Question

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?

Answer 1

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.