Question

Westerville Company reported the following results from last year’s operations:

Sales	$	1,000,000
Variable expenses		300,000
Contribution margin		700,000
Fixed expenses		500,000
Net operating income	$	200,000
Average operating assets	$	625,000

This year, the company has a $120,000 investment opportunity with the following cost and revenue characteristics:

Sales	$	200,000
Contribution margin ratio		60	% of sales
Fixed expenses	$	90,000

The company’s minimum required rate of return is 15%.

13.	If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

Answer 1

Residual income=Net operating income-(Minimum required return*Average operating asset)

The new investment opportunity brings additional sales and cost and net income from such investment is calculated below:

Net oeprating income from additional investment=Contribution margin-Fixed expense

=(Additional Sales*Contribution margin ratio)-Fixed expense

=($200,000*60%)-$90,000

=$120,000-$90,000

Additional Net operating income=$30,000

Total Net operating income after adding net oeprating income as per previous year which is same in current year is calculated as below:

Net operating income=$200,000+$30,000

Net oeprating income=$230,000

Average operating assets is changed with this investment made of $120,000, so average operating assets is calculated as below

Average oeprating assets=$625,000+$120,000

Average oeprating assets=$745,000

Residual income=$230,000-($745,000*15%)

=$230,000-$111,750

Residual income=$118,250