Question

Residual Income and Investment Decisions

Jarriot, Inc., presented two years of data for its Furniture Division and its Houseware Division.

Furniture Division:
	Year 1	Year 2
Sales	$35,300,000	$38,300,000
Operating income	1,370,000	1,500,000
Average operating assets	5,560,000	5,560,000

Houseware Division:
	Year 1	Year 2
Sales	$11,600,000	$12,700,000
Operating income	620,000	580,000
Average operating assets	5,750,000	5,750,000

At the end of Year 2, the manager of the Houseware Division is concerned about the division’s performance. As a result, he is considering the opportunity to invest in two independent projects. The first is called the Espresso-Pro; it is an in-home espresso maker that can brew regular coffee as well as make espresso and latte drinks. While the market for espresso drinkers is small initially, he believes this market can grow, especially around gift-giving occasions. The second is the Mini-Prep appliance that can be used to do small chopping and dicing chores that do not require a full-sized food processor. Without the investments, the division expects that Year 2 data will remain unchanged. The expected operating incomes and the outlay required for each investment are as follows:

	Espresso-Pro	Mini-Prep
Operating income	$28,000	$15,400
Outlay	190,000	140,000

Jarriot’s corporate headquarters has made available up to $560,000 of capital for this division. Any funds not invested by the division will be retained by headquarters and invested to earn the company’s minimum required rate of return, 7 percent.

Required:

1. Compute the residual income for each of the opportunities. (Round to the nearest dollar.)

Espresso-Pro residual income	$
Mini-Prep residual income	$

2. Compute the divisional residual income for each of the following four alternatives: (Round to the nearest dollar.)

a. The Espresso-Pro is added.
$

b. The Mini-Prep is added.
$

c. Both investments are added.
$

d. Neither investment is made; the status quo is maintained.
$

Assuming that divisional managers are evaluated and rewarded on the basis of residual income, which alternative do you think the divisional manager will choose?

3. Assuming that management acts as you recommend in requirement 2, compute the change in profit (loss) from the divisional manager's investment decision.

   $

Was the correct decision made?

Answer 1

Ans 1)

Residual Income = Income - (Capital * Rate of return)

Espresso Pro residual Income = $28,000 - ($190,000 * 7%)

= $14,700

Mini Prep residual Income = $15,400 - ($140,000 * 7%)

= $5,600

Ans 2)

Residual Income of Houseware Division without investment = $580,000 - ($5,750,000 * 7%)

= $177,500

a) The Espresso-Pro is added.

Residual Income of Houseware Division = $177,500 + $14,700 = $192,200

b) The Mini-Prep is added.

Residual Income of Houseware Division = $177,500 + $5,600 = $183,100

c) Both investments are added.

Residual Income of Houseware Division = $177,500 + $5,600 + $14,700 = $197,800

d) Neither investment is made; the status quo is maintained.

Residual Income of Houseware Division = $177,500

If divisional managers are evaluated and rewarded on the basis of residual income, than both the investment will be chosen by managers as profit will be high if he choose both.

Ans 3)

Change in Profits = $197,800 - $177,500

= $20,300

Yes, correct ddecision made as it gives more profit.