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Zachary Company has operating assets of $20,300,000. The company’s operating income for the most recent accounting...

Zachary Company has operating assets of $20,300,000. The company’s operating income for the most recent accounting period was $2,610,000. The Dannica Division of Zachary controls $8,210,000 of the company’s assets and earned $1,190,000 of its operating income. Zachary’s desired ROI is 8 percent. Zachary has $1,070,000 of additional funds to invest. The manager of the Dannica division believes that his division could earn $141,000 on the additional funds. The highest investment opportunity to any of the company’s other divisions is 9 percent.

Required

Calculate the ROI of Dannica Division.

(1) Before investment opportunity.

(2) Only on the new investment opportunity.

(3) Dannica total ROI if investment opportunity is accepted.

Calculate the Dannica Division residual income from the new investment opportunity. If residual income is used as the sole performance measure would the manager of the Dannica Division be likely to accept or reject the additional funding?

Solutions

Expert Solution

ROI of Dannica Division:

1. Before the investment opportunity:

ROI = Operating Income / Operating Assets = $ 1,190,000 / $ 8,210,000 = 0.1449 or 14.50 %.

2. Only on the new investment opportunity :

ROI = $ 141,000 / $ 1,070,000 = 0.13177 or 13.18 %

3. If investment opportunity is accepted:

Total ROI = $ ( 1,190,000 + 141,000) / $ ( 8,210,000 + 1,070,000) = $ 1,331,000 / $ 9,280,000 = 14.34 %

Please note that the ROI of the Dannica Division has decreased from 14.50 % to 14.34 %. Therefore, the manager of the Dannica Division might not be keen to take on the additional investment.

Residual Income of the new investment opportunity = Operating Income - ( Operating Assets x Minimum Required Rate of Return ) = $ 141,000 - ( $ 1,070,000 x 9%) = $ 44,700.

As the residual income from the new investment opportunity is greater than zero, it would add value to the Dannica Division. Therefore, the manager of the Dannica Division would be likely to accept the additional investment.

ekkarill92 answered 1 year ago
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