Question

Selected sales and operating data for three divisions of different structural engineering firms are given as follows: Division A Division B Division C Sales $ 12,280,000 $ 35,350,000 $ 20,280,000 Average operating assets $ 3,070,000 $ 7,070,000 $ 5,070,000 Net operating income $ 601,720 $ 600,950 $ 567,840 Minimum required rate of return 10.00 % 10.50 % 11.20 % 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 11% 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

= ($601720/$12280000)*100

= 4.9%

Turnover = Sales/ Average operating assets

= $12280000/$3070000

= 4

Return on investment = Margin*Turnover

= 4.9%*4

= 19.6%

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

= ($600950/$35350000)*100

= 1.7%

Turnover = Sales/ Average operating assets

= $35350000/$7070000

= 5

Return on investment = Margin*Turnover

= 1.7%*5

= 8.5%

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

= ($567840/$20280000)*100

= 2.8%

Turnover = Sales/ Average operating assets

= $20280000/$5070000

= 4

Return on investment = Margin*Turnover

= 2.8%*4

= 11.2%

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

Division A= $601720-($3070000*11%)

= $601720-$337700

= $264020

Division B= $600950-($7070000*11%)

= $600950-$777700

= $(176750)

Division C= $567840-($5070000*11%)

= $567840-$557700

= 10140

3-a)-If performance is being measured by ROI, both Division A and Division C probably would reject the 11% investment opportunity. These divisions’ ROIs currently exceed 11%; accepting a new investment with a 11% rate of return would reduce their overall ROIs. Division B probably would accept the 11% 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 11% investment opportunity. The 11% rate of return promised by the new investment is greater than their required rates of return of 10% and 10.50%, respectively, and would therefore add to the total amount of their residual income. Division C would reject the opportunity because the 11% return on the new investment is less than its 11.20% required rate of return