Explain why, in the calculation of EVA, the profit measure used (NOPAT) excludes interest expense. ...

Question

Explain why, in the calculation of EVA, the profit measure used (NOPAT)

excludes interest expense.

exercise 12-2. [lO 2] Write a paragraph explaining why, in the calculation of a company’s EVA, noninterest-bearing current liabilities are subtracted from total assets to determine investment.

exercise 12-3. Why Firms Decentralize [lO 1] The Lyndstrom Glass Company is a manufacturer of automotive glass and glass products used in the home. Discuss the advantages of forming two divisions (an Automotive division and a Home Products division) and allowing the division managers substantial decision-making autonomy.

exercise 12-4. responsibility centers and performance measures [lO 1] Department managers at Nadaire Department Stores are allowed considerable discretion in sourcing and pricing products based on local tastes and competition. They are also responsible for staffing their departments.

Required

Suggest two financial performance measures that would be useful in evaluating the performance of department managers at Nadaire Department Stores.

exercise 12-5. responsibility centers [lO 1] A major software company has established customer service centers in India, Ireland, and Israel to provide support to its U.S. customers with foreign operations. The prices that the company charges for software reflect estimated costs in operating the centers (i.e., there is no separate charge for service).

problem 12-1. cost centers and performance measures [lO 1, 3] Magellan Materials manufactures metal and plastic gutters for use in commercial and residential construction. Production occurs in two separate plants. Distribution is from a central warehouse, and there is a centrally managed sales office. Both production plants are currently treated as cost centers, and their bud- gets are prepared in close consultation with the central office. Analysis of standard cost variances is used as a control mechanism in the two plants.

Required

a. Explain how budgets and variance analysis provide a means of controlling cost in the production plants.

b. List four nonfinancial performance measures that plant managers can use to assess the operations they control.

problem 12-2. investment centers and performance measures [lO 1, 2] LEO Corporation has five divisions, each of which is managed by a divisional president who reports to the chief executive officer of LEO. LEO is decentralized, and divisional presidents are granted authority to make investments under $3,000,000 without prior approval by the CEO.

Suggest three financial performance measures that could be used to evaluate the divisions and the divisional presidents.

Harshit · Accepted Answer

Serial No.
	Contents
	Page No.
	1.
	Exercise 12(1)
	2
	2.
	Exercise 12(2)
	3
	3.
	Exercise 12(3)
	4
	4.
	Exercise 12(4)
	5
	5.
	Problem 12(1)
	6
	6.
	Problem 12(2)
	7
Exercise 12(1)
Economic value added shows the economic profit made by the company. This method helps in comparing the returns received from a project with the cost of carrying out the project. This is based on the idea that a project is valuable only when returns from it exceed the cost of capital. We do not include interest expense while calculation of net operating profits after tax because this profit is attributable to all capital investors (shareholders, lenders, etc). And this profit is then subtracted with the capital charge which is the weight average cost of capital multiplied with the total capital invested. In this step the interest earlier excluded is taken care of. The economic value added is the difference between net operating profit after tax and the cost of capital.
This shows that wealth creation for shareholders is the main objective of financial management.
Economic value added = Net operating profit after tax -(weighted average cost of capital*total capital )
Therefore we can see that the earlier ignored interest is taken care of while reducing the cost of capital.
Exercise 12(2)
While calculating economic value added we regard the product of the weighted average cost of capital and capital invested as the cost for a project or undertaking. Non-interest bearing current liabilities are not considered as the capital as they are used in the business for a very short amount of time i.e. one operating cycle whereas capital is used in business for a long period of time. We know that capital employed is equal to the total asset reduced by the number of current liabilities. This capital employed is the capital invested. We use the capital for the calculation of economic value-added, not total liabilities therefore we reduce non-interest bearing current liabilities from total assets to calculate the capital invested.
Exercise 12(3)
Decentralization is an approach in which the power for making decisions is dispersed throughout the company whereas in centralized system power is concentrated at the top. Each approach has its own advantage and disadvantage depending upon the needs and type of the company.
The following are the causes of decentralization:
· Efficiency- Decentralization decreases the time required for a decision to be made as people who are near the problem have the authority to take redressal decisions. No time is wasted in moving up or down the corporate ladder for redressal of issues. This increases efficiency and results in better productivity.
· Size- when a company is too huge to be handled at the top then they go for decentralization as top management is unaware of the issues at the ground level. Moreover, they don't have the time to cater to such issues. This results in the smooth management of large multinational corporations.

Explain why, in the calculation of EVA, the profit measure used (NOPAT) excludes interest expense. exercise 12-2. [lO 2] Write a paragraph explaining why, in the calculation of a company’s EVA,...

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