Question

Westerville Company reported the following results from last year’s operations:

Sales	$	1,800,000
Variable expenses		435,000
Contribution margin		1,365,000
Fixed expenses		1,005,000
Net operating income	$	360,000
Average operating assets	$	1,200,000

At the beginning of this year, the company has a $300,000 investment opportunity with the following cost and revenue characteristics:

Sales	$	360,000
Contribution margin ratio		70	% of sales
Fixed expenses	$	216,000

The company’s minimum required rate of return is 10%.

11. What is last year’s residual income?

12. What is the residual income of this year’s investment opportunity?

13. If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

14. If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?

• Yes

• No

15-a. Assume that the contribution margin ratio of the investment opportunity was 65% instead of 70%. If Westerville’s Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?

• Yes

• No

15-b. Would the owners of the company want her to pursue the investment opportunity?

• Yes

• No

Answer 1

investment Total Westerville opportunity 3,60,000 Company Sales 18,00,000 21,60,000 a Variable exp (5,43,000) b (4,35,000) (1,08,000) Contribution margin 2,52,000 13,65,000 16,17,000 с Fixed Exp d (10,05,000) (2,16,000) (12,21,000) Net operating income 3,60,000 36,000 3,96,000 f Average operating assets 3,00,000 15,00,000 12,00,000 minimum required rate of return Expected profit (f*g Residual income (e-h) 10% 10% 10% g h 1,20,000 30,000 1,50,000 2,46,000 2,40,000 6,000 11 What is last year's residual income? 2,40,000 12 What is the residual income of this year's investment opportunity? $ 6,000 will it earn this year? 13 If the company pursues the investment opportunity and otherwise performs the same as last year, what residual inco $ 2,46,000 14 If Westerville's chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Yes As Residual income after considering investment opportunity is 2,46,000 which is more than last years residual income.

15 a Assume that the contribution margin ratio of the investment opportunity was 65% instead of 70%. If Westerville's Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? No, As Residual income after considering investment opportunity is 2,28,000 which is less than last years residual income. At 65% margin of investment opportunity Westerville investment Total opportunity Company Sales 18,00,000 3,60,000 21,60,000 a Variable exp (4,35,000) b (1,26,000) (5,61,000) Contribution margin 13,65,000 2,34,000 15,99,000 с d Fixed Exp (10,05,000) (2,16,000) (12,21,000) Net operating income 3,60,000 18,000 3,78,000 f Average operating assets 3,00,000 12,00,000 15,00,000 10% minimum required rate of return 10% 10% g h Expected profit (f*g) Residual income (e-h) 1,20,000 1,50,000 30,000 (12,000) 2,40,000 2,28,000 15 b Would the owners of the company want her to pursue the investment opportunity? No, As Residual income investment opportunity is negative 12,000$