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.”
