Question

Evaluating New Investments Using Return on Investment (ROI) and Residual Income

Three divisions of Watcore Inc. report the following sales and operating data:

Division A Division B    Division C


Sales . . .... . . . . . .. . .. ..      $6,000,000     $10,000,000     $8,000,000
Average operating assets . . .         $1,500,000 $5,000,000 $2,000,000
Operating income ... .... . . $300,000      $900,000      $180,000
Minimum required rate of return.         15%                   18%              12%


Required:

1. Compute the return on in vestment (ROI) for each division, using the formula stated in terms of margin and turnover.

2. Compute the residual income for each division.

3. Assume that each division i s presented with an in vestment opportunity that would yield a rate of return of 17%.
a.    If performance i s being measured by ROI, which division or divisions will probably accept the opportunity? Reject it? Why?

b.    If performance is being measured by residual income, which division or divisions will probably accept the opportunity? Reject it? Why?

Answer 1

1) ROI: (Operating income/ Sales) * (Sales / Average operating assets)

Division A: ($300,000 / $1,500,000) = 20%

Division B: ($900,000 / $5,000,000) = 18%

Division C: ($180,000 / $2,000,000) = 9%

2)

	Division A	Division B	Division C
Average operating assets	1,500,000	5,000,000	2,000,000
Required rate of return	0.15	0.18	0.12
Minimum required return	225,000	900,000	240,000
Actual net operating income	300,000	900,000	180,000
Minimum required return (above)	225,000	900,000	240,000
Residual income	75,000	0	-60,000

　

3) When performance is being measured by ROI, Division A and Division B are likely to be rejected and Division C is likely to be accepted. It is because:

Return on investment (ROI)	20%	18%	9%
	Reject > 17%	Reject > 17%	Accept < 17%

　

When performance is being measured by residual income, Division B is likely to be rejected and Division A and Division C are likely to be accepted. It is because:

Minimum required return for computing residual income	15%	18%	12%
	Accept < 17%	Reject > 17%	Accept < 17%