Question

Richard's, Ananya's, and Div's Company (RAD) has many different divisions within their firm.   Assume Munoz Winters, Inc., is a division of RAD. RAD uses ROI as the primary measure of managerial performance. RAD has a desired return on investment (ROI) of 5.60 percent. The company has $200,000 of investment funds to be assigned to its divisions. The president of Munoz is aware of an investment opportunity for these funds that is expected to yield an ROI of 5.90 percent.

Income Statement
Sales revenue	$	700,000
Cost of goods sold		(505,000	)
Gross margin	$	195,000
Sales commission		(40,000	)
Depreciation expense		(12,000	)
Administrative expense		(73,950	)
Net income	$	69,050

Balance Sheet
Assets:
Cash	$	732,050
Manufacturing equipment, net of accumulated depreciation		290,000
Office equipment, net of accumulated depreciation		37,000
Total assets	$	1,059,050
Equity:
Common stock	$	990,000
Retained earnings		69,050
Total equity	$	1,059,050

Required

a-1. Calculate the existing ROI for Munoz.

a-2. Based on your computations will the President of Munoz accept or reject the $200,000 investment opportunity?

c-1. Calculate the estimated residual income of the new investment opportunity.

c-2. Based on the residual income would the President of Munoz accept or reject the $200,000 investment opportunity?

Answer 1

a.1

Net income	$        69,050
Capital Employed	$ 1,059,050
ROI	6.5%

a.2 President of Munoz will reject the $200,000 investment opportunity, since it will dilute existing ROI.

c.1

Net income	$        69,050
Capital Employed	$ 1,059,050
Charge on Capital @ 5.6%	$        59,307
Residual Income (Net income - Charge on Capital)	$          9,743

c. 2 President of Munoz will accept the $200,000 investment opportunity, since it yields Return will be higher than expected return. So will increase the residual income for the company.

Net income	$    11,800.0
Capital Employed	$     200,000
Charge on Capital @ 5.6%	$        11,200
Residual Income (Net income - Charge on Capital)	$              600