Question

Solano Company has sales of $700,000, cost of goods sold of $470,000, other operating expenses of $50,000, average invested assets of $2,100,000, and a hurdle rate of 9 percent.

Required:
1. Determine Solano’s return on investment (ROI), investment turnover, profit margin, and residual income.
2. Several possible changes that Solano could face in the upcoming year follow. Determine each scenario’s impact on Solano’s ROI and residual income. (Note: Treat each scenario independently.)
a. Company sales and cost of goods sold increase by 30 percent.
b. Operating expenses decrease by $8,000.
c. Operating expenses increase by 10 percent.
d. Average invested assets increase by $400,000.
e. Solano changes its hurdle rate to 15 percent.

Answer 1

	1-
	sales		700000
	cost of goods sold		470000
	gross margin		230000
	other operating expenses		50000
	operating income		180000
	return on investment = operating profit/average invested assets	180000/2100000	8.57%
	Investment turnover ratio = sales/average of invested assets	700000/2100000	0.33
	profit margin =operating income/sales	180000/700000	25.71%
	residual income = income from operations-(hurdle rate*average invested assets)	180000-(2100000*9%)	-9000
	2-
A-	sales	700000*1.3	910000
	cost of goods sold	470000*1.3	611000
	gross margin		299000
	other operating expenses		50000
	operating income		249000
	return on investment = operating profit/average invested assets	249000/2100000	11.86%
	residual income = income from operations-(hurdle rate*average invested assets)	249000-(2100000*9%)	60000
B-	sales		700000
	cost of goods sold		470000
	gross margin		230000
	other operating expenses	50000-8000	42000
	operating income		188000
	return on investment = operating profit/average invested assets	188000/2100000	8.95%
	residual income = income from operations-(hurdle rate*average invested assets)	188000-(2100000*9%)	-1000
C-	sales		700000
	cost of goods sold		470000
	gross margin		230000
	other operating expenses	50000*1.1	55000
	operating income		175000
	return on investment = operating profit/average invested assets	175000/2100000	8.33%
	residual income = income from operations-(hurdle rate*average invested assets)	175000-(2100000*9%)	-14000
D-	sales		700000
	cost of goods sold		470000
	gross margin		230000
	other operating expenses		50000
	operating income		180000
	return on investment = operating profit/average invested assets	180000/(2100000-400000)	10.59%
	residual income = income from operations-(hurdle rate*average invested assets)	180000-(1700000*9%)	27000
E-	sales		700000
	cost of goods sold		470000
	gross margin		230000
	other operating expenses		50000
	operating income		180000
	return on investment = operating profit/average invested assets	180000/(2100000)	8.57%
	residual income = income from operations-(hurdle rate*average invested assets)	180000-(2100000*15%)	-135000