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 .l Competitor

Sales........................................................$8,400,000 l . $5,200,000
Variable costs ..............................................70% of sales l. 65% of sales
Fixed costs ................................................ .$2,150,000 l $1,670,000
Invested capital ............................................ $1,850,000 l. $625,000

Management has determined that in order to upgrade the competitor to Megatronics’ standards, an additional $375,000 of invested capital would be needed.

To do:
1. Compute the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired.
2. What is the likely reaction of divisional management toward the acquisition? Why?
3. What is the likely reaction of Megatronics’ corporate management toward the acquisition? Why?
4. Would the division be better off if it didn’t upgrade the competitor to Megatronics’ standards? Show computations to support your answer.
5. Assume that Megatronics uses residual income to evaluate performance and desires a 12 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. Will divisional management be likely to change its attitude toward the acquisition? Why?

Answer 1

1.

	Northeast	Competitor	After
Particulars	Division		Acquired
	$	$	$
Sales	84,00,000	52,00,000	1,36,00,000
Less: Variable Costs	58,80,000	33,80,000	92,60,000
Contribution	25,20,000	18,20,000	43,40,000
Less: Fixed Costs	21,50,000	16,70,000	38,20,000
Profit / EBIT	3,70,000	1,50,000	5,20,000
Invested Capital	18,50,000	6,25,000	28,50,000
ROI = EBIT x 100 / Invested Capital
	20%	24%	18%
Invested Capital after acquired is calculated as follows
= 1850000 + 625000 + 375000 = 2850000
Hence, ROI of Northeast Division is 20%
Divisions ROI if competitor is acquired would be 18%

2.

Divisional management would be against the acquisition of

competitor as there ROI would decrease from 20% to 18%   

3.

Megatronic's corporate management will be in favour of the

acquisition as company's present ROI is 13% only whereas

ROI of competitor is 24%             

4.   

Yes, the division would be better if it didn't upgrade .

Invested Capital = 1850000 + 625000 = 2475000

EBIT = 520000                    

Thus, ROI = 520000 x 100 / 2475000 = 21%