capital X Cost of Capital)

= $847,000 – ($7,300,000 X 9%)

= $847,000 – $657,000

= $190,000

Thus, Based on this EVA, this division has performed well and should be continued.

C) Being the CEO of this Firm, if I have to choose between ROS/ROA and EVA for evaluating this division, I would choose EVA for evaluating the Division A because by using this, we can easily judge the profit earned by making use of the capital. Also, it gives the clear idea about the profit earned by the firm for the shareholders.