In: Finance
Exercise 12-2 : Juniper Design Ltd. of Manchester, England, is a company specializing in providing design services to residential developers. Last year the company had net operating income of $600,000 on sales of $3,000,000. The company’s average operating assets for the year were $2,800,000 and its minimum required rate of return was 18%.
1. Required: Compute the company’s residual income for the year—use the worksheet below and information given.
Average operating assets |
|
Net operating income |
|
Minimum required return: |
|
Residual income |
$ 96,000 |
2. Below is the worksheet calculating the residual income of above
Average operating assets................................. |
$2,200,000 |
Net operating income...................................... |
$400,000 |
Minimum required return: |
352,000 |
Residual income.............................................. |
$ 48,000 |
Assume the residual income changes to $60,000, what could have caused it to happen?
Increase in Revenue: Yes or No
Decrease in minimum required rate: Yes or No
Increase in Operating Assets: Yes or No
Assume there are two divisions, one with operating assets of 10 million and the other with operating assets of 2 million. Which will likely have a higher residual income in actual dollars, even though they were equally efficient?
Answer 1:
Residual Income is calculated as below:
Answer 2:
Residual Income = Net operating income - Average operating assets * Minimum required return
From above equation, we observe that:
An increase in residual income can happen:
Further operating income = Sales - Cost of Goods sold - Operating expense.
As such an increase in sales normally leads to increase to operating income, which will result in higher residual income.
Hence:
When residual income increases from $48,000 to $60,000, the cause could be:
Increase in Revenue: Yes
Decrease in minimum required rate: Yes
Increase in Operating Assets: No
Residual income is function of Net operating income, Operating assets and Minimum required return.
If other factors are similar, division with lower operating assets is likely to have a higher residual income. If other factors including efficiencies are similar the division with operating assets of 2 million will likely have higher residual income than division with operating assets of 10 million.