Question

ROI and Residual Income:
Impact of a New Investment
The Mustang Division of Detroit Motors had an operating income of $900,000 and net assets of $4,000,000. Detroit Motors has a target rate of return of 16 percent.

(a) Compute the return on investment. (Round your answer to three decimal places.)
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(b) Compute the residual income.
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(c) The Mustang Division has an opportunity to increase operating income by $250,000 with an $750,000 investment in assets.

1. Compute the Mustang Division's return on investment if the project is undertaken. (Round your answer to three decimal places.)
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2. Compute the Mustang Division's residual income if the project is undertaken.
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Answer 1

A )  Return on Investment = Operating income / Net Assets

A )  Return on Investment = ( $ 900,000 * 100 ) / $ 4,000,000

A )  Return on Investment = 22.5 %.

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B) Residual income = Operating income - ( Net Assets * Rate of Return )

B) Residual income = $ 900,000 - ( $ 4,000,000 * 16 % )

B) Residual income = $ 260,000.

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>> New Operating Income = $ 900,000 + $ 250,000 = $ 11,50,000.

>> New Net Assets = $ 4,000,000 + $ 750,000 = $ 4,750,000

C ) New Return on Investment = Operating income / Net Assets

C ) New Return on Investment = ( $ 11,50,000 * 100 ) / $ 4,750,000

C ) New Return on Investment = 24.21 %.

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D) New Residual income = Operating income - ( Net Assets * Rate of Return )

D) New Residual income = $ 11,50,000 - ( $ 4,750,000 * 16 % )

D) New Residual income = $ 390,000

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