Question

Wescott Company has three divisions: A, B, and C. The company has a hurdle rate of 8 percent. Selected operating data for the three divisions are as follows: Division A Division B Division C Sales revenue $ 1,300,000 $ 1,091,000 $ 1,096,000 Cost of goods sold 803,000 801,000 796,000 Miscellaneous operating expenses 73,000 61,000 62,000 Interest and taxes 57,000 50,000 50,000 Average invested assets 9,857,000 2,353,000 3,870,000 Wescott is considering an expansion project in the upcoming year that will cost $5.9 million and return $543,000 per year. The project would be implemented by only one of the three divisions. Required: 1. Compute the ROI for each division. (Do not round your intermediate calculations. Round your percentage answer to 2 decimal places, (i.e. 0.1234 should be entered as 12.34%.)) 2. Compute the residual income for each division. (Loss amounts should be indicated by a minus sign.) 3. Rank the divisions according to the ROI and residual income of each. 4-a. Compute the return on investment on the proposed expansion project. (Round your percentage answer to 2 decimal places, (i.e. 0.1234 should be entered as 12.34%.)) 4-b. Is this an acceptable project? No Yes 5. Without any additional calculations, state whether the proposed project would increase or decrease each division’s ROI. 6. Compute the new ROI and residual income for each division if the project was implemented within that division. (Loss amounts should be entered with a minus sign. Enter your ROI percentage answers to 2 decimal places, (i.e., 0.1234 should be entered as 12.34%.))

Answer 1

Solution

Wescott Company

1. ROI for each division:

ROI = net operating income/average invested assets

Net operating income = sales – cost of goods sold – operating expenses

Division A –

Net operating income = sales – cost of goods sold – operating expenses

= $1,300,000 – 803,000 – 73,000 = $424,000

Average invested assets = $9,857,000

ROI = 424,000/9,857,000 = 4.3%

Division B –

Net operating income = sales – cost of goods sold – operating expenses

= $1,091,000 – 801,000 – 61,000 = $229,000

Average invested assets = $2,353,000

ROI = 229,000/2,353,000 = 9.73%

Division C –

Net operating income = sales – cost of goods sold – operating expenses

= $1,096,000 – 796,000 – 62,000 = $238,000

Average invested assets = $3,870,000

ROI = 238,000/3,870,000 = 6.15%

1. Residual income for each division:

Residual income = net operating income – (minimum rate of return x average invested assets)

Hurdle rate = 8%

Division A –

Residual income = 424,000 – 8% (9,857,000) = ($364,560)

Division B –

Residual income = 229,000 – 8% x 2,353,000 = $40,760

Division C –

Residual Income = 238,000 – 8% x 3,870,000 = ($71,600)

1. Ranking the divisions based on ROI and residual income:

	Division A	Division B	DivisionC
ROI	4.30%	9.73%	6.15%
Ranking	III	I	II
Residual Income	($364,560)	$40,760	($71,600)
Ranking	III	I	II

1. ROI on proposed expansion project:

Cost of project = $5,900,000

Return = $543,000 per year

ROI = 543,000/5,900,000 = 9.2%

Yes, this is an acceptable project.

The ROI of the expansion project is 9.2%, which is higher than the company’s hurdle rate of 8%.

1. Expansion project would decrease or increase each division’s ROI:

The project would increase the ROI of Divisions A and C, as the respective ROI’s for these divisions – 4.3% and 6.15% are less compared to the project’s ROI of 9.2%. However, the project would decrease the ROI of Division B, as its ROI 9.73% is higher than the project’s ROI of 9.2%.

1. Computation of new ROI and residual income for each division:

• ROI

Division A –

Net operating income = sales – cost of goods sold – operating expenses

= $1,300,000 – 803,000 – 73,000 = $424,000 + 543,000 = $967,000

Average invested assets = $9,857,000 + 5,900,000 = $15,757,000

ROI = 967,000/15,757,000 = 6.14%

Division B –

Net operating income = sales – cost of goods sold – operating expenses

= $1,091,000 – 801,000 – 61,000 = $229,000 + $543,000 = $772,000

Average invested assets = $2,353,000 + 5,900,000 = $8,253,000

ROI = 772,000/8,253,000 = 9.35%

Division C –

Net operating income = sales – cost of goods sold – operating expenses

= $1,096,000 – 796,000 – 62,000 = $238,000+ 543,000 = $781,000

Average invested assets = $3,870,000 + 5,900,000 = $9,770,000

ROI = 781,000/9,770,000 = 7.99%

	Division A	Division B	Division C
ROI	6.14%	9.35%	7.99%

Residual Income –

1. Residual income for each division:

Residual income = net operating income – (minimum rate of return x average invested assets)

Hurdle rate = 8%

Division A –

Residual income = 967,000 – 8% (15,757,000) = ($293,560)

Division B –

Residual income = 772,000 – 8% x 8,253,000 = $111,760

Division C –

Residual Income = 781,000 – 8% x 9,770,000 = ($600)

	Division A	Division B	Division C
Residual Income	($293,560)	$111,760	($600)