Question

ABC Division currently has an operating profit of $3.75 million on average operating assets of $21 million. ABC is considering investing in two projects:

                                                                        Project #1                    Project #2

Required Investment                                      $1,250,000                  $ 750,000

Annual Revenue or Cost Savings                   $   200,000                  $175,000

ABC’s division manager receives a bonus each year which is tied to the ROI of ABC. Corporate headquarters has made $2.5 million in capital available to ABC. Any unused funds would be invested at the corporate level at an expected rate of 10%.

1. Compute the current division ROI and the ROI of each project.

2. Calculate the new ROI for ABC Division based on: a) adding Project #1; b) adding Project #2; and c) adding Project #1 and Project #2.

3. What investment option is ABC’s manager likely to choose? What are you assuming is motivating the manager?

4. Which investment alternative is in the best interest of the overall company? Why? (Calculations not needed.)

5. Calculate the residual income of each project (use 10% as the minimum return). Also calculate the new Residual income for ABC Division based on all possible investment alternatives.

6. What investment option would ABC choose if the division manager were evaluated based on RI?

Answer 1

1. Current Division rol

Rol= investment gain/ Investment base

= 3.75/21 = 17.86%

Rol of each project

Project 1.

ROI = $200 000/$1250 000

= 16%.

Project 2

ROI = $175'000/$750'000 = 23.333%.

2. a. Project 1.

ROI

Return= .2 million+

3.75 million =3.95 million

Investment

1.25 million+21 million = 22.25 million

Total= 3.95million/22.25 million = 17.75 %

b. For project 2

ROI= 3.75 + .175 million / .750 + 21 million

= 3.925/21.75 = 18%

c. ROI

= Return/ investment

Return= 3.75 + .2 + .175 = 4.125 million

Investment= 21+ 1.250 + .750 = 23 million

ROI = 4.125/23= 17.93%.

3. ROI project 1.

200/1250= 16%

ROI project 2.

175/750 = 23.33%

ABC division have 2.5 million capital available for the investment.If the division select project 1 company ROI is 16% and the division have 1.25 million capital remain balance and division invested in corporate level for 10% return.

That's $ 125'000

If division invested in project two the ROI is 23.33% and division have 1.75 million capital remain balance so the division invest in corporate level and get 20% return that is $175'000.

So the return and ROI of the project 2 is greater than the project 1. So ABC manager should select project 2.

4. Project 2 is good investment policy for the division because the return and ROI is greater than the project 1.

5. Residual income= operating profit- cost of capital

Here the residual income for project 1.=

$200'000 revenue - $125'000 (10%) minimum return.

= $ 75000

Residual income for project 2

Revenue $175'000 - $ 75'000 (10%) minimum return

= 100'000

For ABC division the residual income is by adding project 1.

Operating revenue= .2 + 3.75 = 3.95 million

Investment 21+ 1.250 = 22.25 million

So residual income= 3.95 - 2.225 million( 10%) minimum return= $ 1.725 million

For ABC division the residual income by adding project 2

Operating revenue = 3.75 + .175 = 3.925 million

Investment 21+ .750 = 21.75 million

Residual income= 3.925 - 2.175 = $1.75 million

6. Project 2. If, ABC division chose project 2 it will causes Abc's overall residual income is greater compare to the project 1.