Question

Generic Motors Corporation has two divisions, Kadillack and Chevrolay. Their performance for last year is as follows.

	Kadillack	Chevrolay
Investment (operating assets)	$500 million	$2,000 million
Profit	$75 million	$250 million

The required rate of return (cost of capital) for Generic Motors is 10% a year.

Required:

a) What is the return on investment (ROI) for each division?
Kadillack ROI =  % (enter say 9.5% as 9.5, not as 0.095 and not as 9.5%)
Chevrolay ROI =  %
Which division performs better, based on ROI? (1=Kadillack, 2=Chevrolay)

b) What is the residual income (RI) for each division?
Kadillack RI = $  million (enter say $3.52 million as 3.52, not as 3,520,000)
Chevrolay RI = $  million
Which division performs better, based on RI? (1=Kadillack, 2=Chevrolay)

c) Which of the two measures (ROI or RI) would you use to decide which division performs better? (1=ROI, 2=RI)

Answer 1

NOTE: All the following figures are in millions

(a)

return on investment = profit/operating assets

For Kadillack, ROI = $75/$500= 15%

For Chevrolay, ROI = $250/$2000 = 12.5%

Kadillack division performs better.

(b)

Residual income = profit - (operating assets x cost of capital)

For Kadillack,

residual income = $75 - ($500 x 10%) = $25

For Chevrolay,

residual income = $250 - ($2000 x 10%) = $50

Chevrolay division performs better.

(c)

ROI method is better for taking decision as it tells in percentage as to what is the profit earned by investing into the operating assets.