Question

Solano Company has sales of $820,000, cost of goods sold of $530,000, other operating expenses of $60,000, average invested assets of $2,400,000, 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.)
a. Company sales and cost of goods sold increase by 30 percent.
b. Operating expenses decrease by $11,000.
c. Operating expenses increase by 20 percent.
d. Average invested assets increase by $460,000.
e. Solano changes its hurdle rate to 16 percent.

Answer 1

Net income = Sales - COGS - Operating expenses

Required return = average invested assets x hurdle rate

Residual income = Net income - required return

ROI = net income/average invested assets x 100

(a) Sales and COGS increase by 30% :-

Sales = 820,000 x 130% = 1,066,000

COGS = 530,000 x 130% = 689,000

Net income = 1,066,000 - 689,000 - 60,000 = 317,000

ROI = 317,000/2,400,000 x 100 = 13.21%

Residual Income = 317,000 - (2,400,000 x 11%) = $53,000

(b) Operating expenses decreases by 11,000.

Net income = 820,000 - 530,000 - 49,000 = 241,000

ROI = 241,000/2,400,000 x 100 = 10.04%

Residual income = 241,000 - (2,400,000 x 11%) = ($23,000)

(c) Operating expenses increase by 20%

Net income = 820,000 - 530,000 - (60,000 x 120%) = 218,000

ROI = 218,000/2,400,000 x 100 = 9.08%

Residual income = 218,000 - (2,400,000 x 11%) = ($46,000)

(d) Average invested assets increase by 460,000.

Net income = 820,000 - 530,000 - 60,000 = 230,000

ROI = [230,000/(2,400,000 + 460,000)] x 100 = 8.04%

Residual income = 230,000 - (2,860,000 x 11%) = ($84,600)

(e) Hurdle rate changes to 16%.

ROI = 230,000/2,400,000 x 100 = 9.58%

Residual income = 230,000 - (2,400,000 x 16%) = ($154,000)