Question

The Parkes Division of Global Corporation, which has income of $250 000 and an asset investment of $1 562 500, is studying an investment opportunity that will cost $450 000 and yield a profit before tax of $67 500. Assuming that Global Corporation uses an imputed interest charge of 14 per cent, would the investment be attractive to:
1-Divisional management if ROI is used to evaluate divisional performance?
2-Divisional management if residual income (RI) is used to evaluate divisional performance?
3-The management of Global Corporation?

Option	Attractive to Parkes: ROI	Attractive to Parkes: RI	Attractive to Global Corp.
A.	Yes	Yes	Yes
B.	No	Yes	Yes
C.	No	Yes	No
D.	Yes	No	No

Select one:

a. Option A

b. Option D

c. Option B

d. Option C

Answer 1

BEFORE TAKING THE NEW INVESTMENT OPPORTUNITY

Return on investment = ( income/investment) × 100

Return on investment = (250000/1562500) × 100 = 16%

Residual income = income - (investment × required rate of return)

Residual income = 250000 - (1562500×14%) = 31250

AFTER TAKING THE NEW INVESTMENT OPPORTUNITY

Income = 250000 + 67500 = 317500

Investment = 1562500 + 450000 = 2012500

Return on investment = (317500 / 2012500)×100 =15.77%

Residual income = 317500 - ( 2012500 × 14% )

    = 35750

1 Divisional manager is evaluated on the basis of ROI . the manager should not take the opportunity because it will reduce the the ROI of the division from 16% to 15.77%.

2 If the division manager is evaluated on the basis of RI. The manager of the division should take the investment opportunity. Because the opportunity will increase the Residual income from 31250 to 35750.

3 The management of Global corporation should accept the investment opportunity. Because the investment opportunity can conversion the additional cost of capital and produce profit in excess of cost of capital.

Cost of additional capital = 450000 × 14% = 63000

Profit from additional opportunity = 67500

Profit in excess of cost of capital = 67500 - 63000 = 4500

So the Global corporation can produce a additional profit of 4500 .

The Global corporation should accept the new investment opportunity .

Option B is correct

The above calculations,equations and explanations clearly indicate that all other options are incorrect.