Weighted-average cost of capital
Willowbrook Company has a target annual rate of return of 20 percent, and is subject to a 30% tax rate. The Soft Drinks Division was recently presented with an investment in a $105,000 piece of machinery that would save operating costs of $5,000 per year over a period of thirty years. The new machinery would replace a current piece of equipment that could be sold for $2,000 and has a book value of $50,000. The manager of the Soft Drinks Division, with full decision rights on the matter, decided against replacing the current equipment.
The CEO of Willowbrook, David Copperfield, heard about the investment opportunity and is confused about the outcome. From his initial conversations with the Soft Drinks Division’s manager, it sounded like a good investment.
Copperfield is also reconsidering its investment in cider-based drinks – in the three previous years, Cider has shown a net loss. When Copperfield launched the Cider product line four years ago, he gave the division manager until this year to come ‘out of the red’. 80% of the Cider division’s direct fixed costs could be avoided by discontinuing the product line. At this point, Willowbrook has not identified an alternate use for the Cider production space, and all three divisions are currently running at 80% of practical capacity.
a. Multilevel income statement, showing the three divisional incomes and the corporate net income (for Willowbrook overall).
b. Calculate the ROI, residual income, and EVA for the new investment considered by the Soft Drinks Division.
c. Provide a differential analysis of lifetime costs of the Soft Drinks Division’s investment.
d. Did the Soft Drinks division manager make the ‘right’ decision (i.e., was it in Willowbrook’s overall best interest for the Soft Drinks division to reject the investment)? Explain your answer.
e. Recreate the multilevel income statement from requirement (a) showing the overall effect on net income if Willowbrook were to discontinue the Cider product line. Provide a recommendation on whether to discontinue the Cider product line.
f. Provide a recommendation on a different way to allocate corporate overhead.