Exercise 3 (9 pts) : Evaluating New Investments using Return on Investment (ROI)
ID: 2460534 • Letter: E
Question
Exercise 3 (9 pts): Evaluating New Investments using Return on Investment (ROI) and Residual Income.
Selected sales and operating data for three divisions of different structural engineering firms are given as follows:
Division A
Division B
Division C
Sales
12,000,000
14,000,000
25,000,000
Average operating assets
3,000,000
7,000,000
5,000,000
Net operating income
600,000
560,000
800,000
Minimum required rate of return
14%
10%
16%
Required:
Compute the Return on Investment ROI for each division using the formula stated in terms of margin and turnover. (3 pts)
Compute the residual income for each division. (3 pts)
Assume that each division is presented with an investment opportunity that would yield a 15% rate of return. (3 pts)
If performance is being measured by ROI, which division or divisions will probably accept the opportunity? Reject? Why? (1.5 pts)
If performance is being measured by residual income, which division or divisions will probably accept the opportunity? Reject? Why? (1.5 pts)
Division A
Division B
Division C
Sales
12,000,000
14,000,000
25,000,000
Average operating assets
3,000,000
7,000,000
5,000,000
Net operating income
600,000
560,000
800,000
Minimum required rate of return
14%
10%
16%
Explanation / Answer
Solution :
1.ROI
NET OPERATAING INCOME
X SALES
SALES
AVERAGE OPERATING ASSETS
DIVISION A
600000
X 12000000
12000000
3000000
20.00
DIVISION B
560000
X 14000000
14000000
7000000
8.00
DIVISION C
800000
X 25000000
25000000
5000000
16.00
2. RESIDUAL INCOME
A
B
C
Average operating assets
3000000
7000000
5000000
Minimum required rate of return
14%
10.00%
16%
required return
420000
700000
800000
actual return
600000
560000
800000
residual income
180000
-140000
0
a.Decision based on 15% return on alternative
A
B
C
ROI
20.00
8.00
16
Alternative rate of return
15.00
15.00
15.00
Decision (if ROI > rate of return on alternative then reject else accept
reject
Accept
reject
b.Decision based on residual income
A
B
C
Minimum required rate of return
14%
10%
16%
Alternative rate of return
15%
15%
15%
Decision (if Minimum required return > rate of return on alternative then reject else accept
accept
accept
reject
1.ROI
NET OPERATAING INCOME
X SALES
SALES
AVERAGE OPERATING ASSETS
DIVISION A
600000
X 12000000
12000000
3000000
20.00
DIVISION B
560000
X 14000000
14000000
7000000
8.00
DIVISION C
800000
X 25000000
25000000
5000000
16.00
2. RESIDUAL INCOME
A
B
C
Average operating assets
3000000
7000000
5000000
Minimum required rate of return
14%
10.00%
16%
required return
420000
700000
800000
actual return
600000
560000
800000
residual income
180000
-140000
0
a.Decision based on 15% return on alternative
A
B
C
ROI
20.00
8.00
16
Alternative rate of return
15.00
15.00
15.00
Decision (if ROI > rate of return on alternative then reject else accept
reject
Accept
reject
b.Decision based on residual income
A
B
C
Minimum required rate of return
14%
10%
16%
Alternative rate of return
15%
15%
15%
Decision (if Minimum required return > rate of return on alternative then reject else accept
accept
accept
reject
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