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ROI and Residual Income:
Impact of a New Investment
The Mustang Division of Detroit Motors had an operating income of $700,000 and net assets of $4,000,000. Detroit Motors has a target rate of return of 16 percent.

(a) Compute the return on investment. (Round your answer to three decimal places.)
Answer

(b) Compute the residual income.
$Answer

(c) The Mustang Division has an opportunity to increase operating income by $200,000 with an $950,000 investment in assets.

1. Compute the Mustang Division's return on investment if the project is undertaken. (Round your answer to three decimal places.)
Answer

2. Compute the Mustang Division's residual income if the project is undertaken.
$Answer

Answer 1

(a) Computation of Return on Investments (ROI) :

ROI = Net operating Income/ Operating Assets

Therefore, ROI = $700,000 / $4,000,000 * 100 = 17.50%

(b) Computation of the Residual Income:

Residual Income = Net operating Income - (Average Assets Employed * Minimum Required Return)

Therefore, Residual Income = $700,000 - ($4,000,000 * 16%) = $60,000

Now If the Mustang Division increases its income by $200,000 with an increase in investment by $950,000

New Operating Income = $700,000 + $200,000 = $900,000

New Investment = $4,000,000 + $950,000 = $4,950,000

(1) Computation of Return on Investments (ROI) if project is undertaken :

ROI = Net operating Income/ Operating Assets

Therefore, ROI = $900,000 / $4,950,000 * 100 = 18.182%

(2) Computation of the Residual Income if project is undertaken :

Residual Income = Net operating Income - (Average Assets Employed * Minimum Required Return)

Therefore, Residual Income = $900,000 - ($4,950,000 * 16%) = $108,000