Question

The Empire Hotel is a full-service hotel in a large city. Empire is organized into three departments that are treated as investment centers. Budget information for the coming year for these three departments is shown as follows. The managers of each of the departments are evaluated and bonuses are awarded each year based on ROI. Average investment Sales revenue Operating expenses Operating earnings Empire Hotel Hotel Rooms $ 7,869,000 $ 10,000,000 8,779,000 $ 1,221,000 Restaurants $5,410,000 $2,000,000 1,046,000 $ 954,000 Health Spa $ 902,000 $ 600,000 443,000 $ 157,000 Required: a. Compute the ROI for each department. Use the DuPont method to analyze the return on sales and capital turnover. Assume the Health Spa is considering installing new exercise equipment. Upon investigating, the manager of the division finds that the equipment would cost $40,000 and that operating earnings would increase by $8,000 per year as a result of the new equipment. b-1. What would be the ROI of investment in the new exercise equipment and Health Spa? b-2. Would the manager of the Health Spa be motivated to undertake such an investment? C-1. Compute the residual income for each department if the minimum required return for the Empire Hotel is 17 percent. c-2. What would be the impact of the investment on the Health Spa's residual income?

Answer 1

	Hotel Rooms	Restaurants	Health Spa
Average Investment	7,869,000	5,410,000	902,000
Sales Revenue	10,000,000	2,000,000	600,000
Operating Expenses	8,779,000	1,046,000	443,000
Operating Earnings	1,221,000	954,000	157,000
Return on Sales = Operating Earnings/Sales	12.21%	47.70%	26.17%
Capital Turnover = Sales/Average Investment	1.270809506	0.369685767	0.66518847
ROI = Profit Margin*Capital Turnover	15.52%	17.63%	17.41%
b-1 ROI = 8000/40,000 = 20%
Yes, since ROI of new investment is higher than the current ROI
c-1 Residual Income = Operating earnings - Average Investment*Required return	(116,730)	34,300	3,660
Residual Income will increase by 1200 on making new investment