Question

Exercise 11-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO11-1, LO11-2] Selected sales and operating data for three divisions of different structural engineering firms are given as follows: Division A Division B Division C Sales $ 12,640,000 $ 35,800,000 $ 20,640,000 Average operating assets $ 3,160,000 $ 7,160,000 $ 5,160,000 Net operating income $ 606,720 $ 608,600 $ 577,920 Minimum required rate of return 10.00 % 10.50 % 11.20 % Required: 1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover. 2. Compute the residual income (loss) for each division. 3. Assume that each division is presented with an investment opportunity that would yield a 11% rate of return. a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity? b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

Solution 1:

Sales Margin
Division	Choose Numerator		/	Choose denominator		=	Profit Margin
	Details	Amount		Details	Amount
Division A	Operating Income	$606,720.00	/	Sales	$12,640,000.00	=	4.80%
Division B	Operating Income	$608,600.00	/	Sales	$35,800,000.00	=	1.70%
Division C	Operating Income	$577,920.00	/	Sales	$20,640,000.00	=	2.80%

Turnover
Division	Choose Numerator		/	Choose denominator		=	Investment Turnover
	Details	Amount		Details	Amount
Division A	Sales	$12,640,000.00	/	Average operating assets	$3,160,000.00	=	4.00
Division B	Sales	$35,800,000.00	/	Average operating assets	$7,160,000.00	=	5.00
Division C	Sales	$20,640,000.00	/	Average operating assets	$5,160,000.00	=	4.00

Return on Investment - Expended Formula
Division	Profit Margin	*	Investment Turnover	=	Return on Investment
Division A	4.80%	*	4.00	=	19.2%
Division B	1.70%	*	5.00	=	8.5%
Division C	2.80%	*	4.00	=	11.2%

Solution 2:

Computation of Residual Income
Division	Operating Income	Minimum Required Return	Residual Income
Division A	$606,720.00	$316,000.00	$290,720.00
Division B	$608,600.00	$751,800.00	-$143,200.00
Division C	$577,920.00	$577,920.00	$0.00

Solution 3a:

If performance is measured by ROI, then division B will accept the investment opportunity as it will increase ROI of this division. Further Division A and C will reject the opportunity as it will decrease the ROI for these divisions.

Solution 3b:

If performance is being measured by residual income, then Division A and division B will accept the new investment opportunity as ROI offered by new investment is higher than minimum required return. Further Division C will reject the new investment opportunity as ROI offered by new investment is lesser than minimum required return.