Question

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Westerville Company reported the following results from last year’s operations:

Sales	$	1,500,000
Variable expenses		730,000
Contribution margin		770,000
Fixed expenses		470,000
Net operating income	$	300,000
Average operating assets	$	937,500

This year, the company has a $362,500 investment opportunity with the following cost and revenue characteristics:

Sales	$	580,000
Contribution margin ratio		70	% of sales
Fixed expenses	$	319,000

The company’s minimum required rate of return is 10%.

12. What is the residual income of this year’s investment opportunity? 13. If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year? 14. If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Yes or No ? 15-a. Assume that the contribution margin ratio of the investment opportunity was 60% instead of 70%. If Westerville’s Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Yes or No    15-b. Would the owners of the company want her to pursue the investment opportunity? Yes or No

Answer 1

12)	Sales	580000
	Contribution margin	406000
	Fixed expenses	319000
	Net operating income	87000
	Investment	362500
	Required return on investment	10%
	$ return required = 362500*10% =	36250
	Residual income	50750
13)		Without new investment	New invesment	Total
	`	1500000	580000	2080000
	Variable expenses	730000	174000	904000
	Contribution margin	770000	406000	1176000
	Fixed expenses	470000	319000	789000
	Net operating income	300000	87000	387000
	Investment	937500	362500	1300000
	Required return on investment	10%	10%	10%
	$ return required on investment	93750	36250	130000
	Residual income	206250	50750	257000
14)	Yes, the Westerville's CE would pursue the new investment. The reason is that
	the total residual income will increase because of which the CE's bonus will
	be more than last year's bonus.
15-a)		Without new investment	New invesment	Total
	`	1500000	580000	2080000
	Variable expenses	730000	232000	962000
	Contribution margin	770000	348000	1118000
	Fixed expenses	470000	319000	789000
	Net operating income	300000	29000	329000
	Investment	937500	362500	1300000
	Required return on investment	10%	10%	10%
	$ return required on investment	93750	36250	130000
	Residual income	206250	-7250	199000
	No, the Westerville's CE would not pursue the new investment. The reason is that
	the total residual income will decrease because of which the CE's bonus this year will
	will be less than last year's bonus.