a. ROA focuses on both statements because it is a ratio of net income (from the income statement) divided by total assets (from the balance sheet). b. EVA is not more comprehensive than ROA. They both contain exactly the same inputs (net income and total assets). EVA also contains the weighted average cost of capital explicitly in the formula. But to implement ROA, each division's ROA must be compared to its weighted average cost of capital (wacc). Just because two divisions have the same ROA does not mean they are performing the same if they have different wacc (because their risk factors differ). c. Disagree. EVA and ROA can be applied to each case once the appropriate wacc is set. Both metrics are short-run to the extent that accounting earnings measure last year's earnings; they do

Question

not capture future growth opportunities. For example, R&D expenditures reduce current accounting earnings, but are expected to produce future growth. Both EVA and ROA create incentives for managers to cut R&D spending to boost current ROA and EVA. However, these incentives are reduced if R&D is treated as a capital asset and not deducted from earnings. This adjustment can be made to accounting earnings and assets for both ROA and EVA. Finally, providing long-run incentives can be accomplished by the choice of performance rewards such as stock, options, and deferred compensation.

What transfer price should be set for Pepsi transferred from the soft drink division of PepsiCo to a PepsiCo restaurant such as Taco Bell? Justify your answer.

Answer 1

The following points should be covered in the answer:
• There are synergies (interdependencies) between the soft drink and food divisions that cause the firm to be more valuable with both divisions in the same firm than as two separate firms. These synergies involve the food division's exclusive use of Pepsi in their restaurants which increases the market demand for Pepsi consumed outside of the restaurants and the restaurants lowering the average variable costs of Pepsi.
• The use of the market price for the transfer price is wrong as it does not capture the value of the interdependencies. At $0.53 per gallon, each store will set a high retail price and will sell too little Pepsi and there will be too few customers exposed to Pepsi.
• All transfer pricing methods have some imperfections. No method is without some problem. The importance of the problem varies from situation to situation, causing there to be no unambiguous, always preferred, best method.

• Given the data in the case, full cost of $0.22 has the fewest problems. Advantages of full cost include:

- Full cost is simple to compute and is verifiable because it is part of the audited accounting system
- Full cost does not require special studies to estimate the value of the interdependencies
- Full cost approximately equals the opportunity cost of producing an additional gallon if PepsiCo is at capacity (approximately equal to long-run marginal cost). But it misses the value to Pepsi of having its product sampled at restaurants.