Chapter 10

6. a. Net income Plus interest Less tax effect of interest NOPAT Total assets Less noninterest-bearing current liabilities Investment ROI (NOPAT Investment) b. Profit margin (NOPAT sales) Investment turnover (sales invested capital) Profit margin turnover = ROI 2003 $6,000,000 4,000,000 1,400,000 $8,600,000 $80,000,000 7,000,000 $73,000,000 .1178 .0717 1.6438 .1179 2004 $8,000,000 5,000,000 1,750,000 $11,250,000 $90,000,000 8,000,000 $82,000,000 .1372 .0625 2.1951 .1372

c. Between 2003 and 2004, ROI increased. This was due to an increase in investment turnover (2.1951 vs. 1.6438) which overcame a decline in profit margin (.0625 vs. .0717). 8. a. Under GAAP, research and development is treated as an expense even though it creates future value. And managers may be tempted to cut back on research and development in order to increase reported earnings. With EVA, research and development is capitalized and amortized over the future periods that are benefited. Since it is not immediately expense for purposes of calculating EVA (and because managers are rewarded based on their EVA performance), managers will have less incentive to cut research and development. b. Year 2002 2003 2004 Cost $ 600,000 1,500,000 2,100,000 2002 $200,000 Amortization 2003 $200,000 500,000 2004 $ 200,000 500,000 700,000 $1,400,000 Unamortized Amount $ 0 500,000 1,400,000 $1,900,000

Net income Plus interest Less tax effect of interest Plus current period R&D Less amortization of R&D Less tax effect of adjustment (35%) NOPAT (adjusted for R&D) Total assets Plus unamortized R&D Less noninterest-bearing current liabilities Investment

$5,000,000 1,000,000 350,000 2,100,000 1,400,000 700,000 245,000 650,000

455,000 $6,105,000 $54,000,000 1,900,000 20,000,000 $35,900,000 $6,105,000 5,026,000 $1,079,000

NOPAT (adjusted for R&D) Less cost of capital investment (.14 $35,900,000) EVA

c. Given that EVA is positive (i.e., the company is showing an economic profit measured in terms of EVA), managers may very well support introduction of EVA. It shows that they are able to earn a return greater than the cost of capital supplied to the firm. 12. a. CustomerCustomer satisfaction Internal processPercent of shipments delivered on time. b. If Bill continues to manage production to meet short-run profit goals, customer satisfaction may decrease (or fail to increase) and the percent of shipment delivered on time may decrease (or fail to increase). c. I would expect Bill to focus more on actions that increase shareholder value (so his options will be worth more). Hopefully, this will lead to more emphasis on improving on time delivery, which is highly valued by his companys customers. 15. a. Because the Fabric Division has substantial idle capacity, variable cost is a good approximation of the opportunity cost of providing fabric to the Clothing Division and should be used as the transfer price. b. The Fabric Division is operating at capacity. Thus, to produce material for the Clothing Division, it must give up external sales. In light of this, the market price is a good measure of the opportunity cost of providing fabric to the Clothing Division and should be used as the transfer price.

c. See answers to a. and b.