Question

PROBLEM 12-17. ROI and Investment Decisions [LO 2] Sarah Jones, the manager of the Teen division of the Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $5,000,000 with total assets of $33,000,000 and noninterest-bearing current liabilities of $1,500,000. The proposed investment would add $1,027,500 to operating income and would require an additional investment of $5,250,000. The targeted rate of return for the Teen division is 14 percent. (Ignore taxes in this problem.)

REQUIRED

a. Compute the ROI of:

1. The Teen division if the embroidery machine is not purchased.

2. The Teen division if the embroidery machine is purchased.

b. Compute the residual income of:

1. The Teen division if the embroidery machine is not purchased.

2. The Teen division if the embroidery machine is purchased.

c. Will Sarah decide to invest in the embroidery machine if her performance is evaluated in terms of ROI? Why or why not?

Answer 1

Answer:
a1)
Average Invested Assets           = Total assets (-) Noninterest-bearing current liabilities           = $ 33,000,000 (-) $ 1,500,000           =   $ 31,500,000
ROI of the Teen division if the embroidery machine is not purchased              = Operating income / Average Invested Assets              = $ 5,000,000 / $ 31,500,000              =    15.87%	15.87%
a2)
ROI of the Teen division if the embroidery machine is purchased                  = Revised Operating income / Revised Average Invested Assets                  = ( $ 5,000,000 + $ 1,027,500) / ($ 31,500,000 + $5,250,000 )                  =     $ 6,027,500 / $ 36,750,000                  =     16.40%	16.40%
b1)
Residual income of the Teen division if the embroidery machine is not purchased               = Operating income (-) [ Targeted rate of return x Average Invested Assets ]               =   $ 5,000,000 (-) [ 14% x $ 31,500,000 ]               =   $ 5,000,000 (-) $ 4,410,000               =   $ 590,000	$ 590,000
b2)
Residual income of the Teen division if the embroidery machine is purchased               = Rev. Operating income (-) [ Targeted rate of return x Rev. Average Invested Assets ]               =   ( $ 5,000,000 + $ 1,027,500) (-) [ 14% x ($ 31,500,000 + $5,250,000 ]               =   $ 6,027,500 (-) $ 5,145,000               =   $ 882,500	$ 882,500
C)
Yes, Sarah will invest in the embroidery machine if her performance is evaluated in terms of ROI. Since ROI is higher when Compared to this. i.e., 16.40 % > 15.87%