Question Tag: ROI

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  • 5 Marks

MA – Mar 2024 – L2 – Q1b – Divisional performance | Discounted Cash Flow

This question explains why the divisional manager may reject an option with a higher NPV and discusses board acceptability.

The performance bonus of the fragrance divisional manager is linked to Return on Investment (ROI) and Residual Income (RI) and has an impact on the calculation of retirement benefits. The manager is due to retire at the beginning of Year 3.

Required:
Explain why the fragrance Divisional Manager will not invest in the option showing the higher NPV and comment on whether it will be acceptable to the Board

The fragrance Divisional Manager is likely to favor Option 2, despite its lower NPV, because it yields a higher ROI and RI during the first two years. Since the manager is due to retire at the beginning of Year 3, their decision will be influenced by short-term personal interests, specifically maximizing their performance bonus and retirement benefits, which are based on ROI and RI in the first two years.

Board Perspective:
From the board’s perspective, the focus is on the long-term financial health and value creation for the company. The board would likely reject Option 2 because it underperforms in the later years and results in lower overall NPV, which does not align with the company’s objective of achieving sustainable returns exceeding 16%. Option 1, with its higher NPV, would be the better long-term choice for the company despite its lower short-term performance.

  • 10 Marks

MA – Mar 2024 – L2 – Q1a – Divisional performance

This question requires calculating ROI and RI for two investment options and choosing the best based on these performance metrics.

The Board of Otmost Beauty Ltd, a beauty care production company, is planning to introduce a new product. The Board has tasked the Divisional Manager of the fragrance division to evaluate two options to buy a production plant. Both options will have the same capacity and expected life of four years, but they will differ in capital costs and expected net cash flows as shown in the table below:

Option Option 1 (GH¢ million) Option 2 (GH¢ million)
Initial capital investment year 0 640 520
Net cash flows (before tax)
Year 1 240 260
Year 2 240 220
Year 3 240 150
Year 4 240 100
Net present value at 16% p.a 31.6 19.0

All divisions of the company are expected to generate pre-tax returns on divisional investments in excess of 16% per annum, which the fragrance division currently is just managing to achieve. Anything less than 16% would make the divisional managers ineligible for the annual performance bonus.

The performance bonus is linked to Return on Investment (ROI) and Residual Income (RI) and also has an impact on the calculation of retirement benefits, as the retirement benefits take into consideration the performance bonus earned during the two preceding years. The manager of the fragrance division is due to retire at the beginning of Year 3.

In calculating divisional returns, divisional assets are valued at the net book values at the beginning of the year. Depreciation is charged on a straight line basis with nil residual value.

Required:
i) Calculate the ROI and RI for years 1 to 4 and select the best option from the point of view of the fragrance division based on ROI and RI criteria.

i) Computation of ROI and RI for Option 1:

Year NBV at Beginning (GH¢m) Net Cash Flows (GH¢m) Depreciation (GH¢m) Profit (GH¢m) Imputed Interest @16% (GH¢m) Residual Income (GH¢m) ROI (%)
1 640 240 160 80 102.4 (22.4) 12.5%
2 480 240 160 80 76.8 3.2 16.7%
3 320 240 160 80 51.2 28.8 25.0%
4 160 240 160 80 25.6 54.4 50.0%

Computation of ROI and RI for Option 2:

Year NBV at Beginning (GH¢m) Net Cash Flows (GH¢m) Depreciation (GH¢m) Profit (GH¢m) Imputed Interest @16% (GH¢m) Residual Income (GH¢m) ROI (%)
1 520 260 130 130 83.2 46.8 25.0%
2 390 220 130 90 62.4 27.6 23.1%
3 260 150 130 20 41.6 (21.6) 7.7%
4 130 100 130 (30) 20.8 (50.8) (23.1%)

Conclusion:
Over the entire life of the project, both ROI and RI favor Option 1, with an average ROI of 26.05% and a cumulative RI of GH¢16 million, while Option 2 has an average ROI of 8.18% and a cumulative RI of GH¢0.5 million. Therefore, Option 1 is the best option based on both ROI and RI criteria.

  • 20 Marks

MA – July 2023 – L2 – Q1 – Performance analysis

This question involves explaining the controllability principle, calculating controllable profit, ROI, and RI, and analyzing the performance of two divisions.

Kenkah Ltd provides buffer storage for many companies throughout the country. The company has two divisions, namely Abura and Keta. Each division is autonomous and makes its own long-term investment decisions.

Kenkah Ltd measures the performance of its divisions using Return on Investment (ROI), calculated using controllable profit and average divisional net assets. The company has a cost of capital of 12% but a targeted ROI of 18%. The divisional managers’ annual bonus is determined by the extent to which the ROI earned by the division exceeds the target.

At the beginning of the year, the two divisions, Abura and Keta, bought assets worth GH¢12.5 million and GH¢18.2 million respectively. The assets have a five-year life span with no residual value. The company uses the straight-line depreciation method. The other assets are being controlled by the head office.

Over the years, Kenkah Ltd has used ROI in evaluating the performance of managers. However, to discourage dysfunctional behavior, Kenkah Ltd is considering introducing Residual Income (RI) as a performance measure. Like ROI, RI is calculated using controllable profit and average divisional assets.

The current year’s draft operating statement is shown below:

Abura (GH¢000) Keta (GH¢000)
Sales 15,350 17,020
Less controllable Variable Cost 7,505 8,950
Contribution 7,845 8,070
Less Fixed Cost [i) & ii)] 6,335 6,910
Profit 1,510 1,160

Additional Information:
i) Included in fixed costs are the current year depreciation charges of GH¢3,125,000 and GH¢4,550,000 for division Abura and Keta, respectively. Twenty percent (20%) of the depreciation cost in each division is from assets owned and controlled by the head office.
ii) Head office allocates some of its overhead costs to the two divisions using activity-based costing. These costs have been included in the fixed costs and amounted to GH¢210,000 and GH¢230,000 for Abura and Keta, respectively.
iii) The Management Accountant stated at a recent board meeting that “Responsibility accounting is based on the application of the controllability principle.” Hence, he would resist any attempt by management to deviate from this basic principle.

Required:
a) Explain the “controllability principle” and why its application is difficult in practice.
(4 marks)

b) Calculate the current year controllable profit for both divisions of Kenkah Ltd.
(4 marks)

c) Calculate the current year ROI for each of the two divisions of Kenkah Ltd.
(3 marks)

d) Calculate the current year RI for each of the two divisions of Kenkah Ltd.
(4 marks)

e) Discuss the performance of the two divisions for the year.

a) Controllability is defined as “the degree of influence that a specific manager has over costs, revenues, investments, or other items in question”.
The controllability principle is that managers should only be held responsible for costs, revenue, profit, or investment that they have direct control over. So, for example, a divisional manager would not be held responsible for the allocation of central costs or cost of depreciation to her department if she has no control over the incurrence or magnitude of these costs. Under this principle, it would be held that dysfunctional consequences would arise if managers were held accountable for costs over which they have no control.
Holding managers accountable/responsible for costs outside their control may encourage them to become more involved with such issues and, as a result, the total cost may be reduced, or the goods or services may be provided more efficiently.
However, there is difficulty in classification or drawing the line between cost which is controllable and cost which is uncontrollable. Furthermore, holding managers responsible for items outside their control may be demotivating.
(4 marks)

b) Current year controllable profit:

Abura (GH¢000) Keta (GH¢000)
Sales 15,350 17,020
Less: Variable cost 7,505 8,950
Contribution 7,845 8,070
Less: Division Depreciation** (2,500) (3,640)
Less: Other Overheads** (3,000) (2,130)
Controllable Profit 2,345 2,300

Notes:

  • Depreciation: 80% of GH¢3,125,000 for Abura and 80% of GH¢4,550,000 for Keta.
  • Other Overhead: GH¢6,335,000 – (GH¢3,125,000 + GH¢210,000) for Abura and GH¢6,910,000 – (GH¢4,550,000 + GH¢230,000) for Keta.
    (4 marks)

Alternative Solution:

Abura (GH¢000) Keta (GH¢000)
Net profit 1,510 1,160
Add back HQ depreciation 625 910
Add back HO Overhead cost 210 230
Controllable profit 2,345 2,300

Workings:

  1. Depreciation: 20% of GH¢3,125,000 = GH¢625,000 for Abura and 20% of GH¢4,550,000 = GH¢910,000 for Keta.
    (4 marks)

c) ROI Calculation:

Abura (GH¢000) Keta (GH¢000)
Controllable profit 2,345 2,300
Average Net Assets (12,500+10,000)/2 (18,200 + 14,560)/2
ROI (%) 20.84% 14.04%
(3 marks)

d) Residual Income (RI) Calculation:

Abura (GH¢000) Keta (GH¢000)
Controllable profit 2,345 2,300
Less: Imputed interest 1,350 1,965.60
RI (GH¢000) 995 334.40
(4 marks)

e) Comments on Performance:
If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division Keta will reject the proposal whereas the manager of Division Abura will accept the proposal. This is because while division Abura has a ROI of 20.84%, higher than the target of 18%, which entitles the manager to a bonus, Division Keta would reject the investment because its ROI is 14.04%, lower than the target of 18%, hence not entitled to a bonus.
If they used residual income (RI) in order to aid the decision-making process, both proposals would be accepted by the divisions since both have a positive RI.
(5 marks)

  • 12 Marks

MA – May 2019 – L2 – Q1b – Divisional Performance

Evaluate divisional performance using ROI and RI and assess the impact of investment decisions on these metrics.

Ayittey Ltd is an organization with two divisions: A and B, each with its own cost and revenue streams. Each of the two divisions is classified as an Investment center. The company’s cost of capital is 12%. Historically, investment decisions have been made by calculating the return on investment (ROI). A new manager who has recently been appointed in Division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company. The data below shows the current position of the division as at the end of 31 December, 2016:

Details of Projects Project A Project B
Capital required GH¢ 82.8 million GH¢ 40.6 million
Sales generated GH¢ 44.6 million GH¢ 21.8 million
Net Profit margin 28% 33%

The company is seeking to maximize shareholders’ wealth. Assuming that Division A acquires a more efficient asset at GH¢15 million and Division B sold one of its assets with a written down value of GH¢24 million, and profits are expected to increase and decrease by GH¢11 million and GH¢5 million for Division A and B respectively.

Required:
i) Calculate both the current Return on Investment (ROI) and Residual Income (RI) for each of the divisions. (5 marks)
ii) Calculate and comment on the effect of the decision to invest in the new asset and disposal of some assets on the current ROI and RI. (7 marks)

i) Divisional performance measurement using ROI
Division A:
ROI = Net Profit / investment x 100
= 12.49 / 82.8 x 100 = 15.085%

Division B:
ROI = Net Profit / investment x 100
= 7.194 / 40.6 x 100 = 17.72%

Divisional performance measurement using RI
Division A:

GH¢
Net Profit 12.49
Less imputed interest charge (12% @ 82.8) (9.936)
Residual Income (RI) 2.554

Division B:

GH¢
Net Profit 7.194
Less imputed interest charge (12% @ 40.6) (4.872)
Residual Income (RI) 2.322

(5 marks evenly spread using ticks)

ii) Divisional performance after the new investment
Division A:
ROI = Net Profit / investment x 100
= 23.49 / 97.8 x 100 = 24.02%

Division B:
ROI = Net Profit / investment x 100
= 2.194 / 16.6 x 100 = 13.21%

Residual Income after new investment.

A B
Income 23.49 2.194
Cost of capital 11.74 1.992
RI 11.75 0.202

(3 marks)

Comment

  • If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will accept the new proposal whereas the manager of Division B will reject the new proposal. Prior to the new investment Division A had 15.085%, though this is a bit lower than the target rate of return of 16% while Division B had 17.72%. With the new investment Division A’s manager has an ROI of 24.02%, which is above the target rate of return, representing a 37.21% increase in the ROI of division A. Division B has an ROI of 13.21%, which is lower than the target rate of return, representing a 25.45% reduction in the ROI of Division B.
  • However, since Division B’s new ROI of 13.21% is higher than the firm’s cost of capital of 12%, accepting the new investment would encourage goal congruence and improve the firm’s overall performance. Behaviorally, Division B’s manager may not be motivated to venture into the new investment if his rewards are tied to the current level of performance. Accepting the new investment means a reduction in his incentives (bonuses).
  • 40 Marks

CSEG – May 2017 – L2 – Q1a – Strategic alternatives, analysis and selection

Analyze Gussie Perry Ltd's environmental policies, mission statement relevance, division performance, and market position using ROI, RI, and Porter's Five Forces.

CASE STUDY: GUSSIE PERRY LTD

Introduction:
Gussie Perry Ltd (GPL) is a long-established divisionalized company with its origins in shipping. The company has been in existence for nearly 120 years and has developed a reputation for reliability and quality service.

The shipping activities in which Gussie Perry Ltd (GPL) is engaged comprise four divisions – cruise, ferry, container, and bulk shipping. The cruise division is engaged entirely in the carriage of passengers, while the ferry division carries passengers and vehicles. The vehicles carried by the ferries range from motor cars to articulated trucks and buses. The container and bulk shipping divisions are engaged in the carriage of freight only.

Organizational Goals:
The company has stated over recent years that it aims to:

  1. Increase its international business to achieve long-term profitability.
  2. Provide the necessary capital investment to support its international operations.
  3. Train and develop the company’s employees.

Environmental and Safety Policy:
Environmental protection is now a key aspect of corporate social responsibility. Pressure on Gussie Perry Ltd (GPL) for better environmental performance is coming from many quarters. The company recently implemented an environmental and safety policy, which is monitored through an audit system, in an effort to ensure that its policies are being executed. It is the aim of the company to have operational standards that match the best industry standards. Training of management, staff, and specialist auditors is seen as a priority within the organization’s environmental and safety policy. This has become a major concern for the company because of customer anxiety about the safety of the ferries.

Financial Results:
In the last financial year, earnings per share were GH¢2.12, producing a dividend cover of 1.15 times. The dividend per share paid by Gussie Perry Ltd (GPL) has remained at the same level for five years. Comparative values for divisional revenue and operating profit are shown in Table 1.

Table 1: Divisional Financial Data

Division Cruise Ferry Container Bulk Shipping
Current year’s revenue (GH¢’000) 5,136 4,002 7,572 750
Previous year’s revenue (GH¢’000) 4,410 3,756 6,306 672
Current year’s operating profit (GH¢’000) 780 650 252 (30)
Previous year’s operating profit (GH¢’000) 528 480 240 (18)
Assets/Capital Employed (GH¢’000) 2,800 2,500 3,200 3,800

During the year, general inflationary levels in the shipping industry were 14% per annum. The company’s cost of capital is 25%.

Extract from the Chairman’s Statement for the Financial Year:
In his statement, Mr. Aaron Yeboah, the Chairman of Gussie Perry Ltd (GPL), commenting on revenue and profit before the inflation adjustment, said the company achieved encouraging results, particularly in the cruise division. The company had taken delivery of a new cruise liner, at a cost of GH¢1,200,000, and has two more on order. Aaron believed that this was an expanding market and considered the company to be in a good position to take advantage of the opportunity. With regard to the ferry division, Aaron expected continued growth, although there was an expectation of potential new entrants due to increased cargo volumes. This contrasted with his view of the declining performance of the container and bulk shipping divisions as shown in Table 1.

Market Information:
Gussie Perry Ltd (GPL) commissioned market research into its cruise and ferry operations. The results of this research indicated that, in recent years, within the cruise liner industry, there has been a change in customer appeal. Traditionally, the main customer base had comprised traders. In the last five years, the cruise division has experienced an increase in its clientele, especially holidaymakers. This stemmed from the promotion of domestic tourism.

Furthermore, the research showed a 15% increase in marine transport, but Gussie Perry Ltd’s market share actually reduced by 4%. The report indicates that the probability of the cruise market continuing to grow was bright. However, there were uncertainties about the future potential of the container and bulk shipping divisions.

Required:

a) Identify FOUR ways in which GPL’s concern for environmental and safety policy can impact on its performance. (4 marks)

b) The Chairman of the company has recently attended a short course on strategic planning. He was particularly interested in the relevance of mission statements to the strategic management process. Explain in FOUR ways how a mission statement is relevant in strategic management. (8 marks)

c) i) Calculate the current return on investment (ROI) and residual income (RI) for each division for the current year. (4 marks)
ii) Assess the performance of each division and advise the management of Gussie Perry Ltd (GPL). (8 marks)

d) With reference to Porter’s Five Competitive Forces model, assess the nature of the cruise and ferry shipping market in which Gussie Perry Ltd (GPL) is engaged. (16 marks)

a) Impact of Environmental and Safety Policy on Performance:

  1. Understanding and managing environmental costs: Environmental costs are often hidden in overheads, and environmental and energy costs are often not allocated to the relevant budgets.
  2. Minimizing accidents and long-term environmental effects: Accidents and long-term environmental effects can result in large financial liabilities.
  3. Cost of capital considerations: Companies with poor environmental performance may face increased costs of capital because investors and lenders demand a higher risk premium.
  4. Corporate reputation and social responsibility: Environmental protection and ethical labor practices are now key aspects of corporate social responsibility, contributing to both the company’s reputation and societal well-being.

(Total: 4 marks)

b) Relevance of Mission Statements in Strategic Management:

  1. Clarifying Organizational Purpose: A mission statement defines the reason why the firm exists, what it aims to achieve, and how it aims to achieve its purpose. This clarity helps guide decision-making and strategy development.
  2. Influencing Organizational Culture: A mission statement expresses the core values and beliefs of the company, shaping the attitudes and behaviors of employees and aligning them with the organization’s goals.
  3. Communicating with Stakeholders: The mission statement communicates the company’s intentions to both internal and external stakeholders, helping to build trust and align expectations.
  4. Guiding Strategic Planning: Mission statements provide a foundation for setting goals, objectives, and strategies. They ensure that the strategic direction of the company is consistent with its core purpose and values.

(Total: 8 marks)

c) i) Calculation of ROI and RI for Each Division:

Residual Income (RI):

ii) Assessment of the Various Divisions
APPENDIX: SUMMARY OF KEY RATIOS FOR THE ASSESSMENT OF THE DIVISIONS OF GUISIE PERRY LIMITED

Performance Assessment and Management Advice:

  • Cruise Division: The Cruise Division is performing well with a high ROI and positive RI. Management should consider further investment and capital allocation to this division.
  • Ferry Division: The Ferry Division also has a good ROI and a positive RI, indicating satisfactory performance. Management should continue to monitor this division for potential growth opportunities.
  • Container Division: The Container Division has a lower ROI and a negative RI, suggesting underperformance. Management should evaluate the reasons for this and consider restructuring or cost reduction strategies.
  • Bulk Shipping Division: The Bulk Shipping Division is underperforming with both negative ROI and RI. Management should consider whether to divest or significantly restructure this division.

d) Porter’s Five Forces Analysis of the Cruise and Ferry Shipping Market:

  1. Threat of New Entrants: The cruise and ferry market requires significant capital investment, which can act as a barrier to entry. However, the potential for profitability in this growing market could attract new competitors.
  2. Bargaining Power of Suppliers: Suppliers have moderate power due to the need for specialized vessels and the limited number of shipbuilders capable of meeting specific requirements.
  3. Bargaining Power of Buyers: Buyers in the cruise industry, particularly holidaymakers, have a wide range of options. This gives them higher bargaining power, especially if service quality does not meet expectations.
  4. Threat of Substitutes: The threat of substitutes is low as there are limited alternatives to marine transport for the specific services provided by Gussie Perry Ltd.
  5. Industry Rivalry: Competition is moderate, with a few established players in the market. However, as new entrants and expansions occur, the rivalry could intensify.

 

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