Question

Problem 9-21B Comparing return on investment and residual income

Gwinnett Corporation operates three investment centers. The following financial statements apply to the investment center named Rite Division:

RITE DIVISION Income Statement For the Year Ended December 31, 2018
Sales revenue	$ 300,000
Cost of goods sold	??(180,000)
Gross margin	120,000
Operating expenses
Selling expenses	(15,000)
Administrative expense	(5,000)
Operating income	100,000
Nonoperating expense
Interest expense	???(10,000)
Net income	$ 90,000
RITE DIVISION Balance Sheet As of December 31, 2018
Assets
Cash	$ ?? 92,000
Accounts receivable	388,000
Merchandise inventory	54,000
Equipment less accum. dep.	466,000
Nonoperating assets	46,000
Total assets	$1,046,000
Liabilities
Accounts payable	$140,000
Notes payable	200,000
Stockholders’ equity
Common stock	480,000
Retained earnings	??226,000
Total liab. and stk. equity	$1,046,000

Required

Should operating income or net income be used to determine the rate of return (ROI) for the Rite investment center? Explain your answer.

Should operating assets or total assets be used to determine the ROI for the Rite investment center? Explain your answer.

Calculate the ROI for Rite. Round computation to 1 decimal point.

Gwinnett has a desired ROI of 8 percent. Headquarters has $300,000 of funds to assign to its investment centers. The manager of the Rite Division has an opportunity to invest the funds at an ROI of 9 percent. The other two divisions have investment opportunities that yield only 6.5 percent. Even so, the manager of Rite rejects the additional funding. Explain why the manager of Rite would reject the funds under these circumstances. Round the computation to one decimal point.

Explain how residual income could be used to encourage the manager to accept the additional funds.

Answer 1

Solution:

Return on investment = Net Operating income / Average operating assets

Therefore Operating income is used to determine ROI for Rite investment center instead of net income.

And Operating assets is used in denominator to determine ROI for Rite investment center instead of total assets.

Operating assets for Rite division = $1,046,000 - $46,000 = $1,000,000

ROI for rite = $100,000 / $1,000,000 = 10%

Headquarter has $300,000 of funds to assign to Rite division and rite division is having opportunity to earn ROI of 9% on additional investment. If performance of Rite division is measured on the basis of ROI then accepting additional investment will result in decreasing ROI for Rite division as its existing ROI is 10%. This is the main reason manager of Rite reject the fund under these circumstances.

If Rite division accept the investment then new ROI for Rite division = ($100,000 + $300,000*9%) / $1,300,000 = 9.8%

As minimum required return of Gwinnett is 8% and Additional investment is providing 9% return if invested by Rite division. If division performance is measure through residual income then Rite division could accept the investment opportunity because its overall residual income will also increase.

Residual income = Net Operating income - Minimum required return

Accepting additional investment will result 9% ROI and minimum return is 8%, thus result in overall increase in Residual income.