Reference no: EM132549020

Kitchen Appliances, Inc., is a multi division company with each major product line managed by a separate division. Divisional managers have complete autonomy with respect to operating and investment decisions. The company evaluates its division managers on ROI, calculated as operating income before taxes divided by net book value of assets. The firm pays particular attention to year-over-year growth in ROI as well as budget-actual comparison of the measure. Wendy Miller is the manager of the dishwasher division. Wendy expects that the operating income for the current year will be $2,400,000 before taxes on a net asset base (net book value) of $6,800,000. This performance has been fairly representative of the way things have been going for Wendy. She expects a similar performance next year as well and is looking forward to her promotion into the C-suite (the corporate office). Toward the end of the current year, an investment opportunity (project) arises for Wendy- the possibility of introducing a new dishwasher model with improved features.

The following table presents some salient financial information that Wendy's managers put together for her evaluation:

Incremental Cash Outlay: $1,500,000

Useful Life: 10 years

Salvage Value at the End of Useful Life = 0

Annual Revenues = $800,000

Annual Variable Costs = $300,000

Annual Fixed Costs (Excluding Depreciation) = $100,000

Required Rate of Return = 12%

Corporate Tax Rate = 40%

The company uses straight-line depreciation method for accounting and tax purposes.

Question a. Calculate the net after-tax cash flow (including the tax savings from depreciation) per year from the investment opportunity.

Question b. Calculate the net present value of the investment opportunity? From the company's viewpoint, should the project be accepted?

Question c. Calculate ROI of the dishwasher division before and after the investment opportunity. Will Wendy accept the project? Why?

Question d. Assume that the company evaluates its divisional managers based on residual income, using a 12% required rate of return. What is the dishwasher division's expected residual income for the current year (without the proposed investment)? With the proposed investment? If the firm evaluates its divisional managers on residual income, will Wendy accept the investment opportunity? Note: Residual Income = Operating Income before Taxes - Required Rate of Return (Net Book Value of Assets)