Question

Return on Investment and Economic Value Added Calculations with Varying Assumptions

Knitpix Products is a division of Parker Textiles Inc. During the coming year, it expects to earn income of $320,000 based on sales of $3.45 million. Without any new investments, the division will have average operating assets of $3 million. The division is considering a capital investment project—adding knitting machines to produce gaiters—that requires an additional investment of $600,000 and increases net income by $57,500 (sales would increase by $575,000). If made, the investment would increase beginning operating assets by $600,000 and ending operating assets by $400,000. Assume that the actual cost of capital for the company is 9%.

Required:

5. Conceptual Connection: Compute the EVA of the division with and without the investment.

EVA without the investment	$
EVA with the investment	$

Should the manager decide to make the knitting machine investment?
EVA has increased with the investment, so the manager would approve the investment.

Answer 1

Solution

KnitPix Products

Q5. Computation of the EVA of the division with and without the investment:

EVA = income – (average operating assets) x cost of capital

Without the investment –

Income = $320,000

Average operating assets = $3,000,000

Cost of capital = 9%

EVA = 320,000 – (3,000,000 x 9%)

= 320,000 – 270,000 = $50,000

With Investment

Net income = 320,000 + 57,500 = $377,500

Average operating assets = 3,000,000

Add: increase in average operating assets = (600,000 + 400,000)/2 = $500,000

Average operating assets after investment = $3,500,000

EVA = 377,500 – (3,500,000 x 9%)

= 377,500 – 315,000

EVA = $62,500

Yes, the manager should decide to make the knitting machine investment.

Explanation – EVA increased with the investment, so the manager would approve the investment.