Question

Selected sales and operating data for three divisions of different structural engineering firms are given as follows: Division A Division B Division C Sales $ 16,000,000 $ 36,000,000 $ 20,800,000 Average operating assets $ 3,200,000 $ 7,200,000 $ 5,200,000 Net operating income $ 752,000 $ 576,000 $ 540,800 Minimum required rate of return 9.00 % 9.50 % 10.40 %

Required: 1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover. 2. Compute the residual income (loss) for each division. 3. Assume that each division is presented with an investment opportunity that would yield a 10% rate of return. a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity? b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

SOLUTION

1. ROI = Margin * Turnover

= (Net operating income / Sales) * (Sales / Average operating assets)

Division A-

ROI = ($752,000 / $16,000,000) * ($16,000,000 / $3,200,000 )

= 4.7% * 5

= 23.5%

Division B-

ROI = ($576,000 / $36,000,000) * ($36,000,000 / $7,200,000)

= 1.6% * 5 = 8%

Division C-

ROI = ($540,800 / $20,800,000) * ($20,800,000 / $5,200,000)

= 2.6% * 4 = 10.4%

2.

	Division A	Division B	Division C
Average operating income	3,200,000	7,200,000	5,200,000
Required rate of return	9.00%	9.50%	10.40%
Required operating income	288,000	684,000	540,800
Actual operating income	752,000	576,000	540,800
Required operating income	288,000	684,000	540,800
Residual income	464,000	(108,000)	0

3A &B.

	Division A	Division B	Division C
Return on investment (ROI)	23.5%	8%	10.4%
Therefore, if the division is presented with an investment opportunity yielding 10%, it probably would	Reject	Accept	Reject
Minimum required return for computing residual income	9.00%	9.50%	10.4%
Therefore, if the division is presented with an investment opportunity yielding 10%, it probably would	Accept	Accept	Reject