Maurice Tutor
$15/per page/Negotiable
42.   Capital investment analysis and decentralized performance measurement—a com- prehensive case.6 The following exchange occurred just after Diversified Electronics rejected a capital investment proposal.
Ralph Browning (Product Development): I just don’t understand why you have rejected my proposal. This new investment is going to be a sure money maker for the Residential Products division. No matter how we price this new product, we can expect to make
$230,000 on it before  tax.
Sue Gold (Finance): I am sorry that you are upset with our decision, but this product proposal just does not meet our short-term ROI target of 15 percent after tax.
Browning: I’m not so sure about the ROI target, but it goes a long way toward meeting our earnings-per-share growth target of 20 cents per share after  tax.
Phil Carlson (Executive Vice-President): Ralph, you are right, of course, about the importance of earnings per share. However, we view our three divisions as investment centers. Proposals like yours must meet our ROI targets. It is not enough that you show an earnings-per-share increase.
Gold: We believe that a company like Diversified Electronics should have a return on investment of 12 percent after tax, especially given the interest rates we have had to pay recently. This is why we have targeted 12 percent as the appropriate minimum ROI for each division to earn next year.
Carlson: If it were not for the high interest rates and poor current economic outlook, Ralph, we would not be taking such a conservative position in evaluating new projects. This past year has been particularly rough for our industry. Our two major competitors had ROIs of 10.8 percent and 12.3 percent. Though our ROI of about 9 percent after tax was rea- sonable (see Exhibit 11.9), performance varied from division to division. Professional Services did very well with 15 percent ROI, while the Residential Products division man- aged just 10 percent. The performance of the Aerospace Products division was especially dismal, with an ROI of only 6 percent. We expect divisions in the future to carry their share of the load.
Chris McGregor (Aerospace Products): My division would be showing much higher ROI if we had a lot of old equipment like Residential Products or relied heavily on human labor like Professional  Services.
Carlson: I don’t really see the point you are trying to make, Chris.
Diversified Electronics, a growing company in the electronics industry, had grown to its present size of more than $140 million in sales. (See Exhibits 11.7, 11.8, and 11.9 for financial data.) Diversified Electronics has three divisions, Residential Products, Aerospace Products, and Professional Services, each of which accounts for about one-third of Diver- sified Electronics’ sales. Residential Products, the oldest division, produces furnace ther- mostats and similar products. The Aerospace Products division is a large job shop that builds electronic devices to customer specifications. A typical job or batch takes several months to complete. About half of Aerospace Products’ sales are to the U.S. Defense Department. The newest of the three divisions, Professional Services, provides consulting engineering ser- vices. This division has grown tremendously since Diversified Electronics acquired it seven years ago.
Each division operates independently of the others, and corporate management treats each as a separate entity. Division managers make many of the operating decisions. Cor- porate management coordinates the activities of the various divisions, which includes review of all investment proposals over  $400,000.
Â
Â
|
 EXHIBIT 11.7 |
DIVERSIFIED ELECTRONICS Income Statement for Year 1 and Year 2 (all dollar amounts in thousands, except earnings-per-share figures) |
||
|
 |
 Year Ended |
 December 31 |
|
|
 |
Year 1 |
Year 2 |
|
|
Sales  ...................................................................................................................................................... |
$141,462 |
$148,220 |
|
|
Cost of Goods Sold............................................................................................................................. |
 108,118 |
 113,115 |
|
|
Gross Margin ........................................................................................................................................ |
$ 33,344 |
$ 35,105 |
|
|
Selling and General............................................................................................................................ |
   13,014 |
   13,692 |
|
|
Profit before Taxes and Interest..................................................................................................... |
$ 20,330 |
$ 21,413 |
|
|
Interest  Expense................................................................................................................................. |
    1,190 |
   1,952 |
|
|
Profit before Taxes ............................................................................................................................. |
$ 19,140 |
$ 19,461 |
|
|
Income Tax Expense .......................................................................................................................... |
   7, 886 |
   7,454 |
|
|
Net  Income .......................................................................................................................................... |
$ 11,254 |
$ 12,007 |
|
|
Earnings per Share ............................................................................................................................. |
   $5.63       |
  $6.00             |
|
| Â | Â | Â | Â |
Â
Â
|
 EXHIBIT 11.8 |
DIVERSIFIED ELECTRONICS Balance Sheets for Year 1 and Year 2 (all dollar amounts in thousands) |
|
|
 |
 December 31 |
|
|
 |
Year 1Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Year 2 |
|
|
Assets |
 |
|
|
Cash and Temporary Investments................................................................ |
$ Â 1,404Â Â Â Â Â Â Â Â Â Â Â Â Â Â $ Â 1,469 |
|
|
Accounts    Receivable....................................................................................... |
13,688Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 15,607 |
|
|
Inventories........................................................................................................ |
42,162Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 45,467 |
|
|
Total Current Assets ................................................................................... |
$ 57,254Â Â Â Â Â Â Â Â Â Â Â Â Â Â $ 62,543 |
|
|
Plant and Equipment: |
 |
|
|
Original Cost ................................................................................................ |
107,326Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 115,736 |
|
|
Accumulated   Depreciation........................................................................ |
42,691Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 45,979 |
|
|
Net  ............................................................................................................. |
$ 64,635Â Â Â Â Â Â Â Â Â Â Â Â Â Â $ 69,757 |
|
|
Investments and Other Assets ..................................................................... |
3,143Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 3,119 |
|
|
Total Assets ............................................................................................. |
$125,032Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $135,419 |
|
|
Liabilities and Owners’ Equity |
 |
|
|
Accounts Payable ............................................................................................ |
$ 10,720Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $ 12,286 |
|
|
Taxes Payable ................................................................................................... |
1,210Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 1,045 |
|
|
Current Portion of Long-Term  Debt............................................................. |
---Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 1,634 |
|
|
Total Current Liabilities............................................................................. |
$ 11,930Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $ 14,965 |
|
|
Deferred Income Taxes................................................................................... |
559Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 985 |
|
|
Long-Term Debt ............................................................................................... |
12,622Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 15,448 |
|
|
Total Liabilities ........................................................................................... |
$ 25,111Â Â Â Â Â Â Â Â Â Â Â Â Â Â $ 31,398 |
|
|
Common Stock ................................................................................................. |
47,368Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 47,368 |
|
|
Retained Earnings ........................................................................................... |
52,553Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 56,653 |
|
|
Total Owners’ Equity................................................................................... |
$ 99,921Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $104,021 |
|
|
Total Liabilities and Owners’ Equity .................................................. |
$125,032Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â $135,419 |
|
| Â | Â | Â |
Â
Â
|
 EXHIBIT 11.9 |
DIVERSIFIED ELECTRONICS Ratio Analysis |
|
 Year 1                          Year 2
ROI ¼ Net Income                                                                $11,254                         $12,007 Total Assets....................................................................                    $125,032 ¼ 9:0%             $135,419 ¼ 8:9% |
|
Â
Diversified Electronics measures return on investment as the division’s net income divided by total assets. Each division’s expenses include the allocated portion of corporate administrative expenses.
Since each of Diversified Electronics’ divisions is located in a separate facility, management can easily attribute most assets, including receivables, to specific divisions. Management allocates the corporate office assets, including the centrally controlled cash account, to the divisions on the basis of divisional  revenues.
Exhibit 11.10 shows the details of Ralph Browning’s rejected product proposal.
a.   Why did corporate headquarters reject Ralph Browning’s product proposal? Was their decision the right one? If top management used the discounted cash flow (DCF) method instead, what would the results be? The company uses a 15 percent after-tax cost of capital (i.e., discount rate) in evaluating projects such as these.
Â
Â
Â
|
 EXHIBIT 11.10 |
DIVERSIFIED ELECTRONICS Financial Data for New Product Proposal |
|
 1.    Projected Asset Investment: Land  Purchase ...................................................................................................................................................................................                                       $ 200,000 Plant and Equipmenta .....................................................................................................................................................................                                    800,000 Total     ................................................................................................................................................................................................                                        $1,000,000 2.    Cost Data, before Taxes (first year): Variable Cost per Unit.....................................................................................................................................................................                                                 $3.00 Differential Fixed Costsb .................................................................................................................................................................                                       $170,000 3.    Price/Market Estimate (first year): Unit    Price ...........................................................................................................................................................................................                                                     $7.00 Sales    ....................................................................................................................................................................................................                                     100,000 Units 4.    Taxes: The company assumes a 40 percent tax rate for investment analyses. Depreciation of plant and equipment according to tax law is as follows: Year 1, 20 percent; Year 2, 32 percent; Year 3, 19 percent; Year 4, 14.5 percent; Year 5, 14.5 percent. Taxes are paid for taxable income in Year 1 at the end of Year 1, taxes for Year 2 at the end of Year 2, etc. 5.    Inflation is assumed to be 10 percent per year and applies to revenues and costs except depreciation for years 2 through 8 (i.e., Year 2 amounts will reflect a 10 percent increase over the Year 1 amounts shown in the data above). 6.    The project has an eight-year life. Land will be sold for $400,000 at the end of Year 8. Assume the gain on the sale of land is taxable at the 40% rate. Â
aAnnual capacity of 120,000 units. bIncludes straight-line depreciation on new plant and equipment, depreciated for eight years with no net salvage value at the end of eight years. |
|
Â
b.   Evaluate the manner in which Diversified Electronics has implemented the investment center concept. What pitfalls did they apparently not anticipate? What, if anything, should be done with regard to the investment center approach and the use of ROI as a measure of performance?
c.   What conflicting incentives for managers can occur between the use of a yearly ROI performance measure and DCF for capital budgeting?
                                           
                                        
                                         
                                          
