Question

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

Sales	$	2,300,000
Variable expenses		670,000
Contribution margin		1,630,000
Fixed expenses		1,170,000
Net operating income	$	460,000
Average operating assets	$	1,437,500

At the beginning of this year, the company has a $287,500 investment opportunity with the following cost and revenue characteristics:

Sales	$	460,000
Contribution margin ratio		50	% of sales
Fixed expenses	$	161,000

The company’s minimum required rate of return is 15%.

12a. What is the residual income of this year’s investment opportunity?

12b. If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

Answer 1

Answer 12a
Calculation of residual income of investment opportunity
Sales	$460,000.00
Less : Variable cost 50%	$230,000.00
Contribution Margin	$230,000.00
Less : Fixed Expenses	$161,000.00
Net Operating Income	$69,000.00
Less : Minimum required return	$43,125.00
Residual Income	$25,875.00
Minimum required return out of investment = Cost of investment * company’s minimum required rate of return
Minimum required return out of investment = $287500 * 15% = $43,125
Answer 12b
Last year return on investment = Net Operating Income / Average operating assets = $460000 / $1437500 = 32%
As the company performs the same as last year , this year return on investment be = 32%
Residual Income = Net operating Income out of investment - Minimum required return out of investment
Net operating Income out of investment = $287500 * 32% = $92,000
Residual Income = $92000 - $43125 = $48,875