Question

Exercise 10-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO10-1, LO10-2] Selected sales and operating data for three divisions of different structural engineering firms are given as follows: Sales Average operating assets Net operating income Minimum required rate of return Division A $ 5,200,000 $ 1,300,000 $ 223,600 10.00% Division B $ 9,200,000 $ 4,600,000 $ 763,600 16.60% Division C $ 8,300,000 $ 2,075,000 $ 128,650 7.00% Required: 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 an investment opportunity that would yield a 12% 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

Answer Margin Turnover Division A Division B Division C 4.30% 8.30% 1.55% ROI 4.00 17.20% 2.00 16.60% 4.00 6.20% Average Operating Assets Required Rateof Return Required operating income Actula operating income Required operating income Residula Income 2. Residual Income Division A Division B Division C 1300000 46000002075000 10.00% 16.60% 7.00% 130000 763600 145250 223600 763600 128650 130000 763600 145250 93600 0 -16600 3. If Perperformance is measured by ROI Division A Reject Division B Reject Division C Accept 4. If Perperformance is measured by Residual Income Division A Accept Division B Reject Division C Accept

Sales Division A Division B Division C 5200000 9200000 8300000 Average Opearating Assets 1300000 4600000 2075000 Net operating income 223600 763600 128650 Minimum Required Rate of Return 10.00% 16.60% 7.00% Margin : Net operating Income / Net sales Net operating income 223600 763600 128650 Sales 5200000 9200000 8300000 Margin 4.30% 8.30% 1.55% Assets Turnover ration : Netsales / Average Opearating Assets Sales 5200000 9200000 8300000 Average Opearating Assets 1300000 4600000 2075000 Assets Turnover ration: ROI : Margin * Asset Turnover ratio Margin 4.30% 8.30% 1.55% Assets Turnover ration: ROI : Margin * Asset Turnover ratio 17.20% 16.60% 6.20%

Residual Income Division A Division B Division C Average Operating Assets 1300000 4600000 2075000 Required Rateof Return 10.00% 16.60% 7.00% Required operating income 130000 763600 145250 Actula operating income 223600 763600 1286501 Required operating income 130000 763600 145250 Residual income 93600 0 -16600 If Per formance is Measured by ROI Division A Division B Division C ROI of the Division 17.20% 16.60% 6.20% ROI of Investment 12.00% 12.00% 12.00% Decision Reject Reject Accept If Per formance is Measured by Residula income Division A Division B Division C Minimum Required Rate of Return 10.00% 16.60% 7.00% ROI of Investment 12.00% 12.00% 12.00% Decision Accept Reject Accept