Question

Exercise 10-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO10-1, LO10-2] Selected sales and operating data for three divisions of different structural engineering firms are given as follows: Division A Division B Division C Sales $ 6,400,000 $ 10,400,000 $ 9,500,000 Average operating assets $ 1,600,000 $ 5,200,000 $ 2,375,000 Net operating income $ 352,000 $ 988,000 $ 261,250 Minimum required rate of return 18.00 % 19.00 % 15.00 %

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 19% 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

1
Margin = Net operating income/Sales
Turnover = Sales/Operating assets
ROI = Margin*Turnover
	Margin	Turnover	ROI
Division A	5.50%	4.00	22.00%
Division B	9.50%	2.00	19.00%
Division C	2.75%	4.00	11.00%
2
	Division A	Division B	Division C
Average Operating assets	1600000	5200000	2375000
Required rate of return	18%	19%	15%
Required operating income	288000	988000	356250
Actual Net operating income	352000	988000	261250
Required operating income	288000	988000	356250
Residual income(loss)	64000	0	(95000)
3a
Division A	Reject	As ROI exceeds 19%
Division B	Accept	As ROI equals 19%
Division C	Accept	As ROI is less than 19%
3b
Division A	Accept	As Minimum required return is less than 19%
Division B	Accept	As Minimum required return equals 19%
Division C	Accept	As Minimum required return is less than 19%

Workings for 1:
	Margin	Turnover
Division A	=352000/6400000	=6400000/1600000
Division B	=988000/10400000	=10400000/5200000
Division C	=261250/9500000	=9500000/2375000