Question

Question # 3 XYZ is a subsidiary of and asset turnover was 3.5. Cost of capital was 15%. Calculate had operating income of $144,000 lst year. Its sales margin was 5 1) Return on investment 2) Sales 3) Operating assets 4) Residual income xYZ XYZ's bonus is based on return on investment. has an opportunity to invest in an asset that will return a guarantee 16% return. The manager of best interest? You must Would the manager make the investment? Is this decision in explain your answer. Would your answer for 5) change if the bonus was based on residual income? You must explain your answer 5) 6)

Answer 1

Question 3

Part (1): Return on investment = Operating Income / Operating Assets = Operating income / Sales x Sales / Operating Asset = Sales margin x Asset turnover = 4% x 3.5 = 14%

Part (2): Sales = Operating income / Sales margin = 144,000 / 4% = $ 3,600,000

Part (3): Operating assets = Sales / Asset turnover = $ 3,600,000 / 3.5 = $ 1,028,571.43

Part (4): Residual income = Operating income - charge on operating assets = Operating income - cost of capital x Operating assets = 144,000 - 15% x $ 1,028,571.43 = - $ 10,285.71

Part (5): Guarantee ROI = 16% from the new opportunity. This ROI of 16% > traditional ROI of 14% XYZ is making (as calculated in part (1)). Since manager's bonus is linked to ROI, the manager will make this investment as the expected ROI from this investment is better than ROI made by XYZ last year. As ROI > Cost of capital, this investment will be in the interest of the firm as well.

Part (6): Residual income from this asset will be positive as Residual income = Investment x (ROI - Cost of capital)

ROI = 16% > Cost of capital = 15%. Hence residual income from this asset > 0 in contrast to the residual income of XYZ last year which was negative. If manager's bonus is linked to residual income then also, the manager will make this investment as residual income > 0. So, the answer to part (5) will not change.