ROA and Residual Income
Sylvia Zang is a president of the Wilson Division of Performance Technologies, a multinational conglomerate. Zang managers $100 million of assets and is currently generating earnings before interest (EBI) of $12 million. The corporate office of Performance Technologies has determined that Wilson’s existing assets have a risk adjusted cost of capital of 11%. All division presidents (including Zang) are rewarded based on their individual division’s ROA. If Zang is able to increase the Wilson Division’s current ROA, she can earn a substantial bonus whereby the larger the increase in the division’s ROA, the larger is Zang’s bonus. Performance Technology computes ROA as EBI divided by total assets.
Currently Zang is considering two new investment opportunities: Project A and Project B. She can accept one or the other, or both or neither. Each project, A and B, has a risk profile that differs from that of her existing portfolio of assets. Project A (with a risk-adjusted cost of capital of 15%) requires her purchasing new assets for $25 million that will generate EBI of $3.5 million. Project B (with a risk-adjusted cost of capital at 9%) requires her purchasing new assets for $30 million that will generate EBI of $3 million.
Assume there are no synergies between Wilson’s existing assets and either project A and B and there are no synergies between project A and project B.
Assuming that Zang is rewarded based on improving the ROA of the Wilson Division, will she accept or reject profits of A and B? Support your answer with detailed computations.
Instead of basing divisional managers’ bonuses on ROA, Performance Technologies switches to residual income as the methodology used to measure divisional performance and rewarded divisional managers, including Ms. Zang. Assuming that Zang is rewarded based on improving the residual income of the Wilson Division, what decision(s) will she make regarding accepting or rejecting projects A and B? Support your answer with detailed computations.
Discuss why your answers differ or are the same in parts (a) and (b).
Should Performance Technologies use ROA or residual income to evaluate and reward division mangers? Justify your recommendation with sound logical analysis.