performance management part 2 Flashcards
MCQ-06773
All of the following statements about Return on Investment (ROI) are correct, except:
A. ROI is expressed as a percentage of profit to investment.
B. ROI is an outstanding performance measure since it motivates managers to delay or avoid investing in new plant, property, & equipment (PP&E).
C. Delayed investment in new plant, property, & equipment (PP&E) generally makes achievement of ROI targets easier.
D. ROI targets are designed to motivate managers to achieve target levels of net
earnings on company resources.
Choice “B” 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 “A” 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 “C” 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 “D” is incorrect. The return on investment (ROI) measurement motivates achievement of levels of net earnings on company resources.
What is the formula for investment turnover?
Investment Turnover = Sales / Average Investment
NOTE: DONT FORGET TO AVERAGE
Galax, Inc. had operating income of $5,000,000 before interest and taxes. Galax’s net book
value of plant assets at January 1 and December 31 were $22,000,000 and $18,000,000, respectively. Galax achieved a 25 percent return on investment for the year, with an investment turnover of 2.5. What were Galax’s sales for the year?
A. $55,000,000
B. $50,000,000
C. $45,000,000
D. $20,000,000
Explanation
Choice “B” is correct. Sales are a component of the investment turnover ratio. The investment turnover formula is:
Investment turnover = sales / average investment
The fact pattern provides beginning and ending asset values and the amount of the investment turnover. The solution involves populating the variables in the investment turnover formula and solving for “×” (sales) as follows:
2.5 = sales / (($22,000,000 + $18,000,000) / 2)
2.5 = sales / $20,000,000
Sales = $20,000,000 × 2.5
Sales = $50,000,000
What is the formula for RETURN ON INVESTMENT (ROI)?
SHORT AND LONG VERSION
short version: ROI = income / investment
long version : ROI = (Revenues - COG sold - G&A expense) / investment
What is the formula for residual income (RI)?
RI = Income - (Investment x Hurdle Rate)
MCQ-08299
Managers of the Doggie Food Co. want to add a bonus component to their compensation plan. They are trying to decide between return on investment (ROI) and residual income (RI) as the performance measure they will use. If Doggie adopts the RI performance measure, the relevant required rate of return would be 18%. One segment of Doggie is the
Good Treats division, where the manager has invested in new equipment. The operating results from this equipment are as follows:
Revenues $80,000
Cost of goods sold $45,000
General and administrative expenses $15,000
Assuming that there are no income taxes, what would be the ROI and RI for this equipment
that has an average value of $100,000?
ROI RI A. $2,000 20% B. 35% $3,600 C. $3,600 35% D. 20% $2,000
Choice “D” is correct. Return on investment and residual income measures are computed as follows:
Return on Investment (ROI)
ROI = Income ÷ Investment
ROI = (Revenues − Cost of goods sold − General & administrative expense) ÷ Investment
ROI = ($80,000 − $45,000 − $15,000) ÷ $100,000
ROI = $20,000 ÷ $100,000 = 20%
Residual Income (RI)
RI = Income − (Investment × Hurdle rate)
RI = ($80,000 − $45,000 − $15,000) − ($100,000 × 18%)
RI = $20,000 − $18,000 = $2,000
MCQ-03437
Listed below is selected financial information for the Western Division of the Hinzel Company for last year.
Account Amount (thousands)
Average working capital $625
General and administrative expense 75
Net sales 4,000
Average plant and equipment 1,775
Cost of goods sold 3,525
If Hinzel treats the Western Division as an investment center for performance measurement
purposes, what is the before-tax return on investment for last year?
A. 26.76 percent.
B. 22.54 percent.
C. 19.79 percent.
D. 16.67 percent.
Choice “D” is correct. 16.67% return on investment.
ROI Formula (Short version) = $400 income / $2,400 investment = 16.67%
Income:
Sales $4000
minus
Cost of goods sold (3,525)
minus
G & A expense (75)
= Net income of $400
Investment:
Average working capital 625
+
Average plant & equipment 1,775
= Investment $2,400
Formula for asset turnover?
Asset turnover = Sales / Assets
Formula(s) for profit margin?
Profit margin = Net Income / Sales
Profit Margin = Return on investment / asset turnover
MCQ-04999
Harbor Corporation had sales of $1,500,000 for the year ended December 31, Year 1, an asset turnover ratio of 2 for the same period, and a return on investment of 6%. What was Harbor’s total assets and net income?
Assets Net Income A. $500,000 $30,000 B. $750,000 $45,000 C. $1,000,000 $60,000 D. $1,500,000 $90,000
Choice “B” is correct. Return on investment (which is given in this question) is equal to the ratio of net income to invested assets and is also expressed as the product of asset turnover times profit margin, as follows:
Step 1: Determine the Investment Base
The asset turnover ratio of 2.0 is given in the problem. Asset turnover is calculated as
Sales divided by Assets.
Sales is also given in the problem. Therefore, we can derive the amount of assets as follows:
Asset Turnover =
Sales / Assets
2.0 = $1,500,000 / Assets
Assets = $1,500,000 / 2.0
Assets = $750,000
Step 2: Determine Net Income
Profit margin is equal to net income divided by sales. We are given the sales amount in the problem, but not the net income (which is part of the answer).
Profit margin is also calculated by dividing return on investment by the asset turnover.
Both of these are given in the problem; therefore, profit margin is calculated to be 3%
(6.0% ÷ 2.0)
Once the profit margin is calculated, we can use the given amount of sales ($1,500,000) to derive the net income, as follows:
Profit Margin =
Net Income / Sales
3% = Net Income / $1,500,000
Net Income = 3% × $1,500,000
Net Income = $45,000
MCQ-04817
Vested, Inc. made some changes in operations and provided the following information:
Year 2 Year 3
Operating revenues 900,000 1,100,000
Operating expenses 650,000 700,000
Operating assets 1,200,000 2,000,000
What percentage represents the return on investment for year 3?
A. 28.57%
B. 25%
C. 20.31%
D. 20%
Choice “B” is correct.
Return on investment is the ratio of operating income to average operating assets and is computed as follows based on Year 2 and Year 3 data:
Operating revenue (Year 3) $1,100,000
Operating expense (Year 3) (700,000)
Operating income 400,000
Operating assets (Year 2) 1,200,000
Operating assets (Year 3) 2,000,000
Total 3,200,000
Average operating assets ÷2 = 1,600,000
Return on investment 25%
Return on assets:
A. Is a measure of profitability that indicates how much is left of each sales dollar to
cover operating expenses and interest expense.
B. Is a profitability measure that can be used to evaluate the efficiency of asset usage and management, and the effectiveness of business strategies to create profits.
C. Measures the amount of operating income earned above the imputed cost of capital for the operating unit. If the measure is positive, returns exceed the cost of financing the operating unit.
D. Measures asset activity and the ability of the firm to generate sales through them use of assets. Generally, the more sales dollars generated per dollar of assets used, the better the net income of an entity
Choice “B” is correct. This answer choice correctly describes the purpose of return on
assets (ROA).
MCQ-04248
One approach to measuring divisional performance is return on assets. Return on assets is expressed as income:
A. Divided by the current year’s capital expenditures plus cost of capital.
B. Divided by average fixed assets.
C. Divided by average current assets.
D. Divided by average total assets.
Choice “D” is correct. On a divisional level, return on assets is (operating) income divided by average total assets.
Choice “A” is incorrect. Current year’s capital expenditures plus cost of capital would be a meaningless denominator.
Choice “B” is incorrect. This omits the current assets employed by the division.
Choice “C” is incorrect. This omits fixed assets
MCQ-11115
Gamma Co., a manufacturer of medical products, had a 10% return on assets and an asset turnover of 4:1. What was Gamma’s profit margin on sales?
A. 40.0%
B. 10.0%
C. 4.0%
D. 2.5%
Choice “D” is correct. Return on assets (ROA) is equal to net income divided by total assets. ROA can also be calculated by multiplying profit margin (net income / sales) by asset turnover (sales / assets). If ROA is given as 10%, and the asset turnover is equal
to 4, the profit margin is derived by dividing 10% by 4 = 2.5%.
10% = Profit margin × 4; Profit margin = 10% / 4 = 2.5%.
Choice “A” is incorrect. This choice incorrectly multiplies the ROA of 10% by 4.
Choice “B” is incorrect. 10% is the ROA, not the profit margin.
Choice “C” is incorrect. Although the asset turnover ratio (not the profit margin) is equal to 4, this is expressed as a raw number ratio and not a percentage.
MCQ-12451
In analyzing its current year operating performance, Merle Co. determined that its return on
assets improved significantly from the prior year. Total assets and operating expenses were
stable and overall debt decreased, while net earnings increased due to greater sales
volume. An additional 50,000 shares of common stock were authorized during the year.
Which of the following statements best explains Merle’s improved return on assets in the
current year?
A. Merle made more efficient use of its assets.
B. Merle made more efficient use of its cash flow.
C. Merle increased its outstanding capital.
D. Merle decreased its operating expenses.
Choice “A” is correct. Return on assets is equal to net income divided by average total
assets. The ratio can be further broken down into two components: net profit margin
(net income divided by sales) and asset turnover (sales divided by average total
assets). Assets are stable and operating expenses are stable, but sales and net
earnings have increased. The effect on the net profit margin is unclear because both
sales and earnings have increased, but the effect on the asset turnover is evident
because sales increased while assets remained stable. The increase in the asset
turnover is therefore the driver of the increase in return on assets, which reflects more
efficient usage of firm assets.
Choice “B” is incorrect. The efficient usage of cash flow is not reflected in the return on
assets.
Choice “C” is incorrect. Although additional common shares were issued and debt
decreased, outstanding capital is not factored into the return on assets calculation.
Choice “D” is incorrect. Net earnings did increase, but that was due to sales increases;
operating expenses were noted to be stable.
MCQ-05249
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 is a percentage, while RI is a dollar amount.
B. ROI may lead to rejecting projects that yield positive cash flows.
C. ROI does not necessarily reflect the company’s cost of capital.
D. ROI does not reflect all economic gains.
Choice “B” 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.”
______________ encourages shortsighted behavior that defers or avoids investment for the sake of current performance. Short-term benefits are emphasized over long-term commitments.
Return on Investment (ROI)
MCQ-08378
Spear Corp. had sales of $2,000,000, a profit margin of 11 percent, and assets of $2,500,000. Spear decided to reduce its debt ratio to 0.40 from 0.50 by selling new common stock and using the proceeds to repay principal on some outstanding long-term
debt. After the refinancing, what is Spear’s return on equity?
A. 3.5 percent
B. 5.3 percent
C. 14.7 percent
D. 22.9 percent
ROE = NetIncome/Sales x Sales/Assets x Assets/Equity
AKA
ROE = Net profit margin x Asset Turnover x financial leverage
The three terms in the calculation (in order) are known as the net profit margin, asset turnover, and financial leverage, respectively. For Spear, these amounts given in the question are reflected in the formula below:
ROE = 0.11 x 2,000,000/2,500,000 x 2,500,000/2,500,00 (1-.0.40)
ROE = .11 * .8 * 1.666666667
ROE = .1466666 = 14.7%
Note that equity is derived using the new debt ratio of 0.40. If debt represents 40 percent of total assets, equity must represent 60 percent.
WORK/ A = L + E
2,500,000 = L + E
Debt ratio is 40%
Means Equity = 60%
Equity = 2.5 million * .6 = 1,500,000
MCQ-12430
Last year a segment of Dickson Company had the following sales, assets, and operating
income:
Sales $500,000
Assets 200,000
Operating income 50,000
What is the segment’s asset turnover?
A. 2 times
B. 2.5 times
C. 4 times
D. 10 times
Asset Turnover = Sales / Average total assets
In this case with a single asset amt give the answer is
$500,000 ÷ $200,000 = 2.5
Choice “B” is correct. The asset turnover ratio is a measure of the degree of efficiency with which a company is using its assets. The ratio is equal to sales divided by average total assets. However, because the only asset number provided is a single asset amount of $200,000, that is the number to use. The ratio is therefore equal to $500,000 ÷ $200,000 = 2.5.
MCQ-04345
A company has the following financial information:
Sales $200,000
Net income 100,000
Depreciation 20,000
Interest 10,000
Taxes 5,000
What is the company’s operating profit margin?
A. 32.5%
B. 50.0%
C. 57.5%
D. 67.5%
Choice “C” is correct. Operating profit (often used synonymously with EBIT—earnings before interest and taxes) can be derived by starting with net income and backing out
the effects of interest expense and taxes. Here, interest ($10,000) and taxes ($5,000) are added back to bottom line net income ($100,000) to derive an operating profit (or
EBIT) of $115,000. The operating profit margin is equal to operating profit divided by sales.
$115,000/$200,000 = 57.5%.
What is the formula and other terminology or “Operating Profit Margin”?
Operating profit = EBIT
aka
= Earnings before Interest and Taxes
If given Net Income, add back in Interest and Taxes to derive the Operating Profit / Ebit
ALSO
Gross Profit - Operating Expenses = Operating Profit
Operating Profit = Revenue - Operational Expenses - Cost of Goods Sold - Day-to-Day Costs
The______________ describes the ratio of gross margin to sales and serves to evaluate a company’s profitability.
gross margin ratio
_____________________ is the segment margin of an investment center
after deducting the imputed interest (hurdle rate) on the assets used by the investment center.
Hint: Operational Efficiency is NOT considered in this method.
Residual income
_________________ is the ratio of income earned to the investment.
Return on investment
_______________ is the ratio of income produced to assets
employed (not the amount invested).
Return on assets
The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its:
A. Return on investment rate.
B. Imputed interest rate charge.
C. Cash flows in excess of a desired minimum amount.
D. Income in excess of a desired minimum amount.
Choice “D” is correct.
Residual income is defined as income in excess of a desired
minimum return.
_________________ is usually used as the target or hurdle rate in the residual income approach.
Historical weighted average cost of capital
The optimal imputed interest rate used in the residual income approach to performance evaluation can best be described as the:
A. Historical weighted average cost of capital for the company.
B. Target return on investment set by the company’s management.
C. Average return on investments for the company over the last several years.
D. Marginal after-tax cost of capital on new equity capital.
Choice “B” is correct. The optimal imputed interest rate used in the residual income approach can best be described as the target return on investment set by the company’s management.
Choice “A” is incorrect. While the historical weighted average cost of capital is often used as the target or hurdle rate, it is not the optimal rate.
Choice “C” is incorrect. The average return on investments for past years may not be a good indication of management’s future intentions.
Choice “D” is incorrect. Marginal after-tax cost of capital on new equity may be how management sets its targets, but it may not be, too.
Optimal rate <–|–> Hurdle rate
MCQ-06657
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. $60,000
B. $30,000
C. $20,000
D. $0
Choice “D” 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).
Sales / Asset turnover = ?
Assets
MCQ-03439
James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year.
Category Amount
(Amt in thousands)
Working capital $1,800
Revenue 30,000
Plant and equipment 17,200
If the imputed interest charge is 15 percent and Webb wants to achieve a residual income target of $2 million, what will costs have to be in order to achieve the target?
A. $10,800,000
B. $23,620,000
C. $25,150,000
D. $25,690,000
Choice “C” is correct. $25,150,000 costs to achieve residual income target of $2 million.
First note that the thing it’s asking for is COSTS.
Asset base = Working Capital + PPE
= 1800 + 17200 = 19000
(note: in thousands)
Asset Base = 19 million
19,000,000 * imputed rate of 15% = 2,850,000
Residual income target (given) of 2,000,000 + income from asset base of 2,850,000 = 4.85 million
given revenue forecasts - COSTS = 4.85 million
—> 30,000,000 - 4,850,000 = 25,150,000
Residual Income = ? - ?
Residual Income = Net income - Required Return
{NOTE 1: Can use Net or Operating income to find residual income}
<NOTE 2: Required Return is calculated as the net book value * hurdle rate>
{also expressed as TOTAL ASSETS * REQUIRED RATE}
MCQ-04250
The following selected data pertain to the Darwin Division of Beagle Co. for the current year:
Sales $400,000
Operating income 40,000
Capital turnover 4
Imputed interest rate 10%
What was Darwin’s current year residual income?
A. $0
B. $4,000
C. $10,000
D. $30,000
Choice “D” is correct. Residual income is income less the imputed interest rate times average invested capital.
Capital turnover is equal to sales / average invested capital.
Capital Turnover of 4 = Sales of 400,000 / Avg invested Capital
therefore
Average invested Capital = $100,000
Imputed Rate of 10% * $100,000 = $10,000
RESIDUAL INCOME = Operating Income of $40,000 - $10,000 = $30,000
What is the formula for Capital Turnover?
Capital turnover = Sales / Average Invested Capital
MCQ-04820
A divisional manager receives a bonus based on 20% of the residual income from the division. The results of the division include: Divisional revenues, $1,000,000; divisional expenses, $500,000; divisional assets, $2,000,000; and the required rate of return is 15%.
What amount represents the manager’s bonus?
A. $200,000
B. $140,000
C. $100,000
D. $40,000
Choice “D” is correct as shown in the computation below:
2 million * 15 % required rate = Hurdle = $300,000
1 million - 500k = 500k Actual income
Actual - Hurdle = $200,000
Manager gets 20% of $200k, which is $40,000.
___________________ is a firm’s (investment center’s) net
operating profit after taxes (NOPAT) less its required return (after-tax cost of capital on the investment).
Economic value added
____________________ is calculated by multiplying EBIT × (1 – Taxes), whereas the required return is determined by multiplying the investment (total assets) by the cost of capital or WACC
net
operating profit after taxes (NOPAT)
The ______________ on accounts receivable is the balance of gross accounts receivable less the allowance for uncollectible accounts.
net realizable value
The _________________ is the present value of the net future cash inflows divided by the present value of the net initial investment.
A _______________ greater than one is associated with a positive NPV capital budgeting project.
profitability index
profitability index
MCQ-04333
Which of the following methods is best suited for evaluating the performance of a firm’s capital in any given year?
A. Internal rate of return.
B. Net present value.
C. Economic value-added.
D. Payback
Choice “C” is correct. Economic value-added is a measure that uses net operating profit after taxes (NOPAT) and compares it to the required return for the capital. Each
of these components is calculated on an annual basis, so this model is well suited for evaluating performance in a given year.
Choice “A” is incorrect. Internal rate of return (IRR) is used to evaluate the overall rate of return over the life of a project relative to a required return. It is not used to evaluate
performance in a single year.
Choice “B” is incorrect. Net present value (NPV) is used to evaluate the overall dollar return for a project over its entire life; it is not used as a means for evaluating single
year performance.
Choice “D” is incorrect. The payback method is used to evaluate how long it will take to recover cash outflows for a project. It is not used to evaluate performance for a given
year.
Zig Corp. provides the following information:
Pretax operating profit $300,000,000
Tax rate 40%
Capital used to generate profits 50% debt, 50% equity = $1,200,000,000
Cost of equity 15%
Cost of debt (after tax) 5%
Which of the following represents Zig’s year-end economic value-added amount?
A. $0
B. $60,000,000
C. $120,000,000
D. $180,000,000
Choice “B” is correct. Economic value added (EVA) is computed as after-tax income in excess of required return. EVA is applied to the fact pattern as follows:
300,000,000 - 40% tax rate = 300,000,000 * (1-.4) =
$180,000,000
600,000,000 * 15% = $90 million equity hurdle amt
600,000,000 * 5% after tax rate of debt = $30 million debt hurdle amt
30 million + 90 million = 120,000,000 total hurdle amt
300,000,000 - 120,000,000 = Economic value added = $180,000,000
