Question

The manager of a division that produces computer hardware is considering the opportunity to invest in two independent projects. The first is a monitor and the second is a CPU. Without the investments, the division will have total assets for the coming year of $14.5 million and after-tax income of $1.58 million. The invested capital required for each investment and the expected operating incomes are as follows:

Monitor CPU

After-tax operating income         $33,750                                    $44,850

Invested capital                         375,000                                    345,000

Corporate headquarters will obtain its financing for the computer hardware division’s further investments from long term debt and shares and the weighted average cost of capital is estimated to be 9%

Required:

  

1. Compute the budgeted divisional ROI for each of the following alternatives:
a. The monitor investment is made
b. The CPU investment is made
c. Both investments are made
d. Neither investment is made

Assuming that divisional managers are evaluated and rewarded on the basis of ROI performance, which alternative do you think the divisional manager will choose?

Answer 1

		Existing	Monitor	CPU	Existing+ Monitor	Existing+CPU	Existing+ Monitor+CPU
	After-tax operating income	$        1,580,000	$            33,750	$          44,850	$      1,613,750	$       1,624,850	$      1,658,600
	Invested capital	$      14,500,000	$          375,000	$        345,000	$   14,875,000	$     14,845,000	$    15,220,000
	Budgeted ROI	10.90%	9.00%	13.00%	10.85%	10.95%	10.90%
1]	ANSWERS:
	a. The monitor investment is made	10.85%
	b. The CPU investment is made	10.95%
	c. Both investments are made	10.90%
	d. Neither investment is made	10.90%
2]	The divisional manager will choose the CPU as it will increase his division's ROI from 10.90% to 10.95%, entitling him
	for higher evaluation and reward.