Question

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 13 percent return on its investment.

During the past week, management of the company’s Northeast Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Northeast Division and the competitor:

	Northeast Division					Competitor
Sales		$	4,300,000				$	2,700,000
Variable costs			70	% of sales				65	% of sales
Fixed costs		$	1,062,000				$	889,000
Invested capital		$	950,000				$	200,000

Management has determined that in order to upgrade the competitor to Megatronics’ standards, an additional $150,000 of invested capital would be needed.

Required:

1. Compute the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired.

1A. If divisional management is being evaluated on the basis of ROI, will the Northeast Division likely pursue acquisition of the competitor?

1C. Compute the ROI of the competitor as it is now and after the intended upgrade.

1D. If ROI is used as the basis for evaluation, would Megatronics Corporation likely be in favor of the acquisition of the competitor?

1E. Calculate the Northeast Division's ROI after acquisition of competitor but before upgrading.

1F. Assume that Megatronics uses residual income to evaluate performance and desires a 10 percent minimum return on invested capital. Compute the current residual income of the Northeast Division and the division’s residual income if the competitor is acquired.

1G. If divisional management is being evaluated on the basis of residual income, will the Northeast Division likely pursue acquisition of the competitor?

Answer 1

1G. If divisional management is being evaluated on the basis of residual income, will the Northeast Division likely pursue acquisition of the competitor?
1)
Current ROI of the Northeast Division:
Sales Revenue		$4,300,000.00
Less: Variable Cost = 70% of Sales	$3,010,000.00
Fixed costs	$1,062,000.00	$4,072,000.00
Operating Income		$228,000.00
ROI = Income ÷ invested capital
ROI = $228,000 ÷ $950,000	24.00%
Northeast’s ROI if competitor is acquired:
Sales Revenue = $4,300,000 + $2,70,000		$7,000,000.00
Less: Variable Cost = $3010 000 + (65% x $2,700,000)	$4,765,000.00
Fixed costs ($1,062,000 + $889,000)	$1,951,000.00	$6,716,000.00
Operating Income		$284,000.00
ROI = Income ÷ invested capital
ROI = $295,000 ÷ ($950,000 + $200,000 + $150,000)	21.85%
1a)
Divisional management will likely be against the acquisition because ROI will be lowered from 24% to 21.85%
1c)
Current ROI of the Competitor:
Sales Revenue		$2,700,000.00
Less: Variable Cost = 65% of Sales	$1,755,000.00
Fixed costs	$889,000.00	$2,644,000.00
Operating Income		$56,000.00
ROI = Income ÷ invested capital
ROI = $88,000 ÷ $200000	28.00%
After Upgrade ROI = $56000/(200000+150000)	16.00%
1d)
Corporate management would probably favor the acquisition because Megatronoics has been earning a 16% return, and the competitor’s ROI of 28% will help the organization as a whole. Even the upgrade is made, the competitor’s ROI would be 16%
1e)
Northeast’s ROI if competitor is acquired before upgrade
Sales Revenue = $4,300,000 + $2,70,000		$7,000,000.00
Less: Variable Cost = $3010 000 + (65% x $2,700,000)	$4,765,000.00
Fixed costs ($1,062,000 + $889,000)	$1,951,000.00	$6,716,000.00
Operating Income		$284,000.00
ROI = Income ÷ invested capital
ROI = $295,000 ÷ ($950,000 + $200,000)	24.70%
1f)
Current residual income of the Northeast Division:
Divisional profit	$228,000.00
Less: Imputed interest charge ($950,000 x 13%)	-$123,500.00
Residual income	$104,500.00
Residual income if competitor is acquired:
Divisional profit	$284,000.00
Less: Imputed interest charge (($950,000 + $200,000 + $150,000)x 13%)	-$169,000.00
Residual income	$115,000.00
1g
Yes, Divisional management would probably favor the acquisition.Residual income will increase by $10,500 ($115,000 - $104,500)