Question

You may use your book, but collaboration of any kind with another student is prohibited. Selected sales and operating data for three divisions of different structural engineering firms are given as follows: Division A Division B Division $12,480,000 $28,480,000 $20,480,000 Sales Average operating assets $3,120,000 $7,120,000 $5,120,000 Net operating income $561,600 $512,640 $532,480 Minimum required rate of return 8.00% 8.50% 10.40% Requirements 1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover. 2. Compute the residual income (loss) for each division. 3. Assume that each division is presented with another investment opportunity that would yield a 9% rate of return. a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity? b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

1. Compute the return on investment for each division using the formula stated in terms of margin and turnover as shown below: Particulars Division A Division B Division C Sales (A) $12,480,000 $28,480,000 $20,480,000 Average operating assets (B) | $3,120,000 $7,120,000 $5,120.000 Net operating income (C) $561,600 $512,640 $532,480 Margin (D=C-A) 0.045 0.0181 0.026| Turnover (E=A-B) Return on investment ( D E) 18.0% 7.2% 10.4%

2. Compute residual income (loss) for each division as shown below: Particulars Average operating assets (A) Net operating income (B) Minimum required rate of return (C) Residual income [B-(AXB)) Division A $3,120,000 $561.600 8.00% $312,000 Division B $7,120,000 $512,640 8.50% -$92,560 Division C | $5,120.000 $532.480 10.40% so

3a. If performance is measured by using ROI Division A and Division C should reject the opportunity as the investment opportunity yields 9% return i.e., less than the ROI earned by division A and C. 3b. Compute residual income assuming opportunity rate of return 9% as shown below: Particulars Average operating assets (A) Net operating income (B) Minimum required rate of return (C) Residual income B-(AXB)] Division A Division B $3,120,000 $7,120,000 $561,600 $512,640 9.00% 9.00% $280.800l -$128.160 Division C $5,120,000 $532.480 9.00% $71,680| If performance is being measured using residual income by considering a 9% rate of return, then division A and division C should accept the investment opportunity as its residual income is positive and division B should reject investment opportunity as its residual income is having negative effect.