B3-4 Flashcards
Wexford Co. has a subunit that reported the following data for Year 1:
Asset (investment) turnover
1.5 times
Sales
$750,000
Return on sales
8%
The imputed interest rate is 12%. What is the division residual income for Year 1?
a.
$30,000
b.
$60,000
c.
$0
d.
$20,000
Explanation
Choice “c” is correct. The residual income method measures the excess of actual income earned by an investment over the amount required to achieve a target or hurdle rate of return. The computation is simple; however, the fact pattern hides the basic information needed. Required data are computed as follows. Actual income earned is $60,000 (given sales of $750,000 times an 8% return on sales). The amount required to achieve the target rate of return is $60,000 (assets of $500,000 times 12%). Assets are computed to be $500,000 (sales of $750,000 divided by the asset turnover of 1.5). The imputed interest rate is the cost of capital or required return and is given at 12% of assets.
Based on the above, division residual income is $0 (actual income of $60,000 minus required income of $60,000).
Choices “b”, “a”, and “d” are incorrect, based on the above explanation
Which of the following performance measures may lead a manager of an investment center to forgo investments that could benefit the company as a whole?
a.
Return on investment.
b.
Economic value added.
c.
Profitability index.
d.
Residual income.
Choice “a” is correct. Return on investment (ROI) measures may discourage mangers from avoiding investments that could benefit the company as a whole. Use of the ROI exclusively as a measure of performance can inadvertently focus managers purely on maximizing short-term returns. Profitable units are reluctant to invest in additional productive resources because their short-term result will be to reduce ROI.
Choice “d” is incorrect. Residual income methods (including economic value added) focus on target return and amount and encourage managers to invest in projects that exceed the hurdle rate. As a result, divisions with high rates of return do not fear dilution of their rates and are not discouraged from making investments that demonstrate strong residual income performance.
Choice “c” is incorrect. The profitability index is a method for ranking previously screened investments and rationing available capital. It would not discourage a manager from making an investment.
Choice “b” is incorrect. Residual income methods (including economic value added) focus on target return and amount and encourage managers to invest in projects that exceed the hurdle rate. As a result, divisions with high rates of return do not fear dilution of their rates and are not discouraged from making investments that demonstrate strong residual income performance.
Which of the following terms represents the residual income that remains after the cost of all capital, including equity capital, has been deducted?
a.
Net operating capital.
b.
Market value-added.
c.
Free cash flow.
d.
Economic value-added.
Explanation
Choice “d” is correct. Economic value-added is a residual income technique used for capital budgeting and performance evaluation. It represents the residual (excess) income of project earnings in excess of the cost of capital (including cost of equity) associated with invested capital.
Choice “c” is incorrect. Free cash flow is defined as operating cash flows net of dividends paid to shareholders and capital expenditures-it is not a residual income technique.
Choice “b” is incorrect. Market value added is defined as the difference between the market value of company’s stock and the adjusted book value of the equity and debt invested in the company, it is not a residual income technique.
Choice “a” is incorrect. Net operating capital is a term generally synonymous with working capital-it is not a residual income technique.
Which of the following ratios would be used to evaluate a company’s profitability?
a.
Debt to total assets ratio.
b.
Current ratio.
c.
Inventory turnover ratio.
d.
Gross margin ratio.
Choice “d” is correct. The gross margin ratio describes the ratio of gross margin to sales and serves to evaluate a company’s profitability.
Choice “b” is incorrect. The current ratio evaluates a company’s liquidity, not profitability.
Choice “c” is incorrect. Inventory turnover is an activity ratio used to evaluate the efficiency of the firm, not profitability. The number of days in the year, 365, divided by inventory turnover equals “days of inventory on hand.”
Choice “a” is incorrect. Debt to total assets measures solvency, not profitability.
What is the primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers?
a.
ROI may lead to rejecting projects that yield positive cash flows.
b.
ROI does not reflect all economic gains.
c.
ROI does not necessarily reflect the company’s cost of capital.
d.
ROI is a percentage, while RI is a dollar amount.
Choice “a” is correct. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows. Profitable investment center managers might be reluctant to invest in projects that might lower their ROI (especially if their bonuses are based only on their investment center’s ROI), even though those projects might generate positive cash flows for the company as a whole. This characteristic is often known as the “disincentive to invest.”
Choice “d” is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows, not that ROI is a percentage and RI is a dollar amount. The fact that one is a percentage and one is a dollar amount might make them a little harder to interpret, but this interpretation difficulty would certainly not seem to be the “primary” disadvantage.
Choice “c” is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows, not that ROI does not necessarily reflect the cost of capital.
Choice “b” is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows, not that ROI does not reflect all economic gains.
The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:
a.
Return on assets.
b.
Residual income.
c.
Return on investment.
d.
Operating income.
Choice “b” is correct. Residual income is the segment margin of an investment center after deducting the imputed interest (hurdle rate) on the assets used by the investment center.
Choice “c” is incorrect. Return on investment is the ratio of income earned to the investment.
Choice “d” is incorrect. Operating income is not well defined, but is generally the income from operations for the entire organization, not a segment.
Choice “a” is incorrect. Return on assets is the ratio of income produced to assets employed (not the amount invested).
Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is incorrect?
a.
The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models.
b.
ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation.
c.
The use of ROI can make it undesirable for a skillful manager to take on trouble-shooting assignments such as those involving turning around unprofitable divisions.
d.
When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate.
Choice “b” is correct. ROI is no more and no less capable of being independently verified or manipulated than other performance measures.
Choice “d” is incorrect. Old fixed assets may be undervalued and make comparison with a segment with newer assets inappropriate.
Choice “a” is incorrect. Investment projects with positive present value may be rejected because ROI is too low.
Choice “c” is incorrect. Turning around an unprofitable division would be good for the company but would probably lower a manager’s ROI.
Which of the following ratios should be used to compare the profitability of two electronics companies that differ in size?
a.
Inventory turnover.
b.
Return on assets.
c.
Quick (acid-test) ratio.
d.
Asset turnover.
Choice “b” is correct. Return on assets (ROA) is a profitability ratio that produces a percentage output, making it easy to compare companies that differ in size. For instance, Company A may have net income of $2,000 and assets of $20,000, for an ROA of 10%. Company B may have $1 million in net income and assets of $10 million, also resulting in an ROA of 10%. The companies are very different in terms of size, but an ROA output allows them to be easily compared.
Choice “c” is incorrect. The quick (acid-test) ratio compares highly liquid current assets to current liabilities, and is therefore not a measure of profitability.
Choice “d” is incorrect. Asset turnover is a measure of how effectively a company is using its assets to generate sales. It does not measure profitability.
Choice “a” is incorrect. Inventory turnover is a measure of the number of times in a period that inventory is sold. It does not measure profitability.
Residual income is a better measure for performance evaluation of an investment center manager than return on investment because:
a.
Desirable investment decisions will not be neglected by high-return divisions.
b.
Issues related to the implicit cost of interest are eliminated.
c.
The problems associated with measuring the asset base are eliminated.
d.
Only the gross book value of assets needs to be calculated.
Choice “a” is correct. Residual income measures actual dollars that an investment earns over its required return rate. Performance evaluation on this basis will mean that desirable investment decisions will not be rejected by high-return divisions.
Choice “c” is incorrect. The asset base must still be measured to use the residual income approach.
Choice “d” is incorrect. Book value or fair market value may be used for either method.
Choice “b” is incorrect. The implicit cost of interest is an issue in either case.
Return on investment (ROI) is criticized as a performance measure since it is not a well balanced measure. What characteristic of effective performance measures does the ROI lack?
a.
ROI does not balance long and short-term issues.
b.
ROI is not easily measured.
c.
ROI is not controlled or influenced by the manager.
d.
ROI is not understood.
Choice “a” is correct. ROI encourages shortsighted behavior that defers or avoids investment for the sake of current ROI performance. Short-term benefits are emphasized over long-term commitments.
Choice “b” is incorrect. ROI is a simple and relatively objective computation that can be drawn from accounting records.
Choice “d” is incorrect. ROI is a well understood concept.
Choice “c” is incorrect. ROI is controlled or influenced by managers and can be manipulated
The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the:
a.
Average prime lending rate for the year being evaluated.
b.
Historical weighted average cost of capital for the company.
c.
Average return on investment that has been earned by the company over a particular time period.
d.
Average return on assets employed over a particular time period.
Choice “b” is correct. Historical weighted average cost of capital is usually used as the target or hurdle rate in the residual income approach.
Choices “c”, “d”, and “a” are incorrect, per the above definition.
The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its:
a.
Cash flows in excess of a desired minimum amount.
b.
Imputed interest rate charge.
c.
Income in excess of a desired minimum amount.
d.
Return on investment rate.
Choice “c” is correct. Residual income is defined as income in excess of a desired minimum return.
Choices “d” and “b” are incorrect. Residual income is not a “rate” of return; it is a dollar amount.
Choice “a” is incorrect. Residual income is an accrual method.
All of the following statements about Return on Investment (ROI) are correct, except:
a.
ROI is an outstanding performance measure since it motivates managers to delay or avoid investing in new plant, property, & equipment (PP&E).
b.
ROI is expressed as a percentage of profit to investment.
c.
ROI targets are designed to motivate managers to achieve target levels of net earnings on company resources.
d.
Delayed investment in new plant, property, & equipment (PP&E) generally makes achievement of ROI targets easier.
Choice “a” is correct. While it is true that ROI can motivate managers to delay or avoid investing in new PP&E, this is often an inappropriate business decision. The company with very old PP&E may have very high ROI measures but could be more profitable with newer, more efficient PP&E.
Choice “b” is incorrect. ROI is expressed as a percentage of profit to investment or as the product of asset turnover and gross margin. It is, in either case, a percentage.
Choice “d” is incorrect. Delaying or avoiding investing in new PP&E may make the achievement of ROI targets easier simply because the denominator remains low.
Choice “c” is incorrect. The return on investment (ROI) measurement motivates achievement of levels of net earnings on company resources.
