Part 1 : 07/28/10 08:45:53

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1 Question 1 - CMA Performance Measures Part 1 : 07/28/10 08:45:53 The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the A. Average return on investment that has been earned by the company over a particular period. B. Marginal after-tax cost of new equity capital. C. Target return on investment set by management. D. Historical weighted average cost of capital for the company. A. The average return on investment that has been earned by the company over a particular period may be used in residual income calculation only if it is set as a target rate of return. Otherwise, this past figure is irrelevant to the evaluation of future managerial performance. B. The marginal after-tax cost of new equity capital may be used in the residual income calculation only if it is set as a target rate of return. Otherwise, this past figure is irrelevant to the evaluation of future managerial performance. C. In the calculation of residual income, management normally sets a desired target rate of return that it wants to achieve. The target rate of return may be set based prior experience or any other estimation depending on management's decision. D. The historical weighted average cost of capital for the company may be used in residual income calculation only if it is set as a target rate of return. Otherwise, this past figure is irrelevant to the evaluation of future managerial performance. Question 2 - CMA Performance Measures Which one of the following items would most likely not be incorporated into the calculation of a division's investment base when using the residual income approach for performance measurement and evaluation? A. Fixed assets employed in division operations. B. Division inventories when division management exercises control over the inventory levels. C. Land being held by the division as a site for a new plant. D. Division accounts payable when division management exercises control over the amount of short-term credit used. A. When the target return in dollars for residual income is calculated as a percentage of assets employed, it would normally include assets that are in use and expected to generate a return. Fixed assets that are used in division operations are expected to provide a return in the current period and would usually be included in the residual income calculation. B. When the target return in dollars for residual income is calculated as a percentage of assets employed, it would normally include assets that are in use and expected to generate a return. Inventories that management controls are expected to provide a return in the current period and would usually be included in the residual income calculation. C. When the target return in dollars for residual income is calculated as a percentage of assets employed, it would normally include assets that are in use and expected to generate a return. Therefore, land that is being held for a future plant would not be included because it is not expected to provide any return in the current period. D. Although gross assets employed are generally used in calculating Residual Income, a variation on the calculation adjusts net income to remove interest expense (i.e., by adding interest expense after tax back to net income) and adjusts the calculation of the target return by subtracting from total employed assets the current liabilities that do not incur interest. The calculation is: Net Income + [Interest expense (1 t)] Target return in dollars: a % of (Employed assets Non-incurring bearing current liabilities) = Residual Income (c) HOCK international, page 1

2 When the target return in dollars for residual income is calculated as a percentage of assets employed minus non-interest incurring current liabilities, division accounts payable would be incorporated into the calculation of a division's investment base because accounts payable normally do not incur interest. Question 3 - CMA Performance Measures The imputed interest rate used in the residual income approach to performance evaluation can best be described as the A. Average lending rate for the year being evaluated. B. Average return on investments for the company over the last several years. C. Target return on investment set by the company's management. D. Historical weighted-average cost of capital for the company. A. This answer is incorrect. See the correct answer for a complete explanation. B. This answer is incorrect. See the correct answer for a complete explanation. C. In residual income the imputed rate of interest that is used can best be described as the target return on investment that has been set by management. D. This answer is incorrect. See the correct answer for a complete explanation. Question 4 - CMA Performance Measures Residual income is a better measure for performance evaluation of an investment center manager than return on investment because A. Desirable investment decisions will not be neglected by high return divisions. B. The problems associated with measuring the asset base are eliminated. C. Only the gross book value of assets needs to be calculated. D. Returns do not increase as assets are depreciated. A. Residual income (RI) is calculated as the amount of return (net income before taxes) that is in excess of a targeted amount of return on the investments that are employed by that division. RI is focused on the dollar amount of income that is in excess of a targeted amount. It is not focused on a percentage of return as ROI is. When using RI to evaluate investment opportunities, any project that has a positive RI will be accepted even if it will reduce the overall company or division ROI. Thus, desirable investment decisions will not be neglected by high return divisions. B. The asset base or amount of invested capital are calculated in the same manner for both methods, so residual income does not eliminate this problem. C. The asset base or amount of invested capital are calculated in the same manner for both methods. D. As assets are depreciated, both methods will be affected in the same manner. Question 5 - CMA Performance Measures One approach to measuring divisional performance is return on investment. Return on investment is expressed as operating income A. Divided by fixed assets. (c) HOCK international, page 2

3 B. Divided by total assets. C. Divided by the current year's capital expenditures plus cost of capital. D. Minus imputed interest charged for invested capital. A. This answer is incorrect. See the correct answer for a complete explanation. B. The formula for return on investment is operating income divided by total assets (or average total assets). C. This answer is incorrect. See the correct answer for a complete explanation. D. This answer is incorrect. See the correct answer for a complete explanation. Question 6 - CMA Performance Measures A firm earning a profit can increase its return on investment by A. Increasing investment and operating expenses by the same dollar amount. B. Increasing sales revenues and operating expenses by the same percentage. C. Increasing sales revenue and operating expenses by the same dollar amount. D. Decreasing sales revenues and operating expenses by the same percentage. A. One way to solve this problem is to simply set up a basic ROI of, for example, $100,000 of profit / $400,000 total assets giving a ROI of.25 and then go through the choices changing these figures as outlined in each option. In this choice we should increase the investment (the denominator) and expenses (which will decrease income) by the same amount. Let us assume that this amount is $50,000. That would make the ROI calculation $50,000 $450,000, which is.111, or a decrease in the ROI. B. Since the firm is profitable, income is greater than expenses, so increasing both income and expenses by the same percentage will cause the increase in income to be larger than the decrease in expenses. As a result, net income will increase and, since investment would not change, ROI will increase. C. One way to solve this problem is to simply set up a basic ROI of, for example, $100,000 of profit $400,000 total assets giving a ROI of.25, and then go through the choices changing these figures as outlined in each option. In this choice we would increase sales (which will increase income) and expenses (which will decrease income) by the same amount. This will cause income to remain unchanged and so will not change the ROI of the company. D. Decreasing sales will decrease income and decreasing expenses will increase income. Since the firm is profitable, income is greater than expenses, so decreasing both income and expenses by the same percentage will cause the decrease in income to be larger than the decrease in expenses. As a result, net income will decline and, since investment would not change, ROI will decrease. Question 7 - CMA Performance Measures Most firms use return on investment (ROI) to evaluate the performance of investment center managers. If top management wishes division managers to use all assets without regard to financing, the denominator in the ROI calculation will be A. Total assets available. B. Total assets employed. C. Shareholders' equity. D. Working capital plus other assets. A. If the company does not care what the financing of the assets used is, the company should use total assets available as the denominator in ROI. This will mean that managers are expected to use all of the (c) HOCK international, page 3

4 assets to generate return for the company. Part 1 : 07/28/10 08:45:53 B. If the company uses total assets employed, there will be no motivation for the managers to make better use of the assets that are currently not employed. C. Using shareholders' equity takes into account only those assets financed with equity. It does not include assets that were financed by debt, or other liabilities. D. By using working capital in this measure the company is excluding assets that are financed by short-term obligations. This is because working capital is current assets minus current liabilities. Question 8 - CMA Performance Measures Which one of the following firms is likely to experience dysfunctional motivation on the part of its managers due to its allocation methods? A. To allocate depreciation of forklifts used by workers at its central warehouse, Shahlimar Electronics uses predetermined amounts calculated on the basis of the long-term average use of the services provided. B. Tashkent Auto's MIS is operated out of headquarters and serves its various divisions. Tashkent's allocation of the MIS-related costs to its divisions is limited to costs the divisions will incur if they were to outsource their MIS needs. C. Rainier Industrial does not allow its service departments to pass on their cost overruns to the production departments. D. Manhattan Electronics uses the sales revenue of its various divisions to allocate costs connected with the upkeep of its headquarters building. It also uses ROI to evaluate the divisional performances. A. This question asks which of these allocation methods would lead to negative (dysfunctional) behavior on the part of managers. The allocation of costs based on usage is a reasonable method for the allocation of these costs. B. This question asks which of these allocation methods would lead to negative (dysfunctional) behavior on the part of managers. By allocating costs equal to a market value of the services provided, the management of the divisions will use the services in the necessary manner. C. This question asks which of these allocation methods would lead to negative (dysfunctional) behavior on the part of managers. By not allowing cost overruns in the service departments to be passed to other departments, this will motivate the service departments to control their costs. D. This question asks which of these allocation methods would lead to negative (dysfunctional) behavior on the part of managers. If a division receives more allocated costs for increased levels of sales, this will serve as a minor demotivator for the manager of the divisions. Also, using ROI to measure divisional performance is probably not the best method since the denominator in ROI will include things that are outside the control of the divisional managers. Furthermore, use of ROI to evaluate divisional performance could lead to managers' rejecting profitable new investments because their ROI is lower than the divisions' historical ROI and could bring down future ROI. Question 9 - CMA Performance Measures The selection of the denominator in the return on investment (ROI) formula is critical to the measure's effectiveness. Which denominator is criticized because it combines the effects of operating decisions made at one level of the organization with financing decisions made at another organizational level? A. Total assets employed. B. Total assets available. C. Working capital. D. Shareholders' equity. A. This does not take into account the source of financing since it includes all assets that are employed, no matter (c) HOCK international, page 4

5 the source of the financing. B. This does not take into account the source of financing since it includes all assets that are available, no matter the source of financing. C. This does not take into account the source of financing of assets, as it will include those assets financed by debt and equity. D. Shareholders' equity is not a good denominator to use in the ROI calculation because it takes into account decisions made about financing that are not made at the manager level. The decision to use equity for the financing of assets is one that is made at the highest levels in the organization. Question 10 - CMA Performance Measures Edith Carolina, president of the Deed Corporation, requires a minimum return on investment of 8% for any project to be undertaken by her company. The company is decentralized, and leaves investment decisions up to the discretion of the division managers as long as the 8% return is expected to be realized. Michael Sanders, manager of the Cosmetics Division, has had a return on investment of 14% for his division for the past 3 years and expects the division to have the same return in the coming year. Sanders has the opportunity to invest in a new line of cosmetics which is expected to have a return on investment of 12%. If the Deed Corporation evaluates managerial performance using return on investment, what will be the preference for taking on the proposed cosmetics line by Edith Carolina and Michael Sanders? A. Carolina will accept / Sanders will accept B. Carolina will accept / Sanders will reject C. Carolina will reject / Sanders will reject D. Carolina will reject / Sanders will accept A. This answer is incorrect. See the correct answer for a complete explanation. B. Since return on investment uses a percentage of return as the measurement, Sanders would not accept this proposal. That is because the return of this investment is less than the return that Sanders' division has earned in the past. Therefore, accepting this investment will decrease Sanders' return on investment. On the other hand, Carolina would accept the project because the return of this project is greater than the 8% required by the company. C. This answer is incorrect. See the correct answer for a complete explanation. D. This answer is incorrect. See the correct answer for a complete explanation. Question 11 - CMA Performance Measures Edith Carolina, president of the Deed Corporation, requires a minimum return on investment of 8% for any project to be undertaken by her company. The company is decentralized, and leaves investment decisions up to the discretion of the division managers as long as the 8% return is expected to be realized. Michael Sanders, manager of the Cosmetics Division, has had a return on investment of 14% for his division for the past 3 years and expects the division to have the same return in the coming year. Sanders has the opportunity to invest in a new line of cosmetics which is expected to have a return on investment of 12%. If the Deed Corporation evaluates managerial performance using residual income based on the corporate minimum required rate of return, what will be the preference for taking on the proposed cosmetics line by Edith Carolina and Michael Sanders? A. Carolina will reject / Sanders will accept B. Carolina will reject / Sanders will reject (c) HOCK international, page 5

6 C. Carolina will accept / Sanders will reject D. Carolina will accept / Sanders will accept A. Residual income measures the dollar return of an investment. Since the return on this investment is 12% and the required return is 8%, both of these projects will have a positive residual income and both Carolina and Sanders would accept the proposal. B. Residual income measures the dollar return of an investment. Since the return on this investment is 12% and the required return is 8%, both of these projects will have a positive residual income and both Carolina and Sanders would accept the proposal. C. Residual income measures the dollar return of an investment. Since the return on this investment is 12% and the required return is 8%, both of these projects will have a positive residual income and both Carolina and Sanders would accept the proposal. D. Residual income measures the dollar return of an investment. Since the return on this investment is 12% and the required return is 8%, both of these projects will have a positive residual income and both Carolina and Sanders would accept the proposal. Question 12 - CMA Performance Measures Fabro Inc. produced 1,500 units of Product RX-6 last week. The inputs to the production process for Product RX-6 were as follows: 450 pounds of Material A at a cost of $1.50 per pound 300 pounds of Material Z at a cost of $2.75 per pound 300 labor hours at a cost of $15.00 per hour What is the best productivity measure for the first-line supervisor in Fabro Inc.'s production plant? A. $2.00 per pound. B units per labor hour. C units per dollar input. D. $15.00 per labor hour. A. This is the average price for the pound of material used in production Product RX-6. However, the first-line supervisor does not control the price and his or her performance cannot be measured on this basis. B. The first-line supervisor is usually responsible for the productivity in terms of units produced during the period. He or she can not control the price of inputs (materials, labor). Thus, the best productivity measure for the first-line supervisor is the units produced per labor hour, which is 5.00 units per labor hour (1, ). C. This is the units per labor dollar. However, the first-line supervisor does not control the labor rates and his or her performance cannot be measured on this basis. D. This is the labor rate. However, the first-line supervisor does not control the labor rates and his or her performance cannot be measured on this basis. Question 13 - CIA 1190 IV-21 - Performance Measures When comparing the residual income of several investment centers, the validity of comparisons may be destroyed by A. Common amounts of invested capital for each investment center. B. Peculiarities of each investment center. C. Consistent use of an imputed interest rate. (c) HOCK international, page 6

7 D. None of the answers is correct. A. Common amounts of invested capital make the comparison of investment centers easier because there is then no size difference between them. B. In any investment measure, the unique features of or situations faced by an individual investment center may make comparison between investment centers difficult. C. The use of a consistent imputed interest rate is useful in the comparison of investment centers. D. One of the answers is correct. Question 14 - CMA Performance Measures Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is incorrect? A. ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation. B. The use of ROI can make it undesirable for a skillful manager to take on trouble-shooting assignments such as those involving turning around unprofitable divisions. C. When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate. D. The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models. A. ROI uses many of the same measures that other methods use and is therefore susceptible to the same manipulation as other methods are. B. This is a true statement. If ROI is used to evaluate managers, a good manager may not want to be affiliated with a division that is performing poorly because the poorly performing division will have a difficult time generating the required return. And yet, a division that is performing poorly needs the skills of a good manager if it is to have any chance of turning around. C. This is a true statement. When there are substantially different ages of assets in different segments, the use of ROI may not be appropriate. This is because the assets will have different book values based on their age and so each segment would have a different basis for what may be essentially the same assets. D. This is a true statement. Under ROI, a manager may reject a project that has a positive net present value only because the return is not high enough when compared with the manager's historical ROI. Question 15 - CMA Performance Measures Return on investment (ROI) is a term often used to express income earned on capital invested in a business unit. A company's ROI is increased if A. Sales remain the same and expenses are reduced by the same dollar amount that total assets increase. B. Sales decrease by the same dollar amount that expenses increase. C. Sales increase by the same dollar amount as expenses and total assets. D. Net profit margin on sales increases by the same percentage as total assets. A. ROI is calculated as net income divided by total assets. One way to solve this problem is to simply set up some actual numbers for a basic ROI. For example, sales = $500,000, expenses = $400,000, net income = $100,000 and total assets = $400,000. ROI = $100,000 $400,000, or.25. (c) HOCK international, page 7

8 If we reduce expenses by $50,000 and increase total assets by $50,000, net income will increase by $50,000 to $150,000 because sales remained the same while expenses were reduced. Total assets will increase by $50,000 to $450,000. ROI will change to $150,000 $450,000, which is.33, an increase. B. ROI is calculated as net income divided by total assets. One way to solve this problem is to set up some actual numbers for a basic ROI. For example, sales = $500,000, expenses = $400,000, net income = $100,000 and total assets = $400,000. ROI = $100,000 $400,000, or.25. If we decrease sales and increase expenses by $25,000 each, sales will decrease to $475,000, expenses will increase to $425,000, and net income will fall to $50,000. ROI will become $50,000 $400,000, which is lower. C. ROI is calculated as net income divided by total assets. One way to solve this problem is to set up some actual numbers for a basic ROI. For example, sales = $500,000, expenses = $400,000, net income = $100,000 and total assets = $400,000. ROI = $100,000 $400,000, or.25. If we increase sales, expenses and total assets by the same amounts, for example by $50,000, the new amounts will be: sales = $550,000, expenses = $450,000, net income = $100,000 (unchanged because both sales and expenses increased by the same amount), and total assets = $450,000. ROI will become $100,000 $450,000, which is.22. This is a decrease because the denominator has increased while the numerator has stayed the same. So ROI would not be increased by this. D. ROI is calculated as net income divided by total assets. One way to solve this problem is to set up some actual numbers for a basic ROI. For example, sales = $500,000, expenses = $400,000, net income = $100,000 and total assets = $400,000. ROI = $100,000 $400,000, or.25. If we increase both the profit margin on sales and the assets of the company by the same percentage, say 10%, ROI will remain unchanged. Net income will increase by 10% to $110,000 and total assets will increase by 10% to $440,000. ROI will be $110,000 $440,000, which is unchanged at.25. Question 16 - CMA Performance Measures James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year: Category Amount (thousands) Working capital $1,800 Revenue 30,000 Plant and equipment 17,200 If the imputed interest charge is 15% and Webb wants to achieve a residual income target of $2,000,000, what will costs have to be in order to achieve the target? A. $25,150,000 B. $25,690,000 C. $9,000,000 D. $10,800,000 A. Residual income is equal to net income before taxes minus target return in dollars (a % of assets or (c) HOCK international, page 8

9 invested capital). Invested capital is equal to the sum of working capital and plant and equipment or $19,000,000 ($1,800,000 + $17,200,000). Hence, the imputed interest charge is equal to $2,850,000 ($19,000,000 15%). Net income needs to be equal to the sum of the imputed interest charge and the amount of residual income, or $4,850,000 ($2,850,000 + $2,000,000). Thus, costs are equal to the revenue minus net income or $25,150,000 (30,000,000 $4,850,000). B. See the correct answer for a complete explanation. C. See the correct answer for a complete explanation. D. See the correct answer for a complete explanation. Question 17 - CMA Performance Measures Listed below is selected financial information for the Western Division of the Hinzel Company for last year. Amount Account (thousands) Average working capital $ 625 General and administrative expenses 75 Net sales 4,000 Average plant and equipment 1,775 Cost of goods sold 3,525 If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment (ROI) for last year? A % B % C % D % A. ROI is calculated as Net Income divided by Average Total Assets (or Investments). Average assets are equal to the sum of average plant and equipment plus working capital or $2,400,000 ($625,000 + $1,775,000). Net Incomes equals Net Sales minus COGS and G&A expenses or $400,000 ($4,000,000 - $3,525,000 - $75,000). Now we can calculate ROI: $400,000 $2,400,000 = 16,67%. B. This answer does not include working capital in average total assets. See the correct answer for a complete explanation. C. This answer fails to subtract general and administrative costs in the calculation of income. See the correct answer for a complete explanation. D. This answer is incorrect. See the correct answer for a complete explanation. Question 18 - CMA Performance Measures REB Service Co. is a computer service center. For the month of May 1995, REB had the following operating statistics: Sales $450,000 Operating income 25,000 Net profit after taxes 8,000 Total assets 500,000 (c) HOCK international, page 9

10 Shareholders' equity 200,000 Cost of capital 6% Based on the above information, which one of the following statements is correct? REB has a A. Residual income of $(22,000). B. Residual income of $(5,000). C. Return on investment of 1.6%. D. Return on investment of 4%. A. This answer is incorrect. See the correct answer for a complete explanation. B. The target income for this company is $30,000, as this is 6% of the assets of the company. Operating income was $25,000, so residual income is $25,000 $30,000, or $(5,000). C. Return on investment is calculated as operating income divided by total assets. The total assets were $500,000 and operating income was $25,000. This gives a return on investment of 5%. D. Return on investment is calculated as operating income divided by total assets. The total assets were $500,000 and operating income was $25,000. This gives a return on investment of 5%. (c) HOCK international, page 10