Comparing return on investment and residual income
Wells Corporation operates three investment centers. The following financial statements apply to the investment center named Huber Division.
HUBER DIVISION Income Statement For the Year Ended December 31, 2011 | |
Sales revenue | $105,480 |
Cost of goods sold | (60,275) |
Gross margin | 45,205 |
Operating expenses |
|
Selling expenses | (2,840) |
Depreciation expense | (4,205) |
Operating income | 38,160 |
Nonoperating income |
|
Gain on sale of land | (5,000) |
Net income | $ 33,160 |
HUBER DIVISION Balance Sheet As of December 31, 2011 | |
Assets |
|
Cash | $ 12,472 |
Accounts receivable | 40,266 |
Merchandise inventory | 36,000 |
Equipment less accum. dep. | 90,258 |
Non-operating assets | 9,000 |
Total assets | $187,996 |
Liabilities |
|
Accounts payable | $ 9,637 |
Notes payable | 72,000 |
Stockholders’ equity |
|
Common stock | 80,000 |
Retained earnings | 26,359 |
Total liab. and stk. equity | $187,996 |
Required
a. Should operating income or net income be used to determine the rate of return (ROI) for the Huber investment center? Explain your answer.
b. Should operating assets or total assets be used to determine the ROI for the Huber investment center? Explain your answer.
c. Calculate the ROI for Huber.
d. Wells has a desired ROI of 15 percent. Headquarters has $96,000 of funds to assign its investment centers. The manager of the Huber division has an opportunity to invest the funds at an ROI of 17 percent. The other two divisions have investment opportunities that yield only 16 percent. Even so, the manager of Huber rejects the additional funding. Explain why the manager of Huber would reject the funds under these circumstances.
e. Explain how residual income could be used to encourage the manager to accept the additional funds.
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