Question

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

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

At the beginning of this year, the company has a $200,000 investment opportunity with the following cost and revenue characteristics:

Sales	$	300,000
Contribution margin ratio		60	% of sales
Fixed expenses	$	132,000

The company’s minimum required rate of return is 10%.

What is the residual income of this year’s investment opportunity?

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

• All working forms part of the answer
• Requirement 1: This year’s Investment opportunity

A	Sales	$         300,000.00
B = A x 60%	Contribution margin	$         180,000.00
C	Fixed Expenses	$         132,000.00
D = B - C	Net Operating Income	$           48,000.00
E	Investment required	$         200,000.00
F	Minimum required ROR	10%
G = E x F	Target net operating income	$           20,000.00
H = D - G	Residual Income of this year's Investment opportunity	$           28,000.00 = ANSWER

• Requirement 2

	Last year	This year	Total
Net Operating Income	$         300,000.00	$          48,000.00	$       348,000.00
Average Operating Assets	$     1,000,000.00	$        200,000.00	$    1,200,000.00
Minimum Required ROR			10%
Target Income			$       120,000.00
Residual Income			$      228,000.00 = ANSWER