Question

Residual Income and Investment Decisions

Jarriot, Inc., presented two years of data for its Furniture Division and its Houseware Division.

Furniture Division:
	Year 1	Year 2
Sales	$35,100,000	$37,800,000
Operating income	1,350,000	1,570,000
Average operating assets	5,710,000	5,710,000

Houseware Division:
	Year 1	Year 2
Sales	$11,900,000	$12,700,000
Operating income	680,000	540,000
Average operating assets	5,750,000	5,750,000

At the end of Year 2, the manager of the Houseware Division is concerned about the division’s performance. As a result, he is considering the opportunity to invest in two independent projects. The first is called the Espresso-Pro; it is an in-home espresso maker that can brew regular coffee as well as make espresso and latte drinks. While the market for espresso drinkers is small initially, he believes this market can grow, especially around gift-giving occasions. The second is the Mini-Prep appliance that can be used to do small chopping and dicing chores that do not require a full-sized food processor. Without the investments, the division expects that Year 2 data will remain unchanged. The expected operating incomes and the outlay required for each investment are as follows:

	Espresso-Pro	Mini-Prep
Operating income	$28,000	$15,400
Outlay	200,000	150,000

Jarriot’s corporate headquarters has made available up to $500,000 of capital for this division. Any funds not invested by the division will be retained by headquarters and invested to earn the company’s minimum required rate of return, 7 percent.

Required:

1. Compute the residual income for each of the opportunities. (Round to the nearest dollar.)

Espresso-Pro residual income	$
Mini-Prep residual income	$

2. Compute the divisional residual income for each of the following four alternatives: (Round to the nearest dollar.)

a. The Espresso-Pro is added.
$

b. The Mini-Prep is added.
$

c. Both investments are added.
$

d. Neither investment is made; the status quo is maintained.
$

Assuming that divisional managers are evaluated and rewarded on the basis of residual income, which alternative do you think the divisional manager will choose?
Both projects

3. Assuming that management acts as you recommend in requirement 2, compute the change in profit (loss) from the divisional manager's investment decision.

Profit   $

Was the correct decision made?
Yes

Answer 1

Answer 1

Residual income is

=Operating income – (cost of capital * Operating assets)

For espresso - pro

= 28000 – ( 7%* 200000)

= 14000

  For Mini-prep

= 15400 – (7%* 150000)

= 4900

Answer 2:

Divisional residual income if espresso pro is added

200000 will be invested in espresso pro and remaining 300000 will be invested to earn minimum return of 7% so the total will be

= 28000 + (7%* 300000)

= 49000

Divisional residual income if mini-prep is added

150000 will be invested in mini-prep and remaining 350000 will be invested to earn minimum return of 7% so the total will be

=15400 + (7%* 350000)

= 39900

Divisional residual income if both investments are added

150000 will be invested in mini-prep and 200000 will be invested in espresso pro and remaining 150000 will be invested to earn minimum return of 7% so the total will be

49000 + 39900 + (7%* 150000)

= 99400

Divisional residual income if no investments are added

= 500000* 7%

= 35000

On the basis of residual income either both investments should be made

Answer 3

The profit will be

49000 + 39900 + (7%* 150000)

= 99400

Was the correct decision made?
Yes