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 $ 8,231,000 $ 4,655,000 $ 1,021,000 Sales revenue $ 10,000,000 $ 2,000,000 $ 600,000 Operating expenses 8,643,000 1,199,000 440,000 Operating earnings $ 1,357,000 $ 801,000 $ 160,000 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

Computation of ROI- Empire Hotels
	Operating income (a)	Sale (b)	Average Investment (c )	Return on sale ( a/b)	Capital turnover (b/c)	ROI (a/c)
Hotel Rooms	1,357,000	10,000,000	8,231,000	13.57%	1.21	16.49%
Restaurants	801,000	2,000,000	4,655,000	40.05%	0.43	17.21%
Health Club—Spa	160,000	600,000	1,021,000	26.67%	0.59	15.67%
Total	2,318,000	12,600,000	13,907,000	80.29%	2.23	49.36%
Return on sale of Hotel rooms is lowest compared to restaurants and spa while the capital turnover is highest for hotel rooms. This is due to small margin of rooms and higher investments of  restaurants and spa compare to hotel rooms.

Part-b-1&2
Particular	Operating income (a)	Average Investment (b)	ROI (a/b)
Health Club—Spa	168,000	1,061,000	15.83%
new exercise equipment	$8,000	$40,000	20.00%
ROI of Health club spa has increased from 15.67% to 15.83%.

Part-C-1&2
	Operating income (A)	Average Investment (B)	Required return (C )	Required income (d=BXc)	Residual Income (A-D)
Hotel Rooms	1,357,000	8,231,000	17%	1399270	-42,270
Restaurants	801,000	4,655,000	17%	791350	9,650
Health Club—Spa (before investment)	160,000	1,021,000	17%	173570	-13,570
Health Club—Spa (After investment)	168,000	$1,061,000	17%	180370	-12,370
The residual income after the investment of the Health Club—Spa's will reduce by $1200 and will become more negative.