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- 10 Marks
Question
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.
Answer
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.
- Tags: Divisional Performance, Investment Appraisal, RI, ROI
- Level: Level 2
- Topic: Divisional Performance
- Series: MAR 2024
- Uploader: Joseph