Question

Company Epsilon has two retail divisions, retail division #1 and retail division #2, which reported the following results for the year end of 2019. The required rate of return set for the retail divisions is 10%.

Results for the year end of 2019	Retail division #1	Retail division #2
Net operating income	$5,000,000	$15,000,000
Average operating assets	$30,000,000	$100,000,000

If no investment in made for 2020, both retail divisions are expected to maintain the same net operating income and average operating assets as of 2019. However, there is an opportunity in 2020 for Company Epsilon to invest in one of the two retail division. The investment would be of $15,000,000 and would generate additional net operating income of $2,400,000 per year.

Required:

1. Which division had the higher return on investment (ROI) in 2019 and why?

2. Which division had the higher residual income (RI) in 2019 and why?

3. If the managers of the retail divisions are evaluated based on return on investment (ROI), will the managers want to invest in 2020 and why?

4. If the managers of the retail divisions are evaluated based on residual income (RI), will the managers want to invest in 2020 and why?

Answer 1

The question provides the following information: Required rate of return = 10%

Net operating income of division 1 = $5,000,000

Average operating assets of division 1 = $30,000,000

Net operating income of division 2 = $15,000,000

Average operating assets pf division 2 = $ 100,000,000

Additional investment = $15,000,000

Additional net operating income = $2,400,000

1. Formula to calculate return on investment (ROI) is as follows:

ROI = (Net operating income / average operating assets) *100

Therefore,

ROI for division 1 = (5,000,000/ 30,000,000)*100

= 16.67%

And, ROI for division 2 = (15,000,000/100,000,000)*100

= 15%

Thus, it is clear from the above calculations that Division 1 has higher ROI in 2019.

2. Formula to calculate residual income (RI) is as follows:

RI = Net operating income - ( Average operating assets * required rate of return)

Therefore,

RI for division 1 = 5,000,000- ( 30,000,000* 10%)

= 5,000,000- 3,000,000

= 2,000,000

And, RI for division 2 = 15,000,000 - (100,000,000*10%)

= 15,000,000 - 10,000,000

= 5,000,000

Thus, it is clear from the above calculation that Division 2 has higher Residual Income in 2019.

3. We will assume that if managers of the company decides to invest in the divisions then the information for the company would be :

*For division 1

New NOI = existing NOI + additional NOI

= 5,000,000 + 2,400,000

= 7,400,000

New Average operating assets = existing +additional

= 30,000,000+15,000,000

= 45,000,000

New ROI = (7,400,000/45,000,000)*100

= 16.44%

* For division 2,

New NOI =existing NOI+ additional NOI

= 15,000,000+2,400,000

= 17,400,000

New average operating assets= existing+additional

= 100,000,000+15,000,000

= 115,000,000

New ROI = (17,400,000/115,000,000)*100

= 15.13%

Under ROI, the basic aim is to maximize the rate of return .

Thus, managers of highly profitable division prefers to invest in projects with lower ROI than the current rate so that their average ROI would be reduced.

Therefore, based on ROI, the managers would prefer to invest in 2020 to maximize the rate of return.

* The above calculation is based on the assumption.

4. RI for division 1 based on above assumption

= New NOI -( new average operating assets*required rate of return)

= 7,400,000-(45,000,000*10%)

=7,400,000-4,500,000

= 2,900,000

And, RI for division 2 based on above assumption

= 17,400,000-(115,000,000*10%)

=17,400,000-11,500,000

= 5,900,000

Under RI approach, managers are more focused to invest in projects earning more than the desired rate of return.

Based on RI, the managers will not invest in 2020.