Question

PA10-3 (Algo) Evaluating Managerial Performance, Proposed Project Impact on Return on Investment, Residual Income [LO 10-4, 10-5]

Wescott Company has three divisions: A, B, and C. The company has a hurdle rate of 8 percent. Selected operating data for the three divisions are as follows:

	Division A	Division B	Division C
Sales revenue	$	1,235,000	$	1,186,000	$	1,206,000
Cost of goods sold		763,000		871,000		876,000
Miscellaneous operating expenses		78,000		66,000		67,000
Interest and taxes		62,000		55,000		55,000
Average invested assets		10,722,000		2,588,000		4,255,000

Wescott is considering an expansion project in the upcoming year that will cost $6.7 million and return $598,000 per year. The project would be implemented by only one of the three divisions.


Required:
1. Compute the ROI for each division.

2. Compute the residual income for each division.

3. Rank the divisions according to the ROI and residual income of each.

4-a. Compute the return on investment on the proposed expansion project.

4-b. Is this an acceptable project?

5. Without any additional calculations, state whether the proposed project would increase or decrease each division’s ROI.

6. Compute the new ROI and residual income for each division if the project was implemented within that division.

Answer 1

Requirement 1                   Calculation Of ROI For Each Division

 

	Division A	Division B	Division C
Sales	$1,235,000	$1,186,000	$1,206,000
Less - COGS	$763,000	$871,000	$876,000
Less - Miscellaneous Operating expenses	$78,000	$66,000	$67,000
A. Net Operating Income	$394,000	$249,000	$263,000
B. Average Invested Assets	$10,722,000	$2,588,000	$4,255,000
C. ROI  ( A/B)	3.67%	9.62%	6.18%

 

Requirement 2                   Calculation of Residual Income

 

	Division A	Division B	Division C
Net Operating Income	$394,000	$249,000	$263,000
Less - Target Income ( Average Invested Assets x8%)	$857,760	$207,040	$340,400
Residual Income/ (Loss)	($463,760)	$41,960	($77,400)

 

Requirement 3                   Ranking of divisions

 

Division A	Rank 3
Division B	Rank 1
Division C	Rank 2

 

Requirement 4

4a)

ROI on Proposed Investment project = Return from project / Investment in project

                                                           = $598,000 /$6,700,000

                                                            = 8.93%

 

4b) Yes, Project should be accepted as the ROI of the project is greater than the company's Hurdle rate

.i.e ( 8.93% >8%)