ROI and Residual Income; Investment Evaluation (LO 2, 3, 4, 8)
Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 13 percent return on its investment.
During the past week, management of the company’s Northeast Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Northeast Division and the competitor:
| Northeast Division | Competitor |
Sales | $8,400,000 | $5,200,000 |
Variable costs | 70% of sales | 65% of sales |
Fixed costs | $2,150,000 | $1,670,000 |
Invested capital | $1,850,000 | $625,000 |
Management has determined that in order to upgrade the competitor to Megatronics’ standards, an additional $375,000 of invested capital would be needed.
Required: As a group, complete the following requirements.
1. Compute the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired.
2. What is the likely reaction of divisional management toward the acquisition? Why?
3. What is the likely reaction of Megatronics’ corporate management toward the acquisition? Why?
4. Would the division be better off if it didn’t upgrade the competitor to Megatronics’ standards? Show computations to support your answer.
5. Assume that Megatronics uses residual income to evaluate performance and desires a 12 percent minimum return on invested capital. Compute the current residual income of the Northeast Division and the division’s residual income if the competitor is acquired. Will divisional management be likely to change its attitude toward the acquisition? Why?
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