Question

Axel Corporation (which has a weighted-average cost of capital of 12%) has two divisions with the following information:

	Beta Division	Cal Division
Total Assets	$720,000	$550,000
Current Liabilities	$220,000	$110,000
After-Tax Operating Income	$105,000	$110,000
ROI	15%	20%

Each manager is offered an investment project opportunity that would increase each division's investment base by $10,000 and generate an additional profit for each division of $1,800. Which of the following is true?

Multiple Choice

• If the managers are evaluated based on their divison's ROI, Beta would accept the project but Cal would reject it.

• If the managers are evaluated based on their divison's ROI, Cal would accept the project but Beta would reject it.

• If the company rewards managers for accepting any project with positive residual income, and the company's target return for projects is 20%, both division managers would accept the project.

• If the compay rewards managers for accepting any project with positive residual income, and the company's target return for projects is 15%, both division managers would reject the project.

Answer 1

The right option is 1st - " If the managers are evaluated based on their division's ROI, Beta would accept the project but Cal. would reject it".

This is because Beta division's current ROI is 15%, but the additional investment opportunity is providing ROI of 18% which will increase the overall ROI for the beta division. This will increase the interest of the manager of the beta division towards the project opportunity. Whereas, if we see the current ROI of the Cal division, it is 20% but the project opportunity is providing ROI of 18%. This will decrease the overall ROI of the Cal division. Therefore, the manager of the Cal. division will not be eager in investing in this project.