BA213 – Chapter 8 Mini-Case – Decentralized Operations XYZ Co. is a privately he

Question

BA213 – Chapter 8 Mini-Case – Decentralized Operations XYZ Co. is a privately held diversified company with five separate divisions organized as investment centers. A condensed income statement for Division 1 for the past year, assuming no service department charges, is as follows: The manager of Division 1 was recently presented with the opportunity to add an additional product line, which would require additional invested assets of $14,200,000. A projected income statement for the new product line is as follows: XYZ Co. has established a required minimum rate of return on investment of 10%. Each Division is evaluated on their ability to meet and exceed this minimum. A bonus is paid, in $8,000 increments, for each whole percentage point that the division's rate of return on investment exceeds the company minimum requirement. The manager of Division 1 rejected the addition of the new product line, even though all estimates indicated that the product line would be profitable and would increase overall company income. The president of XYZ Co. has asked you to analyze the possible reasons why the Division 1 manager rejected the new product line. Some metrics you may find helpful in conducting your analysis include: • The rate of return on investment for Division 1 for 2017, and estimated rate of return on investment for 2018. • The bonus paid to the Division 1 manager in 2017, and the estimated bonus to be paid in 2018. The president is also considering changing the evaluation of Investment Centers from a Rate of Return on Investments benchmark to a Residual Income benchmark. Specifically, he is wondering if such a change would better motivate division managers to accept new investment opportunities (assuming they increase overall company income and rate of return on investment?) He has asked you to prepare an analysis of this potential change to identify whether it should be implemented. Use this case as an example to support your recommendations. (Hint: to identify an appropriate minimum acceptable benchmark for a residual income, determine the minimum acceptable benchmark that results in approximately the same 2017 bonus).

Explanation / Answer

Let income received every year be x

$14200000 = x/(1+0.1)1 + x/(1+0.1)2---------------------

$14200000 = x/0.1

x = $14200000*0.1 = $1420000

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