Question

Recreation 4 Fun is a manufacturer of recreational equipment. Performance of the fishing division is measured as an investment centre because the manager makes all the decision about investments in operating equipment and space. Following is financial information for the fishing division.

Average operating assets	$2,000,000
Current liabilities	500,000
Operating income	300,000

Fishing division’s required rate of return is 12 per cent, but Recreation 4 Fun’s weighted average cost of capital is 9 per cent, and the tax rate is 30 per cent.

Required

Round your answers to 2 decimal places if needed.

(1) Calculate ROI for the fishing division (1 mark).

(2) Calculate residual income (RI) for the fishing division (1 mark).

(3) Calculate economic value added (EVA) for the fishing division .

(4) Suppose the manager of the fishing division identifies a project costing $600,000 that will generate an additional $60,000 in operating profit. Will he choose to invest in the project if ROI is used to measure the performance? Will the CEO of Recreation 4 Fun choose to invest in the project? Show all calculations to support your conclusion .

Answer 1

Answer :

1. Calculation of Return on Investment (ROI) for the fishing division  :

ROI = Operating Income / Average Operating assets

ROI = $300,000 / $2,000,000 x 100

= 15%

2. Calculation of Residual Income (RI) :

Residual Income = Operating Income - (Average Operating assets x Desired rate of return)

Residual Income = $300,000 - ($2,000,000 x 12%)

= $300,000 - $240,000

= $60,000

3. Calculation of EVA :

EVA = Operating Income - (Average Operating assets x Cost of Capital)

= $300,000 - ($2,000,000 x 9%)

= $300,000 - $180,000

= $120,000

4. Project cost =   $600,000

Operating profit = $60,000

After tax Operating profit = Operating profit - Tax @30%

= $60,000 - ($60,000 x 30%)

= $60,000 - $18,000

= $42,000

ROI = Operating Income after tax / Average Operating assets

ROI = $42,000 / $600,000 x 100

= 7%

Comment : No, the CEO of Recreation 4 Fun is not interested to invest in the project because the ROI of project is 7% which is lower than desired ROI of 12%.