Question

Problem 9-21B Comparing return on investment and residual income

Gwinnett Corporation operates three investment centers. The following financial statements apply to the investment center named Rite Division:

RITE DIVISION Income Statement For the Year Ended December 31, 2018
Sales revenue	$ 300,000
Cost of goods sold	(180,000)
Gross margin	120,000
Operating expenses
Selling expenses	(15,000)
Administrative expense	(5,000)
Operating income	100,000
Nonoperating expense
Interest expense	(10,000)
Net income	$ 90,000
RITE DIVISION Balance Sheet As of December 31, 2018
Assets
Cash	$ 92,000
Accounts receivable	388,000
Merchandise inventory	54,000
Equipment less accum. dep.	466,000
Nonoperating assets	46,000
Total assets	$1,046,000
Liabilities
Accounts payable	$140,000
Notes payable	200,000
Stockholders’ equity
Common stock	480,000
Retained earnings	226,000
Total liab. and stk. equity	$1,046,000

Required

a. Should operating income or net income be used to determine the rate of return (ROI) for the Rite investment center? Explain your answer.

b. Should operating assets or total assets be used to determine the ROI for the Rite investment center? Explain your answer.

c. Calculate the ROI for Rite. Round computation to 1 decimal point.

d. Gwinnett has a desired ROI of 8 percent. Headquarters has $300,000 of funds to assign to its investment centers. The manager of the Rite Division has an opportunity to invest the funds at an ROI of 9 percent. The other two divisions have investment opportunities that yield only 6.5 percent. Even so, the manager of Rite rejects the additional funding. Explain why the manager of Rite would reject the funds under these circumstances. Round the computation to one decimal point.

e. Explain how residual income could be used to encourage the manager to accept the additional funds.

Answer 1

1. Operating Income should be used in calculating Return on Investment (ROI) instead of net income. The reason for choosing operating income is because operating income is the income/profits before taking into consideration certain expenses that are not directly related to core business's performance. Hence from Operating income perspective it includes its revenue from operation, its cost of goods sold and other operating expenses which gives an investor and managers a much clearer view of how the company or an unit is managing its key levers or items which it can control.

2. Similarly as mentioned in point 1, we should use operating assets while calculating ROI because operating assets are the assets which the company or an unit deploy to generate operating income. Like cash, inventory, receivables, building, equipment etc. For depreciable asset the net value is used in calculating operating assets value.

3. ROI = Operating Income/Operating Asset = 100,000/(1,046,000-46,000) = 10%

4. ROI on Additional 300,000 Funding @ 9% = 27,000

Hence total ROI for Manager of Rite at portfolio = 100,000+27,000 = 127,000

Total Operating Asset = 1,000,000 + 300,000 = 1,300,000

Combined ROI = 127,000/1,300,000 = 9.77%.

The management has a desired ROI @ 8% and the combined ROI for manager of Rite is 9.77%. But since the additional investment will lead to a fall in the ROI from 10% on standalone basis to 9.77% on combined basis hence the manager rejected the additional investment. Managers are generally measured on the ROI they generate from the available assets at their disposal and since additional investment will lead to fall in ROI for Rite Division hence the offer was rejected.

5. Residual Income is another approach of measuring the performance of divisions or investment centers. It measures the amount each division adds to the shareholder value of the parent company. Residual Income encourages and enables managers to make profitable investments that may be rejected by managers using ROI because it focuses on increasing the dollar value to shareholder.

a. Residual Income for Standalone Rite Division = Operating Profit - (Return Needed * Asset/Investment)

100,000 - (8%*1,000,000) = 20,000

b. Residual income for Additional investment = 27,000 - (8%*300,000) = 3,000.

Total Residual Incomes = 23,000.

Hence under total residual income approach since the dollar value is increasing hence the manager can accept this proposal.