Question

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 13 percent return on its investment.

During the past week, management of the company’s Northeast Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Northeast Division and the competitor:

	Northeast Division					Competitor
Sales		$	4,300,000				$	2,700,000
Variable costs			70	% of sales				65	% of sales
Fixed costs		$	1,062,000				$	889,000
Invested capital		$	950,000				$	200,000

Management has determined that in order to upgrade the competitor to Megatronics’ standards, an additional $150,000 of invested capital would be needed.

Required:

1. 1. Compute the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired.

2. 2. If divisional management is being evaluated on the basis of ROI, will the Northeast Division likely pursue acquisition of the competitor?

3. 3-a. Compute the ROI of the competitor as it is now and after the intended upgrade.

4. 3-b. If ROI is used as the basis for evaluation, would Megatronics Corporation likely be in favor of the acquisition of the competitor?

5. 4. Calculate the Northeast Division's ROI after acquisition of competitor but before upgrading.

6. 5-a. Assume that Megatronics uses residual income to evaluate performance and desires a 10 percent minimum return on invested capital. Compute the current residual income of the Northeast Division and the division’s residual income if the competitor is acquired.

7. 5-b. If divisional management is being evaluated on the basis of residual income, will the Northeast Division likely pursue acquisition of the competitor?

Answer 1

1. Current ROI of Northeast Division:

Net Income = 4,300,000 - (4,300,000 x 70%) - 1,062,000 = 228,000

ROI = Net Income / Invested Capital = 228,000 / 950,000 = 24%

ROI of Northeast Division if competitor is acquired

Net income of competitor = 2,700,000 - (2,700,000 x 65%) - 889,000 = 56,000

ROI = Net Income / Invested Capital = (228,000 + 56,000) / (950,000 + 200,000 + 150,000) = 284,000 / 1,300,000 = 21.85%

2. If divisional management is being evaluated on the basis of ROI, Northeast Division will not pursue acquisition of the competitor as the ROI of the division is getting reduced if acquired.

3-a. ROI of Competitor before upgradation = 56,000 / 200,000 = 28%

ROI of competitor after upgradation = 56,000 / (200,000 + 150,000) = 16%

3-b. If ROI is used as the basis for evaluation, Megatronics Corporation is likely to favor the acquisition of the competitor as even after upgrading ROI of competitor(16%) is more than ROI of Megatronics Corporation (13%)

4. ROI of Northeast Division after acquisition but before upgrading = (228,000 + 56,000) / (950,000 + 200,000) = 284,000 / 1,150,000 = 24.70%

5-a. Residual Income of Northeast Division before acquisition = Net income - Minimum return expected = 228,000 - (950,000 x 10%) = 133,000

Residual Income of Northeast Division after acquisition = (228,000 + 56,000) - [(950,000 + 200,000 + 150,000) x 10%] = 154,000

5-b. If divisional management is being evaluated on the basis of residual income, the Northeast Division is likely to pursue acquisition of the competitor as the residual income is increasing after acquisition.

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