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	$35,900,000	$38,000,000
Operating income	1,370,000	1,510,000
Average operating assets	6,780,000	6,780,000

Houseware Division:
	Year 1	Year 2
Sales	$11,700,000	$12,900,000
Operating income	600,000	560,000
Average operating assets	5,900,000	5,900,000

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	$15,300
Outlay	170,000	120,000

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?
Both projects

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

Profit   $

Was the correct decision made?
Yes

Answer 1

Part 1

	Espresso-Pro	Mini-Prep
Operating assets	$            170,000	$     120,000
Multiply: Minimum Required rate	7%	7%
Minimum Required return	$              11,900	$          8,400
Operating income	$              28,000	$        15,300
Less: Minimum Required return	$              11,900	$          8,400
Residual Income	$              16,100	$          6,900

Part 2

Houseware Division (if Espresso-Pro is added)
	Houseware Division	Espresso-Pro	Mini-Prep	Total
Operating assets	$        5,900,000	$     170,000		$      6,070,000
Multiply: Minimum Required rate				7%
Minimum Required return				$          424,900
Operating income	$            560,000	$        28,000		$          588,000
Less: Minimum Required return				$          424,900
Residual Income				$          163,100
Houseware Division (if Mini-Prep is added)
	Houseware Division	Espresso-Pro	Mini-Prep	Total
Operating assets	$        5,900,000		$      120,000	$      6,020,000
Multiply: Minimum Required rate				7%
Minimum Required return				$          421,400
Operating income	$            560,000		$         15,300	$          575,300
Less: Minimum Required return				$          421,400
Residual Income				$          153,900
Houseware Division (if Espresso-Pro and Mini-Prep both are added)
	Houseware Division	Espresso-Pro	Mini-Prep	Total
Operating assets	$        5,900,000	$     170,000	$      120,000	$      6,190,000
Multiply: Minimum Required rate				7%
Minimum Required return				$          433,300
Operating income	$            560,000	$        28,000	$         15,300	$          603,300
Less: Minimum Required return				$          433,300
Residual Income				$          170,000
Houseware Division (No investment made)
	Houseware Division	Espresso-Pro	Mini-Prep	Total
Operating assets	$        5,900,000			$      5,900,000
Multiply: Minimum Required rate				7%
Minimum Required return				$          413,000
Operating income	$            560,000			$          560,000
Less: Minimum Required return				$          413,000
Residual Income				$          147,000

Divisional manager are evaluated and rewarded on the basis of Residual income performance, then Both Project will be choose.	Both Project
Company earns the higher residual income when Both investments are added.				Option C

Part 3

Houseware Division (if Espresso-Pro and Mini-Prep both are added)				$          170,000
Houseware Division (No investment made)				$          147,000
Change in Operating Profit	$            23,000