Question

Westerville Company reported the following results from last year’s operations:

Sales	$	1,400,000
Variable expenses		680,000
Contribution margin		720,000
Fixed expenses		440,000
Net operating income	$	280,000
Average operating assets	$	875,000

At the beginning of this year, the company has a $300,000 investment opportunity with the following cost and revenue characteristics:

Sales	$	480,000
Contribution margin ratio		80	% of sales
Fixed expenses	$	336,000

The company’s minimum required rate of return is 15%.

1.  If the company pursues the investment opportunity and otherwise performs the same as last year, what ROI will it earn this year? (Round your percentage answer to 1 decimal place (i.e., 0.1234 should be considered as 12.3%.))

2. What is last year’s residual income? What is the residual income of this year’s investment opportunity?

3. If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

4. Assume that the contribution margin ratio of the investment opportunity was 75% instead of 80%. If Westerville’s Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Would the owners of the company want her to pursue the investment opportunity? Yes or NO question

Thank you

Answer 1

1. If the company pursues the investment opportunity, this year’s ROI would be:

ROI = Margin * Turnover

= 17.45% * 1.60

= 27.92 %

2.

Last year’s residual income is:

Residual income = Net operating income - Minimum required return

= $280,000 - 131,250

= $ 148,750

Minimum required return = Average operating assets * rate of return  

= 15% * $875,000 = $131,250

b)

The residual income for this year’s investment opportunity is:

Net operating income - Minimum required return

Residual income= $48000 - $30000

= $18000

Minimum required return = Rate of return * Investment  

= 10% * $300,000 = $30,000

3.

If the company pursues the investment opportunity, this year’s residual income will be:

Residual income = Net operating income - Minimum required return  

Residual income = $328000 - $ 176250

=$ 151,750

Minimum required return = 15% * $1,175,000= $176,250

4. NO

The CEO and the company would not want to pursue this investment opportunity because it does not exceed the minimum required return.