Question

The Singer Division of Patio Enterprises currently earns $2.45 million and has divisional assets of $19.6 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $3,381,000 and will have a yearly cash flow of $841,500. The asset will be depreciated using the straight-line method over a six-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company’s cost of capital is 11 percent. Ignore taxes.

Required:

a. What is the divisional ROI before acquisition of the new asset?

b. What is the divisional ROI in the first year after acquisition of the new asset?

Answer 1

ROI= RETURN ON INVESTMENT

ROI is the ratio between net profit and investment.

it measures the efficiency of assets invested.Higher the ROI better the returns.

ROI= net income/ cost of investment*100

a. ROI = $2,450,000/ $19,600,000 *100

=12.5%

b.ROI AFTER ACQUISITION

divisional cost of investment in the first year after acquisition of the new asset =$19,600,000+$3,381,000=$22,981,000

Net income after acquisition = additional cash inflow- depreciation

straight line method depreciation = cost-salvage/ years

=[3,381,000-0 ]/ 6

=$563,500

Net income after acquisition = additional cash inflow- depreciation

=$841,500-$563,500

=$278,000

ROI = [income/ investment] *100

=[278,000+2,450,000]/[$22,981,000]

=$2,728,000/$22,981,000]*100

=11.9%

ROI decreased from 12.5% to 11.9%

so the new investment has not yet been proved beneficial in first year after acquisition.