Question

Charteris is a division of Capriola Corporation and operates as an investment center. Charteris currently has assets of $15 million, revenues of $12 million, and expenses of $9 million. The president of Charteris has an opportunity to acquire Grampan Corporation, which has revenues of $4 million, and expenses of $2.8 million. Acquisition price (value of assets) would be $7.5 million. Capriola has a target ROI for all divisions of 14%.

a) Compute Charteris' current ROI.

b) If Capriola evaluates divisions based on ROI, will be the president of Charteris be inclined to make the acquisition?Explain. Use the DuPont method to provide insight into your answer.

c) Would your answer change if Capriola also used residual income in evaluating divisions? Explain.

Answer 1

Capriola Corporation

1. Computation of Charteris’ current ROI:

As per the DuPont method,

Return on investment (ROI) = margin x turnover

Margin = net operating income/sales

Net operating income = revenues – expenses

Revenues= $12 million

Expenses = $9 million

Net operating income = $12 - $9 = $3 million

Margin = $3 million/$12 million = 25%

Turnover = sales/operating assets

Operating assets = $15 million

Turnover = $12/$15 = 0.8 times

Return on Investment = 25% x 0.8 = 20%

Hence, Return on Investment of Charteris division = 20%

1. Computation of Grampan Corporation’s ROI:

Return on investment (ROI) = margin x turnover

Margin = net operating income/sales

Net operating income = revenues – expenses

Revenues= $4 million

Expenses = $2.8 million

Net operating income = $4 - $2.8 = $1.2 million

Margin = $1.2 million/$4 million = 30%

Turnover = sales/operating assets

Operating assets = $7.5 million

Turnover = $4/$7.5 = 0.53 times

Return on Investment = 30% x 0.53 = 16%

Hence, Return on Investment of Grampan Corporation is = 16%

Now, computation of the combined ROI of both Chartaris and Grampan –

Return on investment (ROI) = margin x turnover

Margin = net operating income/sales

Net operating income = revenues – expenses

Revenues= ($12 million + $4 million) = $16 million

Expenses = ($9 million + $2.8 million) = $11.80 million

Net operating income = $16 - $11.8 = $4.2 million

Margin = $ 4.2 million/$16 million = 26.25%

Turnover = sales/operating assets

Operating assets = ($15 million + $7.50)

Turnover = $16/$22.5 = 0.71 times

Return on Investment = 26.25% x 0.71 = 18.67%

Hence, Return on Investment of Charteris division and Grampan corporation together = 18.67%

No, the President of Charteris would not be inclined to make the acquisition, as the ROI of the combined Charteris division and Grampan Corporation, 18.67% is less than the Charteris division’s ROI, 20%.

However, Capriola Corporation would find the investment profitable as the combined ROI, 18.67% as well as the Grampan’s ROI by itself 16%, is higher than Capirola’s target ROI of 14% for all of its divisions.

1. Use of residual income in evaluating divisions:

Residual income = net operating income – minimum return on operating assets

Minimum return on operating assets = operating assets x target ROI

For Charteris Division –

Net operating income = $3 million

Minimum return on operating assets = $15 million x 14% = $2.1 million

Residual income = $3 million - $2.1 million = $0.9 million

For Grampan Corporation –

Net operating income = $1.2 million

Minimum return on operating assets = $7.5 million x 14% = $1.05 million

Residual income = $1.2 million - $1.05 million = $0.15 million

For combined Charteris and Grampan –

Net operating income = ($3 million + $1.2 million) = $4.2 million

Minimum return on operating assets = ($15 million + $7.5 million) x 14% = $3.15 million

Residual income = $4.2 million - $3.15 million = $1.05 million

If the company uses the residual income approach, Charteris would be inclined to make the acquisition of Grampan Corporation as the residual income, $1.05 million of combined Charteris and Grampan is higher than the Charteris division’s residual income, $0.9 million.