Question

Chinsali Division, a subsidiary of Mungwi Group Plc has the following budgeted results: K’000 Capital Employed 6,400 Operating Profit 1,600 Mungwi Group uses the Return on (ROI) and the Residual Income (RI) to evaluate the performance of division managers. The non-current assets are valued at net book value at year end while net current assets are valued at the average for the year. Depreciation is calculated on straight line basis. Mungwi Group expects all new projects to earn a minimum 18% discounted cashflow return over four years. In addition to the budgeted results, Chinsali division is considering investment in the following three new independent projects: Project 1 Investment outlay of K1,200,000 in a processing plant Benefit - the plant will reduce annual revenue costs by K400,000’ The plant would be purchased at the beginning of next year, with a useful life of four years and no scrap value. Project 2 Investment outlay of K32,000 in computerized inventory control system at start of next year. Plus an additional member of staff to be employed specifically to manage the system at an annual salary of K36,000. Benefit of new system – reduction in inventory levels by an average of K180,000 over the year. This project investment to be regarded as a revenue expense lasting only one year. The extra cash to be remitted to Mungwi group head office. Project 3 Head office be allowed to assist chinsali handle its accounts receivable by injecting some extra cash. This assistance will enable chinsali increase accounts receivable by an average of K140,000 over a year. This will result in increased sales generating an additional annual contribution of a K100,000. Ignore inflation and taxation

Required: (1) Calculate the existing return on investment (ROI) and residual income (RI) for Chinsali Division without the proposed new investment projects’ (2)

Calculate Chinsali division’s return on investment and residual income for the next year for each of the three new independent projects. (3)

Recommend the new project(s) that are likely to encourage goal congruence between Mungwi group plc and chinsali division. Comment on the residual income decision rules. Discount factors (18%) Year 0 Year 1 Year 2 Year 3 Year4 Year5 1 0.847 1.566 2.174 2.690 3.127

Answer 1

According to the above calculations, Project 2 and 3 are likely to encourage goal congruence between Mungwi group plc and chinsali division as they increase both RI and ROI over the current existing levels.

Residual Income is the income remaining from the Operating Profit after charging an Imputed cost of capital at a fixed percentage of the Capital Employed (18%).