In: Accounting
The manager of a division that produces kitchen appliances is
considering the opportunity to invest in two independent projects.
The first is a toaster and the second is a blender. 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:
Toaster Blender
After-tax operating income $33,750 $44,850
Invested capital 375,000 345,000
Corporate headquarters will obtain its financing for the kitchen
appliances division’s further investments from long term debt and
shares and the weighted average cost of capital is estimated to be
9 per cent.
Required:
Compute ROI for each investment project
Compute the budgeted divisional ROI for each of the following
alternatives:
a. The toaster investment is made
b. The blender investment is made
c. Both investment 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?
Return on Investment (ROI):
ROI is defined as the ratio of net operating income to average operating assets for a given year. An investment with high ROI is usually preferable.
1. ROI for each investment project:
ROI for toaster project is
= Net operating income/ Capital investment
= 33,750 / 375,000
= 9%
ROI for blender project is
= Net operating income/ Capital investment
= 44,850 / 345,000
= 13%
Budgeted Divisional ROI for each alternatives:
Toaster investment | Blender investment | Both investment | Neither investment | |
Operating Income (A) |
$1,613,750 (1,580,000+33750) |
$1,624,850 (1,580,000+44850) |
$1,658,600 (1,580,000+33750+44850) |
$1,580,000 |
Assets (B) |
$14,875,000 (14,500,000+375,000) |
$14,845,000 (14,500,000+345,000) |
$15,220,000 (14,500,000+375,000+3,45,000) |
$14,500,000 |
ROI (A/B) | 10.85% | 10.95% | 10.9% | 10.9% |
Based on ROI, the divisional managers will choose the blender investment.