1) What is last year\'s residual income? 2) What is the residual income of this

Question

1) What is last year's residual income?

2)  What is the residual income of this year’s investment opportunity?

3)  If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

4)  If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Y/N?

5a)  Assume that the contribution margin ratio of the investment opportunity was 50% instead of 60%. If Westerville’s Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Y/N?

5b)  Would the owners of the company want her to pursue the investment opportunity? Y/N?

Westerville Company reported the following results from last year's operations: Sales Variable expenses Contribution margin Fixed expenses Net operating income Average operating assets 1,200,000 420,000 780,000 600,000 $ 180,000 600,000 At the beginning of this year, the company has a $137,500 investment opportunity with the following cost and revenue characteristics: Sales Contribution margin ratio Fixed expenses 220,000 60 % of sales $ 99,000 The company's minimum required rate of return is 20%.

Explanation / Answer

Q1. Average operating assets 600,000 Minimum rate of returnr 20% Target return (600,000*20%) 120,000 Actual income 180,000 Residual income 60,000 Q2. Investment in opportunity 137,500 Minimum rate of return 20% Target return 27500 Expected return: Sales 220,000 CM ratio 60% Ciontribution 132000 Less: Fixed cost 99000 Expcted profits 33000 Residual income 5500 Req 3: Total Investment (600,000+137500) 737500 Min return 20% Target income 147500 Actual expected return(180000+33000) 213000 Residual income 65500 Req 4: Yes, As per CEO, the investment shall be made. Req 5. Investment in opportunity 137,500 Minimum rate of return 20% Target return 27500 Expected return: Sales 220,000 CM ratio 50% Ciontribution 110000 Less: Fixed cost 99000 Expcted profits 11000 Residual income -16500 NO, CEO will not go this investment as it reduces the residual income by $ 16,500 Req 6: Expected return on investment 11000 Investment 137500 ROI of investment (Return/Investment) 8% Min return required 20% No, the management does not pursue the investmennt

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