Question

1. Meade Corp has the following operating data for the past 2 years: Year 1 Year 2 Return on Investment 10% 20% Residual Income ? $25,000 Required Rate of return 8% 10% Sales $400,000 $500,000 Asset Turnover ? ? The sales margin in year 2 is twice the margin for the first year. The Company had the same asset turnover in both years. What is the residual income in year1? A. $4,000 B. $8,000 C. $10,000 D. $12,000 E. None of the above

Answer 1

A. $ 4,000

Working:

Assets in Year 2	=	Residual Income/(Return on Investment-required rate of return)
	=	$           25,000	/	(20%-10%)
	=	$       2,50,000
Net Income for Year 2	=	$       2,50,000	x	20%
	=	$           50,000
Sales margin for Year 2	=	Net Income /Sales
	=	$           50,000	/	$       5,00,000
	=	10%
Sales Margin in Year 1	=	10%	/2
	=	5%
Net Income in Year 1	=	Sales x Sales Margin
	=	$       4,00,000	x	5%
	=	$           20,000
Assets Turnover in Year 2	=	Sales /Assets
	=	$       5,00,000	/	$       2,50,000
	=	2.00
Same Asset turnover in both years.
So, Asset turnover in year 1	=	2.00
Sales in Year 1	=	$       4,00,000
Assets in Year 1	=	Sales/Sales Turnover
	=	$       4,00,000	/	2.00
	=	$       2,00,000
Residual Income in Year 1	=	Assets in Year 1 *(Return on investment-Required rate of return)
	=	$       2,00,000	*(10%-8%)
	=	$            4,000