Question

Return on Investment and Investment Decisions

Leslie Blandings, division manager of Audiotech Inc., was debating the merits of a new product—a weather radio that would put out a warning if the county in which the listener lived were under a severe thunderstorm or tornado alert.

The budgeted income of the division was $975,000 with operating assets of $4,825,000. The proposed investment would add income of $640,000 and would require an additional investment in equipment of $4,000,000. The minimum required return on investment for the company is 13%.

Required:

1. Compute the ROI of the following (round to the nearest whole percent):

a. The division if the radio project is not undertaken.	20%
b. The radio project alone.	16%
c. The division if the radio project is undertaken.	%

2. Compute the residual income of the following:

a. The division if the radio project is not undertaken.	$
b. The radio project alone.	$
c. The division if the radio project is undertaken.	$

3. This depends on whether Leslie’s division is evaluated on the basis of ROI or on the basis of residual income. Overall division ROI wills decrease ; so if ROI is the basis for evaluation, she will decline  the investment. On the other hand, residual income for the project is positive  and will raise  overall residual income. If the division is evaluated on the basis of residual income, the project will be accepted

Answer 1

1
a
Net Operating income	975000
Divide by Operating assets	4825000
The division if the radio project is not undertaken	20%
b
Net Operating income	640000
Divide by Operating assets	4000000
The radio project alone	16%
c
Net Operating income	1615000	=975000+640000
Divide by Operating assets	8825000	=4825000+4000000
The division if the radio project is undertaken	18%
2
a
Net Operating income	975000
Less: Minimum required return	627250	=4825000*13%
The division if the radio project is not undertaken	347750
b
Net Operating income	640000
Less: Minimum required return	520000	=4000000*13%
The radio project alone	120000
c
Net Operating income	1615000
Less: Minimum required return	1147250	=(4825000+4000000)*13%
The division if the radio project is undertaken	467750
3
This depends on whether Leslie’s division is evaluated on the basis of ROI or on the basis of residual income. Overall division ROI wills decrease ; so if ROI is the basis for evaluation, she will decline the investment. On the other hand, residual income for the project is positive and will raise overall residual income. If the division is evaluated on the basis of residual income, the project will be accepted