Question

ROI and Residual Income: Impact of a New Investment The Mustang Division of Detroit Motors had an operating income of $900,000 and net assets of $4,000,000. Detroit Motors has a target rate of return of 16 percent. (a) Compute the return on investment. (Round your answer to three decimal places.) 22.5 (b) Compute the residual income. $ 260,000 (c) The Mustang Division has an opportunity to increase operating income by $250,000 with an $750,000 investment in assets. 1. Compute the Mustang Division's return on investment if the project is undertaken. (Round your answer to three decimal places.) 23.958 2. Compute the Mustang Division's residual income if the project is undertaken. $ 382,000 x

Answer 1

a) Return on investment = Operating Income / Net Assets

= 900,000/4,000,000 = 22.50%

* As per given data, this is the Return on Investment, IF ROI amount is required then it would be 900,000.

b) Residual Income = Actual operating Income - (Net Assets * Return on investment)

= 900,000 - (4,000,000*16%) = 900,000 - 640,000 = 260,000

c) If operating income increases by 250,000 with additional investment of 750,000

New operating Income = 900,000+250,000 = 1,150,000

New Assets= 4,000,000+750,000 = 4,750,000

1. New return on investment = New operating Income / New Assets

= 1,150,000/4,750,000 = 24.211%

2. New residual Income = New operating Income - (New Assets * Return on investment)

= 1,150,000 - (4,750,000*16%) = 1,150,000-760,000 = 3,90,000