Question

Exercise 11-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO11-1, LO11-2]

Selected sales and operating data for three divisions of different structural engineering firms are given as follows:

Division A Division B Division C Sales $ 12,840,000 $ 28,840,000 $ 26,050,000 Average operating assets $ 3,210,000 $ 7,210,000 $ 5,210,000 Net operating income $ 564,960 $ 346,080 $ 755,450 Minimum required rate of return 6.00 % 6.50 % 14.50 %

Required:

1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover.

2. Compute the residual income (loss) for each division.

3. Assume that each division is presented with an investment opportunity that would yield a 7% rate of return.

a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?

b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

Answer-1)-Division A- Margin – (Net operating income /Sales)*100

= ($564960/$12840000)*100

= 4.4%

Turnover = Sales/ Average operating assets

= $12840000/$3210000

= 4

Return on investment = Margin*Turnover

= 4.4%*4

= 17.6%

Division B- Margin – (Net operating income /Sales)*100

= ($346080/$28840000)*100

= 1.2%

Turnover = Sales/ Average operating assets

= $28840000/$7210000

= 4

Return on investment = Margin*Turnover

= 1.2%*4

= 4.8%

Division C- Margin – (Net operating income /Sales)*100

= ($755450/26050000)*100

= 2.9%

Turnover = Sales/ Average operating assets

= $26050000/$5210000

= 5

Return on investment = Margin*Turnover

= 2.9%*5

= 14.5%

2)- Residual income =Operating income –(Average operating assets*Required rate of return)

Division A= $564960-($3210000*6%)

= $564960-$192600

= $372360

Division B= $346080-($7210000*6.5%)

= $346080-$468650

= $(122570)

Division C= $755450-($5210000*14.50%)

= $755450-$755450

= $0

3-a)-If performance is being measured by ROI, both Division A and Division C probably would reject the 7% investment opportunity. These divisions’ ROIs currently exceed 7%; accepting a new investment with a 7% rate of return would reduce their overall ROIs. Division B probably would accept the 7% investment opportunity because accepting it would increase the division’s overall rate of return.

3-b)-If performance is measured by residual income, both Division A and Division B probably would accept the 7% investment opportunity. The 7% rate of return promised by the new investment is greater than their required rates of return of 6% and 6.50%, respectively, and would therefore add to the total amount of their residual income. Division C would reject the opportunity because the 7% return on the new investment is less than its 14.50% required rate of return