SWZ is a manufacturing company that has many trading divisions. Return on Investment
(ROI) is the main measure of each division’s performance. Each divisional manager’s salary
is linked only to their division’s ROI.
The following information summarises the financial performance of the S division of SWZ over
the last three years:
Year ending 31 October 2008
$000
2009
$000
2010
$000
Turnover 400 400 400
Cost of sales 240 240 240
Gross profit 160 160 160
Other operating costs 120 104 98
Pre-tax operating profit 40 56 62
Capital invested as at the end of the year 400 320 256
Other operating costs include asset depreciation calculated at the rate of 20% per annum on
a reducing balance basis.
The figures shown in the above table for the capital invested as at the end of the year is the
net book value of the division’s fixed assets.
All of the above values have been adjusted to remove the effects of inflation. There have
been no additions or disposals of fixed assets within the S division during this period.
Required
(a) Discuss the performance of the S division over the three year period.
The manager of the S division is now considering investing in a replacement machine. The
machine that would be replaced would be sold for its net book value which was $40,000 at 31
October 2010 and the new machine would cost $100,000. The new machine would have an
expected life of five years and would be depreciated using the same depreciation rates as the
existing machinery. The new machine would reduce the division’s cost of sales by 10%. At
the end of five years it would be sold for its net book value.
The divisional cost of capital is 8% per annum. The company has evaluated the investment
and correctly determined that it has a positive Net Present Value (NPV) of $24,536.
Required
(b) Prepare calculations to show why the manager of the S division is unlikely to
go ahead with the investment.
Ignore taxation.
(11 marks)
(c) Prepare calculations to show how the use of Residual Income (RI) as the
performance measure would have led to a goal congruent decision by the
manager of the S division in relation to the purchase of the replacement
machine.
