ROI versusResidual Income; IncentiveEffects
Holiday Entertainment Corporation (HEC). a subsidiary of New Age Industries, manufactures go-carts and other recreational vehicles. Family recreational centers that feature not only go-cart tracks but miniature golf, batting cages, and arcade games as well have increased in popularity. As a result. HEC has been receiving some pressure from New Age’s management to diversify into some of these other recreational areas. Recreational Leasing. Inc. (RLI), one of the largest firms that leases arcade games to family recreational centers, is looking for a friendly buyer. New Age’s top management believes that RLI’s assets could be acquired for an investment of S3.2 million and has strongly urged Bill Grieco, division manager of HEC, to consider acquiring RLI.
Grieco has reviewed RLI’s financial statements with his controller. Marie Donnelly, and they believe the acquisition may not be in the best interest of HEC. "If we decide not to do this, the New Age people are not going to be happy," said Grieco. "If we could convince them to base our bonuses on something other than return on investment, maybe this acquisition would look more attractive. How would we do if the bonuses were based on residual income, using the company’s 15 percent cost of capital?"
New Age Industries traditionally has evaluated all of its divisions on the basis of return on investment. The desired rate of return for each division is 20 percent. The management team of any division reporting an annual increase in the ROI is automatically eligible for a bonus. The management of divisions reporting a decline in the ROI must provide convincing explanations for the decline in order to be eligible for a bonus. Moreover, this bonus is limited to 50 percent of the bonus paid to divisions reporting an increase in ROI.
In the fbllowins table are condensed financial statements for both HEC and RLI for the most recent year.
RLI | HEC | |
Sales revenue | — | $9,500,000 |
Leasing revenue | $ 3,100,000 | — |
Variableexpenses | 1.300.000! | (6 000,000) |
Fixed expenses | (1,200,000) | (1.500,000) |
Operating income | $ 600,000 | S2,OOO,OOO |
Current assets | $1 ,900000 | $2.300,000 |
Long-livedassets | 1,1 00000 | 5,700,000 |
Total assets | $ 3,000,000 | $8,000,000 |
Current liabilities | $ 850,000 | $1,400,000 |
Long-termliabilities | 1,200,000 | 3,800,000 |
Stockholders' equity | 950,000 | 2,800,000 |
Totalliabilitiesandstockholders ' equity | $3,000,000 | $8,000,000 |
Required:
I. If New Age Industries continues to use ROIas the sole measure of divisional performance, explain why Holiday Entertainment Corporation would be reluctant to acquire Recreational Leasing. Inc.
2. If New Age Industries could be persuaded to use residual income to measure the performance of HEC. explain why HEC would be more willing to acquire RLI.
3. Discuss how the behavior of division managers is likely to be affected by the use of the following performance measures: (a ) return on investment and (b) residual income.
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