Question

Solano Company has sales of $800,000, cost of goods sold of $520,000, other operating expenses of $35,000, average invested assets of $2,350,000, and a hurdle rate of 11 percent.

2. Several possible changes that Solano could face in the upcoming year follow. Determine each scenario’s impact on Solano’s ROI and residual income. (Note: Treat each scenario independently.) (Enter your ROI percentage answers to 2 decimal places, (i.e., 0.1234 should be entered as 12.34%.))

   a. Company sales and cost of goods sold increase by 40 percent.     

    b. Operating expenses decrease by $10,000.       

   c. Operating expenses increase by 10 percent.

    d. Average invested assets increase by $450,000.

    e. Solano changes its hurdle rate to 17 percent.

Answer 1

Solution a:

Last year operating income = $800,000 - $520,000 - $35,000 = $245,000

Average invested assets = $2,350,000

Last year ROI = Operating income / Average assets = $245,000 / $2,350,000 = 10.42%

Last year residual income = $245,000 - ($2,350,000*11%) = ($13,500)

If sales and COGS increase by 40% then

Operating income in next year = ($800,000*140%) - ($520,000*140%) - $35,000 = $357,000

ROI for next year = $357,000 / $2,350,000 = 15.19%

Solution b:

Operating income for next year = $245,000 + $10,000 = $255,000

ROI = $255,000 / $2,350,000 = 10.85%

Residual income = $255,000 - ($2,350,000*11%) = ($3,500)

Solution c:

Operating income for next year = $245,000 - $35,000*10% = $241,500

ROI = $241,500 / $2,350,000 = 10.28%

Residual income = $241,500 - ($2,350,000*11%) = ($17,000)

Solution d:

ROI for next year = $245,000 / ($2,350,000 + $450,000) = 8.75%

Residual income for next year = $245,000 - ($2,800,000*11%) = ($63,000)

Solution e:

ROI for next year = $245,000 / $2,350,000 = 10.42%

Residual income for next year = $245,000 - ($2,350,000*17%) = ($154,500)