Question

In: Accounting

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four...

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 15 percent return on its investment.

During the past week, management of the company’s Northeast Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Northeast Division and the competitor:

Northeast Division Competitor
Sales $ 4,340,000 $ 2,740,000
Variable costs 75 % of sales 70 % of sales
Fixed costs $ 896,000 $ 756,000
Invested capital $ 1,050,000 $ 300,000

Management has determined that in order to upgrade the competitor to Megatronics’ standards, an additional $140,000 of invested capital would be needed.

Required:

1. Compute the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired.

2. If divisional management is being evaluated on the basis of ROI, will the Northeast Division likely pursue acquisition of the competitor?

3-a. Compute the ROI of the competitor as it is now and after the intended upgrade.

3-b. If ROI is used as the basis for evaluation, would Megatronics Corporation likely be in favor of the acquisition of the competitor?

4. Calculate the Northeast Division's ROI after acquisition of competitor but before upgrading.

5-a. Assume that Megatronics uses residual income to evaluate performance and desires a 12 percent minimum return on invested capital. Compute the current residual income of the Northeast Division and the division’s residual income if the competitor is acquired.

5-b. If divisional management is being evaluated on the basis of residual income, will the Northeast Division likely pursue acquisition of the competitor?

Solutions

Expert Solution

Answer 1.
ROI = Net Income / Invested Capital
Northeast Division Competitor (After Upgrading) Total
Sales revenue    4,340,000.00    2,740,000.00    7,080,000.00
Variable Costs    3,255,000.00    1,918,000.00    5,173,000.00
Fixed Cost        896,000.00        756,000.00    1,652,000.00
Net Income        189,000.00          66,000.00        255,000.00
Invested Capital    1,050,000.00        440,000.00    1,490,000.00
ROI 18.00% 15.00% 17.11%
Answer 2.
2. Divisional management will likely be against the acquisition because ROI will be lowered from 18% to 17.11%. Since bonuses are awarded on the basis of ROI, the acquisition will result in less compensation.
Answer 3.
Competitor (Without Upgrade) Competitor (Upgrade)
Sales revenue    2,740,000.00    2,740,000.00
Variable Costs    1,918,000.00    1,918,000.00
Fixed Cost        756,000.00        756,000.00
Net Income          66,000.00          66,000.00
Invested Capital        300,000.00        440,000.00
ROI 22.00% 15.00%
Corporate management would probably favor the acquisition. Megatronoics has been earning a 18% return, and the competitor’s ROI of 22% will help the organization as a whole. Even if the $140,000 upgrade is made, the competitor’s ROI would be 15% if past earnings trends continue .
Answer 4.
Northeast Division Competitor (Before Upgrading) Total
Sales revenue    4,340,000.00    2,740,000.00    7,080,000.00
Variable Costs    3,255,000.00    1,918,000.00    5,173,000.00
Fixed Cost        896,000.00        756,000.00    1,652,000.00
Net Income        189,000.00          66,000.00        255,000.00
Invested Capital    1,050,000.00        300,000.00    1,350,000.00
ROI 18.00% 22.00% 18.89%
Answer 5-a.
Northeast Division Northeast Division -(Competitor is Acquired)
Divisional profit        189,000.00        255,000.00
Desired return - 12% of Investment        126,000.00        178,800.00
Residual Income          63,000.00          76,200.00
Answer 5-b.
Yes, management most likely will change its attitude. Residual income will increase by $13,200 as a result of the acquisition.

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