October 18th, 2004 Mr.

David Chan Rothwell Metal Stamping 27900 Nelson Road Missassauga, ON P2K 4Z9 Dear David As you requested we have prepared the following report to help you decide which measure of past performance should be used to allocate the funds and how much you should allocate to each division. Our report contains a thorough analysis of your options along with concrete recommendations regarding the most appropriate course of action that your firm should follow. If you wish to discuss this report, please do not hesitate to contact me at your convenience. Yours truly,

Executive Summary
Rothwell Metal Stamping is a company organized with three divisions; the automotive division, the appliances division and the leisure products division. Each division requested investment funds for the following year based of similarly attractive business cases. The total funds requested amount to $13 million and there are only $5 million available to meet their needs. As the president of Rothwell, you have difficulty deciding how to divide these funds between the three divisions but you have decided to base your decision on measures of past performance. There are three measures of past performance that you are considering, Return on Investment, Residual Income and Economic Value Added, but you are unsure which method to use. We have determined that we must reach a recommendation as to how the money should be allocated and which method of past performance is the most appropriate to base the allocation decision on. We have selected four criteria in our attempt to arrive at a recommendation. These criteria are: yield on investment - profits; synergy; risk; and satisfaction of divisional managers. Of all of these issues we have determined that yield on investment is the most important criteria upon which to base our recommendation. We began our examination by investigating which of the three measures of past performance, Return on Investment, Residual Income or Economic Value Added is the most appropriate measure to use as a basis for allocating funds. Our analysis showed that Return on Investment (ROI) is best method to use because it shows which division is generating the most profit for each $1 of capital invested, while not taking into account the relative size of divisions. In order to help you decide how the investment funds should be allocated, we have developed the following four alternative courses of action: Allocate all of the funds to the division with the highest ROI Award the requested amount to the division with the highest ROI and the rest to the division with the second highest ROI Allocate most of the funds to two divisions with highest ROI Allocate funds according to relative performance of each division

We have recommended that the firm should allocate $4 million to the Leisure Products division and $1 million to the Automotive division. This course of action offers the best compromise when Yield on investment, Synergy, Risk and Managers Satisfaction are taken into consideration as criteria in the decision making process.

Situation and Problem Definition

Rothwell Metal Stampings (RMS) last years results show that each of the three divisions reported a profit with the overall company profit totaling $5,183,000. In order to continue this success it is important to reinvest in the company in a way that will maximize total profits in the future. Each division is requesting funds for the upcoming year. The automotive division is looking for $3 million, the appliances division is seeking $6 million and the leisure products division is asking for $4 million, with all requests totaling $13 million. As you mentioned, the company has found it more and more difficult to raise capital over the years as investors are looking to other industries for better return. As a result you only have $5 million available to distribute between the three divisions. Since all three divisions have presented very persuading business cases showing similarly healthy future returns from these investments, you are having difficulty deciding how to allocate the investment funds. You have decided that the best way to allocate funds would be to award them to the division or divisions with the best record of providing returns to the company based on measures of past performance. You are not sure however whether you should use Return on Investment, Residual Income or Economic Value Added to measure the effectiveness of each division. Our review of the background information that we were provided indicates that there are a number of issues that need to be addressed: 1. Allocation of Funds Given that you have less investment funds available than the total requested by all divisions, the issue is how much money should be allocated to each division. 2. Method to Measure Past Performance You indicated that you are unsure as to which method should be used to measure the past performance of each division: Return on Investment, Residual Income or Economic Value Added. 3. Satisfaction Level of Each Division With Funds They Receive In the event that a division receives less money than it asked for or if it perceives the funds distribution as unfair, the satisfaction level of that division will be affected. This might have implications on motivation and future performance. Based on the above information, we have determined that we must reach a recommendation as to how much funding you should allocate to each division. Before we can do that however, we will first analyse the three measures of past performance and choose the most appropriate method as the basis for allocating the funds. We feel that an examination of these issues will ensure continued success for RMS in the future.

Recommendation Criteria
In attempting to reach a recommendation we will need to look at a variety of criteria in order to determine how to evaluate the alternatives that we develop. The following is a list of the criteria that we will use to evaluate alternatives. 1. Yield on Investment - Profit Since this is an investment decision, we must determine which division has the best record of providing returns to the company. Specifically, how much profit each division has generated for every $1 of capital invested. 2. Synergy At least two of the three business divisions, Appliance and Leisure Products divisions, maybe complementary and one has the potential to generate business for the other. Given this synergistic relationship, we need to ensure that our recommendation takes into account the relationship between all elements of the business. 3. Risk Basing the allocation of funds on past performance assumes that each divisions performance is expected to be repeated in the following period. There is a risk that if we allocate a large portion of money to one division and their performance declines then RMSs total return will be impacted greatly. 4. Satisfaction of Divisional Managers The respective managers of each division will likely consider the resulting allocation of investment funds in a number of terms. They will consider their allocated share in terms of the percentage of what they originally asked for. They will compare their portion to those of the other two divisions, and they will form an impression of the fairness of the allocation based on what they believe they should have received. Their perception of the fairness of the allocation process will have an effect on their satisfaction with the outcome and this factor should be considered in our analysis. We have determined that the yield on investment is the primary criteria upon which to base our recommendation. The other criteria will also be used in our analysis and the evaluation of alternatives albeit in a secondary capacity. By implementing this recommendation, you will channel the available investment funds to two divisions that have the best and second best records of providing returns to the company.

Analysis
The first step in our analysis is examining the measures of past performance that we will use as the basis for the allocation of investment funds to each division. Our aim is to determine if we should use Return on Investment (ROI), Residual Income (RI) or Economic Value Added (EVA). The formulas that will be used are as follows: ROI = Profit/Invested Capital RI = Profit (Capital x Interest Rate) EVA = Profit (Net Assets x WACC) Where Net Assets = Assets Current Labs And WACC = [(Debt Cost)x(Debt Value) + (Equity Cost)x(Equity Value)] Debt Value + Equity Value WACC can be calculated based on the following information:
Leisure Automotive Division Capital Requested Rate on Marginal Debt Rate on Marginal Equity Debt % Capital 3,000 6% 17% 50% Appliance Division 6,000 6% 17% 50% Products Division 4,000 6% 17% 50%

Since the Debt % Capital figure of 50% indicates a 1 to 1 ratio of debt to capital for each division, WACC is as follows: WACC = [(6%)x(1) + (17%)x(1)]/ 1+1 = 11.5% (the same for all divisions) In our analysis and calculations we have made the following assumptions based on the information that we were provided with: Our definition of Profit for the purpose of using the above formulas is limited to Earnings Before Interest and Taxes (EBIT). This is appropriate because a) it reflects the operating profit margin for each division and b) it excludes items from the Income Statement over which the managers of each division have no direct control (i.e. Interest charge and Allocated corporate fixed costs). We use this definition in calculating all three measures so that we can compare them on an apples to apples basis. Net Assets in the EVA formula is assumed to equal Total Divisional Investment based on the information provided, as there is no mention of Current Liabilities. For the purpose of evaluating alternatives we will assume that if a synergistic relationship exists between the Appliance and the Leisure Products divisions, the closer the divisions are in size, the stronger the synergy will be between them. 5

The original Income Statement is attached in Appendix A and the revised IS for last year excluding Interest charge and Allocated corporate fixed costs is as follows:
Leisure Automotive Division Sales revenue Expenses Direct material & labour Supplies Maintenance & repairs Plant depreciation Administration Total expenses Divisional margin $4,200 Appliance Division $6,300 Products Division $3,200 All Divisions Total $13,700

1,064 44 200 120 120 1,548 2,652

1,798 133 150 90 90 2,261 4,039

995 35 60 180 180 1,450 1,750 Leisure

3,857 212 410 390 390 5,259 8,441 All Divisions Total

Automotive Division Divisional investment Accounts receivable Inventories Net Plant fixed assets Total

Appliance Division

Products Division

$550 350 2,850 $3,750

$895 250 5,650 $6,795

$285 650 1,100 $2,035

$1,730 $1,250 $9,600 $12,580

The calculation of ROI, RI and EVA based on Divisional margin (EBIT Income) and Total Divisional Investment (Capital) is as follows:
Automotive Division ROI (EBIT) ROI * RI @ 6% RI @ 17% RI @ 2% EVA (@ 11.5%) $0.71 $0.44 $2,427.00 $2,014.50 $2,577.00 $2,220.75 Appliance Division $0.59 $0.36 $3,631.30 $2,883.85 $3,903.10 $3,257.58 Leisure Products Division $0.86 $0.53 $1,627.90 $1,404.05 $1,709.30 $1,515.98

* ROI in this case is calculated using Divisional profits including Interest charge and Allocated corporate fixed costs (see Appendix A) for sensitivity analysis purposes. 6

It is clear that RI and EVA are similar measures and they both differ in nature from ROI. RI and EVA both depend on the interest rate and the sensitivity analysis above shows the effect of using different interest rates. More importantly, both measures take into account the size of the divisions and as a result they favour divisions that bring in the most profits in absolute dollar terms. ROI on the other hand, shows which division generates the highest yield for every $1 invested, regardless of the size of the division. Our analysis leads us to conclude that ROI based on EBIT income is the most appropriate method to use in evaluating the effectiveness of each division and should be the basis for the decision of allocating investment funds. Given the constraint of $5 million in available funds and the fact that the sum of funds requested from all divisions is $13 million, we shall now determine how to allocate the money based on the ROI measurement of past performance.

Evaluation of Alternatives
Now that we have decided to use ROI as the measure of past performance, we shall determine the optimal fund distribution structure. In order to aid you in your decision making process, we have developed the following four alternative courses of action: 1. Allocate all of the funds to the division with the highest ROI Under this alternative, if one division is most efficient at generating profits then all funds would be allocated to this division. 2. Award the requested amount to the division with the highest ROI and the rest to the division with the second highest ROI Under this option, the division with the highest ROI would get the amount that it requested (if possible) with the rest going to the second best division. 3. Allocate most of the funds to two divisions with highest ROI Under this option, the two divisions with the highest ROI would be awarded the majority of the funds and the rest would be allocated to the division with the lowest ROI. 4. Allocate funds according to relative performance of each division This option would require the calculation of relative performance of each division in percentage terms where cumulative performance would total 100%. This would ensure that funds would be allocated to all three divisions but the division(s) that performed relatively better would get proportionately more funds. The following sections of the report examine the financial and strategic consequences of each of these alternatives.

Alternative One Allocate all of the funds to the division with the highest ROI
This option is the simplest of all the options, as it requires the firm to allocate all of the funds to the Leisure Products Division based on their highest ROI of $0.86. Pros Under this option, all funds are going to the division that has provided the best returns to the company; therefore company capital is utilized in the most efficient manner assuming that the division can employ all funds awarded to generate the same yield on investment as it did last year. Assuming there is a synergistic relationship between the Leisure Products and the Appliance divisions, the growth of the Leisure Products division as a result new capital might make this relationship stronger and improve the synergy. The Leisure Products division would become similar in size to the Appliance division and this might help the Appliance division generate better returns. This option would make the manager of the Leisure Product Division very satisfied if not a little surprised. Cons $5 million is more than the Leisure Products division has requested (see chart below), so it might not be able to use the remaining $1million as efficiently as the $4 million it requested. In other words, the yield on the remaining $1 million is unlikely to be the same as the yield on the first $4 million because the division has not made plans for the extra $1 million. It can be considered risky to put all of the funds in one division because if due to some unforeseen circumstances the Leisure Products division has a bad year resulting in a low ROI then the effect on the whole company will be more severe. The managers of the Automotive and Appliance divisions would probably perceive this type of fund allocation as unfair and would likely be very unsatisfied with this outcome. This might have a negative effect on motivation for the leaders of these divisions and as a result could have a negative impact on the company as a whole. This form of allocation might have a negative effect on synergy if the performance of the Appliance division declines as a result of not receiving any investment funds.

Capital requested ROI (EBIT) Funds to be awarded

Automotive Division 3000 $0.71 $0

Appliance Division 6000 $0.59 $0

Leisure Products Division 4000 $0.86 $5,000

Alternative Two Award the requested amount to the division with the highest ROI and the rest to the division with the second highest ROI
Under this option, the best performing division would be awarded the funds that it requested with the remainder being allocated to the second best performing division. Pros As the chart below shows, the division that is has provided the best returns to the company will receive as much funds as it requested and the second best performing division will get the remainder; therefore company capital is utilized in the most efficient manner based on calculated ROI for both divisions. Assuming there is a synergistic relationship between the Leisure Products and the Appliance divisions, the growth of the Leisure Products division as a result new capital might make this relationship stronger and improve the synergy. The Leisure Products division would become similar in size to the Appliance division, although not as close as in Alternative One, and this might help the Appliance division generate better returns. In addition the Automotive division will grow as well. This option would make the manager of the Leisure Product Division very satisfied and the manager of the Automotive division somewhat satisfied as he would be receiving one third of what he requested. The risk in this alternative is a little more spread out as two divisions get funds. Cons It can still be considered risky to put a large portion of the funds (80%) in one division because if due to some unforeseen circumstances the Leisure Products division has a bad year resulting in a low ROI then the effect on the whole company will be more severe. This might be somewhat offset by the 20% of funds allocated to the Automotive division. The manager of the Appliance division would probably perceive this type of fund allocation as unfair, and would likely be very unsatisfied with this outcome. This might have a negative effect on his motivation as a result could have a negative impact on the company as a whole. The manager of the Automotive division would also be somewhat unsatisfied. This form of allocation might have a negative effect on synergy if the performance of the Appliance division declines as a result of not receiving any investment funds.
Leisure Products Division 4000

Capital requested

Automotive Division 3000

Appliance Division 6000

ROI (EBIT) Funds to be awarded

$0.71 $1,000

$0.59 $0

$0.86 $4,000

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Alternative Three Allocate most of the funds to two divisions with highest ROI
Under this alternative, the two divisions with the highest ROI would be awarded the majority of the funds and the rest would be allocated to the division with the lowest ROI. The table below shows the distribution. Pros This option would make the managers of Automotive and Leisure Products divisions satisfied, receiving 50% and 75% of what they requested, respectively. The risk in this alternative is a better spread out as all divisions get funds even though it is still heavily weighted towards the Leisure Products division. Assuming there is a synergistic relationship between the Leisure Products and the Appliance divisions, the growth of the Leisure Products division as a result new capital might make this relationship stronger and improve the synergy. The Leisure Products division would become similar in size to the Appliance division, although not as close as in Alternative One and Two, and this might help the Appliance division generate better returns. In addition the Automotive division will grow considerably as well. Cons The companys capital is not utilized most effectively as two divisions that were worse performers get 40% of available funds allocated to them. Capital allocation is less than optimal compared to Alternatives One & Two. The manager of the Appliance division would not be fully satisfied, as he would only receive 8% of what he requested. This might have a negative effect on his motivation as a result could have a negative impact on the company as a whole. The manager of the Automotive division would also be somewhat unsatisfied. Assuming there is a synergistic relationship between the Leisure Products and the Appliance divisions, the benefits of this relationship are not explored to the same extent as in Alternatives One & Two.

Capital requested ROI (EBIT) Funds to be awarded

Automotive Division 3000 $0.71 $1500

Appliance Division 6000 $0.59 $500

Leisure Products Division 4000 $0.86 $3000

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Alternative Four Allocate funds according to relative performance of each division

Under this alternative, a relative performance of each division is derived by dividing the ROI of each division by the sum of all divisions ROIs. The results are shown in the table below in the Percentage of funds to be awarded row. Then each percentage is multiplied by the $5 million in available funds and the result is shown in the Funds to be awarded row. Pros This option might make the managers of Automotive, Appliance and Leisure Products divisions all relatively satisfied, receiving 55%, 23% and 50% of what they requested, respectively. This will depend on each managers expectations. The spread of risk is best under this alternative as funds get awarded most evenly across all divisions. Cons The companys capital is not utilized most effectively as two divisions that were worse performers get over 60% of available funds allocated to them. Capital allocation is least optimal under this alternative. Assuming there is a synergistic relationship between the Leisure Products and the Appliance divisions, the growth of the Leisure Products division relative to the Appliance division is to small to yield any significant improvement in synergy. The managers of the Automotive and Leisure Products divisions might be unhappy with this type of allocation of funds knowing that their divisions ROIs were much better than the Appliance Divisions ROI.

Capital requested ROI (EBIT) Percentage of funds to be awarded Funds to be awarded

Automotive Division 3000 $0.71 32.87% $1,643.52

Appliance Division 6000 $0.59 27.31% $1,365.74

Leisure Products Division 4000 $0.86 39.81% $1,990.74

Total All Divisions 13000 $2.16 100% 5000

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Recommendation
To arrive at a final recommendation we have developed a ranking mechanism as shown below. We decided at the outset of our analysis that we would base our recommendation on four criteria: Yield on Investment/Profit, Synergy, Risk and Satisfaction. The following chart rates each of the alternatives against these criteria by rank ordering each alternative. In this analysis, the higher the score the better, except for Risk where the higher score reflects lower risk. As we determined that Yield on Investment is the most important criteria, we have given it twice the weight of other alternatives. Alternative 1 All funds to the division with highest ROI 2 Award requested funds to the highest ROI division 3 Allocate most of the funds to two highest ROI divisions 4 Allocate funds based on relative performance Yield/ Profit 6 8 4 2 Synergy 4 3 2 1 Risk 1 2 3 4 Satisfaction 1 2 3 4 Total 12 15 12 11

Based upon this analysis we recommend that you allocate $4 million to the Leisure Products division and $1 million to the Automotive division. This course of action offers the best compromise when Yield on investment, Synergy, Risk and Managers Satisfaction are taken into consideration as criteria in the decision making process. The rationale for this recommendation is detailed on page 9. By implementing this recommendation, you will channel the available investment funds to two divisions that have the best and second best records of providing returns to the company.

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Appendix A - Original information provided

Leisure Automotive Division Sales revenue Expenses Direct material & labour Supplies Maintenance & repairs Plant depreciation Administration Total expenses Divisional margin Interest charge Allocated corporate fixed costs Divisional profits $4,200 Appliance Division $6,300 Products Division $3,200 All Divisions Total $13,700

1,064 44 200 120 120 1,548 2,652 375 613 $1,664

1,798 133 150 90 90 2,261 4,039 680 920 $2,440

995 35 60 180 180 1,450 1,750 204 467 $1,079 Leisure

3,857 212 410 390 390 5,259 8,441 1,259 2,000 5,183 All Divisions Total

Automotive Division Divisional investment Accounts receivable Inventories Net Plant fixed assets Total

Appliance Division

Products Division

$550 350 2,850 $3,750

$895 250 5,650 $6,795

$285 650 1,100 $2,035 Leisure

$1,730 $1,250 $9,600 $12,580

Automotive Division Capital Requested Rate on Marginal Debt Rate on Marginal Equity Debt % Capital 3,000 6% 17% 50%

Appliance Division 6,000 6% 17% 50%

Products Division 4,000 6% 17% 50%

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