Question

Bellco, a division of Becker International Corporation, is operated under the direction of Antoin Sedatt. Bellco is an independent investment center with approximately $74,220,000 of assets that generate approximately $10,990,000 in annual net income. Becker International has additional investment capital of $14,310,000 that is available for the division managers to invest. Mr. Sedatt is aware of an investment opportunity that will provide an 13 percent annual net return. Becker International’s desired rate of return is 12 percent.

Required

a. Assume that Mr. Sedatt’s performance is evaluated based on his ability to maximize return on investment (ROI). Compute ROI using the following two assumptions: Bellco retains its current asset size and Bellco accepts and invests the additional $14,310,000 of assets. Determine whether Mr. Sedatt should accept the opportunity to invest additional funds.

b. Assume that Mr. Sedatt’s performance is evaluated based on his ability to maximize residual income. Compute residual income using the following two assumptions: Bellco retains its current asset base and Bellco accepts and invests the additional $14,310,000 of assets. Determine whether Mr. Sedatt should accept the opportunity to invest additional funds.

c. Which technique (ROI or residual income) is more likely to result in suboptimization?

Answer 1

	New Investment ROI
i.	Current Income	$10,990,000
ii.	Assets	$74,220,000
iii.	ROI = (Annual Net Income / Assets) *100= 10,990,000/74,220,000*100		14.81%
iv.	Additional Investment - See Note 1 below		$11,787,200
v.	ROI with additional investment $12,850,300(See Note a) ÷ $88,530,000 (See Note b)		14.52%
	Notes
a.	Additional Investment : Annual Net Income + (Return on New Opportunity* Additional Capital)
=>	$ 10,990,000 + (13% x $14,310,000)		$12,850,300
b.	Total Assets
=>	$74,220,000+$14,310,000		$88,530,000
Answer	Since the new investment would decrease Bellco’s ROI ( by 14.81%-14.52%= 0.29%), it would have a negative effect on Mr. Sedatt’s performance evaluation. Accordingly, the groups should recommend that Mr. Sedatt not accept the investment opportunity.

Scenario 2 : Residual Income :
	Current Residual Income
	Annual Income - (Rate of Return * Assets)
	$10,990,000 - (12% x $74220000)		$2,083,600
	Residual Income with additional investment
	$12850300 - (12% x $88,530,000) =		$2,226,700
Answer	Since the new investment would increase Bellco’s residual income, it would have a positive effect on Mr. Sedatt’s performance evaluation. Accordingly, the groups should recommend that Mr. Sedatt accept the investment opportunity.

Answer : Which method will be sub-optimal, and why?
ROI is more likely to produce sub-optimization because an opportunity that would benefit the company as a whole would be detrimental to the performance evaluation of an investment center manager.