Pegasus Recycling has a subsidiary that recycles yard waste and another that recycles paper.Information related to the two subsidiaries follows. $\begin{array}{lrr}&\text { Yard Recycling}&\text { Paper Recycling }\
\text { Total assets } & \$ 8,000,000 & \$ 15,000,000 \
\text { Noninterest-bearing current liabilities } & 500,000 & 1,000,000 \
\text { Net income } & 1,500,000 & 2,600,000 \
\text { Interest expense } & 600,000 & 800,000 \
\text { Required rate of return } & 8 \% & 11 \% \
\text { Cost of capital } & 7 \% & 9 \% \
\text { Tax rate } & 30 \% & 32 \%
\end{array}$ Which subsidiary has added the most to shareholder value in the last year?
A)Yard recycling, because it has a higher return on investment
B)Paper recycling, because it has a higher residual income
C)Both contributed equally in different ways
D)More information is needed to determine the answer

Question

Quizplus · Accepted Answer

To determine which subsidiary added the most to shareholder value, we calculate the residual income for each. Residual income is the net income minus the charge for the cost of capital on total assets. For Yard Recycling: Residual Income = Net Income - (Total Assets * Cost of Capital) = $1,500,000 - ($8,000,000 * 7%) = $1,500,000 - $560,000 = $940,000. For Paper Recycling: Residual Income = Net Income - (Total Assets * Cost of Capital) = $2,600,000 - ($15,000,000 * 9%) = $2,600,000 - $1,350,000 = $1,250,000. Since Paper Recycling has a higher residual income ($1,250,000) compared to Yard Recycling ($940,000), it has added more to shareholder value.

Pegasus Recycling Has a Subsidiary That Recycles Yard Waste and Another