Question

The Empire Hotel is a full-service hotel in a large city. Empire is organized into three departments that are treated as investment centers. Budget information for the coming year for these three departments is shown as follows. The managers of each of the departments are evaluated and bonuses are awarded each year based on ROI.

Empire Hotel
	Hotel Rooms				Restaurants				Health Spa
Average investment	$	8,064,000			$	4,908,000			$	750,000
Sales revenue	$	10,000,000			$	2,000,000			$	600,000
Operating expenses		8,767,000				1,025,000				452,000
Operating earnings	$	1,233,000			$	975,000			$	148,000

Required:

a. Compute the ROI for each department. Use the DuPont method to analyze the return on sales and capital turnover.

Assume the Health Spa is considering installing new exercise equipment. Upon investigating, the manager of the division finds that the equipment would cost $40,000 and that operating earnings would increase by $8,000 per year as a result of the new equipment.

b-1. What would be the ROI of investment in the new exercise equipment and Health Spa?

b-2. Would the manager of the Health Spa be motivated to undertake such an investment?

c-1. Compute the residual income for each department if the minimum required return for the Empire Hotel is 17 percent.

c-2. What would be the impact of the investment on the Health Spa's residual income?

Answer 1

A-

	HOTEL ROOMS	RESTAURANTS	HEALTH SPA
AVERAGE INVESTMENT	8064000	4908000	750000
SALES REVENUE	10000000	2000000	600000
OPERATING EXPENSES	8767000	1025000	452000
OPERATING EARNINGS	1233000	975000	148000
ROI	15.3%	19.9%	19.7%
RETURN ON SALES	12.3%	48.8%	24.7%
CAPITAL TURNOVER	1.24	0.41	0.80

ROI = OPERATING EARNINGS / AVERAGE INVESTMENT

RETURN ON SALES = OPERATING EARNINGS / SALES REVENUE

CAPITAL TURNOVER = SALES / AVERAGE INVESTMENT

RETURN ON SALES EXPLAIN THE PROFIT THAT WE GAIN ON THE SALES WE MAKE, WHEREAS CAPITAL TURNOVER EXPLAINS THE REVENUE GENERATED AS A % OF CAPITAL WHICH EXPLAINS HOW EFFICIENTLY WE ARE ABLE TO UTILISE OUR CAPITAL. A CAPITAL TURNOVER ABOVE 1 IS CONSIDERED A GOOD NUMBER.

B-1

	HEALTH SPA	NEW EQUIPMENT	HEALTH SPA POST NEW EQUPMENT
AVERAGE INVESTMENT
SALES REVENUE	750000	40000	790000
OPERATING EXPENSES	600000
OPERATING EARNINGS	452000
	148000	8000	156000
ROI	19.7%	20.0%	19.7%

B-2

YES THE MANAGER WOULD BE MOTIVATED TO UNDERTAKE SUCH AN INVESTMENT SINCE THE ROI OF THE NEW EQUIPMENT IS HIGHER THAN THE ROI OF THE HEALTH SPA.

C-1

	HOTEL ROOMS	RESTAURANTS	HEALTH SPA
AVERAGE INVESTMENT	8064000	4908000	750000
SALES REVENUE	10000000	2000000	600000
OPERATING EXPENSES	8767000	1025000	452000
OPERATING EARNINGS	1233000	975000	148000
REQUIRED EARNINGS	1370880	834360	127500
RESIDUAL INCOME	-137880	140640	20500

REQUIRED EARNINGS IS AVERAGE INVESTMENT * 17%

C-2

	HEALTH SPA	NEW EQUIPMENT	HEALTH SPA POST NEW EQUPMENT
AVERAGE INVESTMENT
SALES REVENUE	750000	40000	790000
OPERATING EXPENSES	600000
OPERATING EARNINGS	452000
	148000	8000	156000
REQUIRED RETURN	127500		134300
RESIDUAL INCOME	20500		21700

SO THE NEW EQUIPMENT WILL ACTUALLY INCREASE THE RESIDUAL INCOME OF THE HEALTH DIVISION