Question

The Empire Hotel is a full-service hotel in a large city. Empire is organized into three departments that are treated as investment centers. Budget information for the coming year for these three departments is shown as follows. The managers of each of the departments are evaluated and bonuses are awarded each year based on ROI. Empire Hotel

Hotel Rooms Restaurants Health Spa

Average investment $ 8,148,000 $ 4,761,000 $ 1,025,000

Sales revenue $ 10,000,000 $ 2,000,000 $ 600,000

Operating expenses 8,775,000 1,359,000 402,000

Operating earnings $ 1,225,000 $ 641,000 $ 198,000

Required:

a. Compute the ROI for each department. Use the DuPont method to analyze the return on sales and capital turnover. Assume the Health Spa is considering installing new exercise equipment. Upon investigating, the manager of the division finds that the equipment would cost $40,000 and that operating earnings would increase by $8,000 per year as a result of the new equipment.

b-1. What would be the ROI of investment in the new exercise equipment and Health Spa?

b-2. Would the manager of the Health Spa be motivated to undertake such an investment?

c-1. Compute the residual income for each department if the minimum required return for the Empire Hotel is 17 percent.

c-2. What would be the impact of the investment on the Health Spa's residual income?

Answer 1

Solution a:

Return on sales
Particulars	Choose Numerator		/	Choose denomerator		=	Profit Margin
	Details	Amount		Details	Amount
Hotel Rooms	Operating Income	$1,225,000.00		Sales	$10,000,000.00		12.25%
Restaurant	Operating Income	$641,000.00		Sales	$2,000,000.00		32.05%
Health Spa	Operating Income	$198,000.00		Sales	$600,000.00		33.00%

Capital Turnover
Particulars	Choose Numerator		/	Choose denomerator		=	Investment Turnover
	Details	Amount		Details	Amount
Hotel Rooms	Sales	$10,000,000.00		Average operating assets	$8,148,000.00		1.23
Restaurant	Sales	$2,000,000.00		Average operating assets	$4,761,000.00		0.42
Health Spa	Sales	$600,000.00		Average operating assets	$1,025,000.00		0.59

Return on Investment
Particulars	Profit Margin	*	Investment Turnover	=	Return on Investment
Hotel Rooms	12.25%		1.23		15.03%
Restaurant	32.05%		0.42		13.46%
Health Spa	33.00%		0.59		19.32%

Solution b1:

ROI of investment = $8,000 / $40,000 = 20%

Solution b-2:

As ROI offered by new investment is higher than current ROI of health spa, therefore manager of health spa is motivated to undertake that investment.

Solution c1:

Computation of Residual Income
Division	Operating Income	Minimum Required Return	Residual Income
Hotel Rooms	$1,225,000.00	$1,385,160.00	-$160,160.00
Restaurant	$641,000.00	$809,370.00	-$168,370.00
Health Spa	$198,000.00	$174,250.00	$23,750.00

Solution c2:

Solution c-2:

Heath spa residual income will increase after undertaking new investment