Profitability Measures-Financial Management

Question 1

A company has two divisions. Division A has operating income of $500 and total assets of $1,000. Division B has operating income of $400 and total assets of $1,600. The required rate of return for the company is 10%. The company's residual income would be which of the following amounts?
	A.  	$0
	B.  	$260
	C.  	$640
	D.  	$900

Answer 1

C. $640

Residual income is the difference between the actual income and the required return on investment. For the facts given actual income is $900 ($500 + $400) and the required return is of $260 [($1,000 + $1,600) * 10%], resulting in residual income of $640 ($900 - $260).

Question 2

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.  	Residual income.
C.  	Profitability index.
D.  	Economic value added.

Answer 2

A. Return on investment.

The use of (an expected) return on investment (ROI) as a performance measure for an investment center may lead a manager to forgo investments that could benefit the company as a whole. In an investment center, management is responsible for the center’s revenues, costs and related investments. The basic ROI calculation for an investment center is Center Operating Income/Average Center Operating Assets. Center management would likely forgo an investment opportunity that may provide a more than adequate ROI for the company as a whole, but which would provide a ROI lower than the center’s already existing ROI, which would lower the center’s overall ROI.

Question 3

Analysis shows that the gross profit margin of a company has declined substantially over the last two years. This decline could be attributed to which of the following possible causes, if any:

I. The cost of inventory has increased faster than selling prices.

II. Stiff competition has resulted in lower selling prices with the same cost.
A. I only is correct.
B. II only is correct.
C. Both I and II are correct.

Answer 3

C. Both I and II are correct.

Gross profit is computed as net sales minus cost of goods sold. Gross profit margin is computed as gross profit/net sales. Therefore, factors that reduce net sales or increase cost of goods sold will adversely affect the gross profit margin.

Both the cost of inventory increasing faster than selling prices and lower selling prices resulting from competition (with no change in the cost of goods sold) will cause a decrease in the gross profit margin.

Question 4

The following data pertain to Cowl Inc. for the year ended December 31, 2006:

Net sales $ 600,000
Net income 150,000
Total assets, January 1, 2006 2,000,000
Total assets, December 31, 2006 3,000,000

Which one of the following was Cowl's rate of return on assets for 2006?
	A.  	5%
	B.  	6%
	C.  	20%
	D.  	24%

Answer 4

B. 6%

The rate of return on assets (ROA) is computed as: ROA = Net Income + Interest Expense/Average Total Assets Since this question does not provide the amount of interest expense, the unadjusted net income must be used as the numerator. Beginning and ending total assets must be used to get an average total assets for the year. That calculation would be: Beginning assets $2,000,000 + Ending assets $3,000,000 = $5,000,000/2 = $2,500,000 average total assets. The ROA

Question 5

Which of the following ratios would be used to evaluate a company’s profitability?

   A.  	Current ratio.
B.  	Inventory turnover ratio.
C.  	Debt to total assets ratio.
D.  	Gross margin ratio.

Answer 5

D. Gross margin ratio.

The gross margin ratio (also the gross profit margin) is used to evaluate a company’s profitability. It is computed as:

Gross Margin Ratio (or Gross Profit Margin) = Gross Profit/Net Sales

Question 6

Ral Co.'s target gross margin is 60% of the selling price of a product that costs $5.00 per unit. The product's selling price per unit should be
	A.  	$17.50
	B.  	$12.50
	C.  	$8.33
	D.  	$7.50

Answer 6

B. $12.50

Correct!
Gross margin is Selling Price - Cost of Sales. Therefore, the formula for solution is:

Selling Price - Cost = .60 Selling Price.
Rearranged: Selling Price - .60 Selling Price = Cost ($5.00).

Therefore, .40 Selling Price = $5.00, or Selling Price = $5.00/.40 = $12.50.

Question 7

costs of $990,000. What is the target price to obtain a 15% profit margin on sales?
	A.  	$2,329
	B.  	$2,277
	C.  	$1,980
	D.  	$1,935

Answer 7

A. $2,329

Two steps are involved in getting the solution. First, the total sales have to be determined using the given “cost” margin (100% - 15% profit margin = 85% cost margin) and the given cost amount. Once the total sales are determined, the given number of units (500) can be used to determine the per unit selling price. Total sales can be computed as:

Total Sales - Cost = 15% Total Sales.
Rearranged: Total Sales - .15 Total Sales = Cost.

Therefore, .85 Total Sales = $990,000, or Total Sales = $990,000/.85 = $1,164,706.

Target Price = $1,164,706/500 units (given) = $2,329 sales price per unit.

Proof: Profit Margin = Net Income/Sales

Net Income = Sales ($1,164,705) - Cost ($990,000) = $174,706 Net Income.

Profit Margin = $174,706/$1,164,705 = 15% (the desired profit on sales).

Question 8

SkBound Airlines provided the following information about its two operating divisions:

Passenger 	Cargo Operating profit 	$ 40,000 	$ 50,000 Investment 	250,000 	500,000 External borrowing rate 	6% 	8%

Measuring performance using return on investment (ROI), which division performed better?
A. The Cargo division, with an ROI of 10%.
B. The Passenger division, with an ROI of 16%.
C. The Cargo division, with an ROI of 18%.
D. The Passenger division, with an ROI of 22%.

Answer 8

B. The Passenger division, with an ROI of 16%.

The Passenger division with an ROI of 16% is the better performing division. Return on investment (ROI) measures the rate of return earned on total assets invested and is computed as operating profit divided by total investment. The greater the ROI, the better the performance. For the facts given:

Passenger division = $40,000/$250,000 = 16% = Greater ROI

Cargo division = $50,000/$500,000 = 10%

Question 9

The following selected data pertain to the Darwin Division of Beagle Co. for 2005:

Sales 	$400,000
Operating income 	40,000
Capital turnover 	4
Imputed interest rate 	10%
What was Darwin's 2005 residual income?
	A.  	$0
	B.  	$4,000
	C.  	$10,000
         D. $30,000

Answer 9

D. $30,000

Residual income is the excess of the division’s income over the income that would be required based on the 10% imputed interest rate and the amount invested in divisional assets. This question requires a determination of divisional assets. The division’s assets turned over four times, meaning, with sales of $400,000, the division has $100,000 of assets. The expected income for this division is then 10% of that amount, or $10,000. Thus, residual income is: Operating income ($40,000) - expected income ($10,000) = $30,000. This amount represents the excess of actual operating income of the division over the minimum amount that is required for a division with $100,000 worth of assets invested.

Question 10

Kim Co.’s profit center Zee had 2004 operating income of $200,000 before a $50,000 imputed interest charge for using Kim’s assets. Kim’s aggregate net income from all of its profit centers was $2,000,000. During 2004, Kim declared and paid dividends of $30,000 and $70,000 on its preferred and common stock, respectively.

Zee's 2004 residual income was
	A.  	$140,000
	B.  	$143,000
	C.  	$147,000
	D.  	$150,000

Answer 10

D. $150,000

The dividend information is not relevant to the question. Dividends are a distribution, rather than a determinant, of income. Residual income is computed as:

Residual income = operating income - imputed charge
= $200,000 - $50,000
= $150,000
The imputed charge is the product of a minimum rate of return and the invested capital in the division. The imputed charge is the minimum income that should be achieved by the division with that much invested capital.

Question 11

Minon, Inc. purchased a long-term asset on the last day of the current year. What are the effects of this purchase on return on investment and residual income?
Return on Investment Residual Income
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease

Answer 11

Return on Investment Residual Income
Decrease Decrease

Acquiring a long-term asset on the last day of the year would decrease the return on investment because a larger asset base would be divided into the net income for the period, and residual income would decrease because the average invested capital, which is multiplied by the hurdle rate of return and subtracted from net income, would increase.

Question 12

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, respectively, for this equipment, which has an average value of $100,000?
	A.  	$2,000, 20%
	B.  	35%, $3,600
	C.  	$3,600, 35%
	D.  	20%, $2,000

Answer 12

D. 20%, $2,000

Correct!
The ROI is computed as: Net Income/Average Total Assets. Substituting the values provided, the calculation would be: Net Income ($80,000 - $45,000 - $15,000) = $20,000/Average Equipment Value = $100,000 = $20,000/$100,000 = .20 (or 20%). RI is computed as: Net Income - Required $ Return. Substituting the values provided, the calculation would be: Net Income ($80,000 - $45,000 - $15,000) = $20,000 - (Average Investment ($100,000) x Required or Hurdle Rate (.18)) = $20,000 - ($100,000 x .18) = $20,000 - $18,000 = $2,000. Thus, ROI = 20% and RI = $2,000.

Question 13

A company’s return on investment is the
A. Profit margin percentage divided by the capital turnover.
B. Profit margin percentage multiplied by the capital turnover.
C. Capital turnover divided by invested capital.
D. Capital turnover multiplied by invested capital.

Answer 13

B. Profit margin percentage multiplied by the capital turnover.

Return on investment = Income/Investment

Profit margin percentage = Income/Sales
Capital turnover = Sales/Investment

Therefore: Return on investment = (Income/Sales) x (Sales/Investment) = Profit margin percentage x capital turnover.
This answer correctly states: Profit margin percentage MULTIPLIED by the capital turnover.

Question 14

Which of the following terms represents the residual income that remains after the cost of all capital, including equity capital, has been deducted?

    A.  	Free cash flow.
B.  	Market value-added.
C.  	Economic value-added.
D.  	Net operating capital.

Answer 14

C. Economic value-added.

Economic value-added (EVA) represents the residual income that remains after the cost of all capital, including equity capital, has been deducted. It is calculated as an entity’s net after-tax operating profit less the cost of capital provided by debt holders and shareholders. It is a performance metric intended to measure economic profit, not accounting profit.

Question 15

Return on assets is computed as Net Income (as appropriately adjusted)/Average Total Assets.
DuPont Company developed a method of separating the return on assets computation into two component ratios.

Which one of the following sets identifies the two component ratios that make up the DuPont return on assets approach?
A. Gross profit margin (ratio) and average total asset turnover ratio.
B. Net profit margin (ratio) and average total asset turnover ratio.
C. Gross profit margin (ratio) and average fixed asset turnover ratio.
D. Net profit margin (ratio) and average fixed asset turnover ratio.

Answer 15

B. Net profit margin (ratio) and average total asset turnover ratio.

The basic return on assets (ROA) calculation is: ROA = Net Income/Total Assets That formula is separated into two components in the DuPont return on assets: ROA = Net Profit Margin (Ratio) x Average Total Asset Turnover Ratio Each of these ratios is defined as: Net Profit Margin Ratio = Net Income/Net Sales and Average Total Asset Turnover Ratio = Net Sales/Average Total Assets. Thus, in its most detailed form the DuPont ROA is:

Net Income
__________

Net Sales

x

Net Sales
________________

Average Total Assets

Question 16

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.

Answer 16

B. ROI may lead to rejecting projects that yield positive cash flows.

When managers are currently producing high ROI rates, they may be reluctant to accept a project that has a lower ROI than their current rate of return. A project may meet the company’s return requirements, but if it causes a manager’s overall ROI to decrease, they may be reluctant to accept the project.

Question 17

Residual income of an investment center is the center’s
A. Income plus the imputed interest on its invested capital.
B. Income less the imputed interest on its invested capital.
C. Contribution margin plus the imputed interest on its invested capital.
D. Contribution margin less the imputed interest on its invested capital.

Answer 17

B. Income less the imputed interest on its invested capital.
Residual income is the achieved income of the division less a measure of the minimum required income that should be earned by a division with that amount of capital invested. Residual income = division income - [(imputed interest rate)(division capital)].

Thus, residual income is the amount of income over and above the minimum required of the division with its amount of invested capital. A larger number indicates a more successful division.

Question 18

Spar Co. calculated the following ratios for one of its profit centers:

Gross margin 	30%
Return on sales 	25%
Capital turnover 	.5 times
What is Spar's return on investment for this profit center?
	A.  	7.5%
	B.  	12.5%
	C.  	15.0%
	D.  	25.0%

Answer 18

B. 12.5%

Rate of return on investment (ROI) is computed as: ROI = Net income/Total investment. Since net income and total investment are not given, an alternative formulation must be used. That alternative recognizes that ROI can be derived as: ROI = Asset turnover x Profit margin on sales. Asset turnover = Sales/Investment and Profit margin on sales = Net income/Sales. Therefore,

ROI = (Sales/Investment) x (Net income/ Sales), or

Using the facts given: ROI = .5 x .25 = .125 or 12.5%, Spar’s return on investment.

Question 19

Select Co. had the following 2004 financial statement relationships: Asset turnover 5. Profit margin on sales 0.02 What was Select's 2004 percentage return on assets?
	A.  	0.1%
	B.  	0.4%
	C.  	2.5%
	D.  	10.0%

Answer 19

D. 10.0%

Rate of return on assets (ROA) is computed as: ROA = Net income/Total assets. Since net income and total assets are not given, an alternative formulation must be used. That alternative recognizes that ROA can be derived as: ROA = Asset turnover x Profit margin on sales. Asset turnover = Sales/Assets and Profit margin on sales = Net income/Sales. Therefore,

ROA = (Sales/Assets) x (Net income/ Sales), or
Using the facts given: ROA = 5 x .02 = .10, or 10%.

A more verbal approach to the solution is: The asset turnover reflects how well assets have generated sales (5 times in the year). If each dollar of assets generates $5 of sales, and if the firm earns 2% on each dollar of sales, then each dollar of assets earns .02 x $5 = $.10 each year, or 10% of each dollar of asset.

Question 20

Which combination of changes in asset turnover and income as a percentage of sales will maximize the return on investment?
Asset turnover Income as a percentage of sales
Increase Decrease
Increase Increase
Decrease Increase
Decrease Decrease

Answer 20

Asset turnover Income as a percentage of sales.
Increase Increase

Return on investment = income/investment = (sales/investment x [income/sales]) = (asset turnover) x (income as a percent of sales). This disaggregation of return on investment allows an analysis of the effect of turnover and income as a percent of sales on return on investment. An increase in either or both of the component ratios will result in an increase in return on investment. This makes intuitive sense. The more times assets “turn over” or produce sales in the amount of assets in a period, the higher will be the return on those assets. Similarly, the larger percentage of sales kept by the firm as income, the higher will be return to investment.

Question 21

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.  	25.00%
	C.  	20.31%
	D.  	20.00%

Answer 21

B. 25.00%

The return on investment is computed as:
Return (Net Income)/Average Investment

In this problem, the return for year 3 is $1,100,000 - 700,000 = $400,000. The average investment is $1,200,000 + 2,000,000/2, or $1,600,000. Therefore, the return on investment is:
$400,000/$1,600,000 = 25%

Question 22

Para Co. is reviewing the following data relating to an energy saving investment proposal:

Cost $50,000
Residual value at the end of 5 years 10,000
Present value of an annuity of 1 at 12% for 5 years 3.60
Present value of 1 due in 5 years at 12% 0.57
What would be the annual savings needed to make the investment realize a 12% yield?
A. $8,189
B. $11,111
C. $12,306
D. $13,889

Answer 22

C. $12,306

To solve this problem, let “A” equal the unknown annual savings needed to realize a 12% annual yield. Recall that the net present value (NPV) is the difference between the present value of cash inflows from the investment and the cost of the investment, and that NPV would be zero (0) when the project earns 12%. Since the unknown “A” is an annual cash savings, it must be “measured” by applying an annuity factor. In addition, the $10,000 residual value is a single cash inflow, that must be converted to present value. The cost of the investment, $50,000, is a present value. Thus, the formula for solving for a NPV of zero (0) is:

“A” (3.60) + $10,000 (.57) - $50,000 = 0
Rearranged: “A” (3.60) = $50,000 - $5,700, or “A” = $44,300/3.60; “A” = $12,306.

Thus, an annual savings of $12,306 would yield a 12% return on the project investment.

Question 23

Division A is considering a project that will earn a rate of return which is greater than the imputed interest charge for invested capital, but less than the division’s historical return on invested capital.

Division B is considering a project that will earn a rate of return which is greater than the division’s historical return on invested capital, but less than the imputed interest charge for invested capital.
If the objective is to maximize residual income, should these divisions accept or reject their projects?
A B
Accept Accept
Reject Accept
Reject Reject
Accept Reject

Answer 23

A B
Accept Reject

For residual income to be positive, the rate of return on the project must exceed the imputed interest charge. Residual income = project income - (imputed interest charge)(project investment). Division A’s project will earn a project rate of return exceeding the imputed interest charge. Therefore, residual income for the project will be positive. Division B’s project will earn a project rate of return less than the imputed interest charge. Therefore, its residual income will be negative. To maximize residual income, Division A’s project should be accepted and Division B’s project rejected. For this question, it is irrelevant whether the rate of return will exceed the historical average for the division.