[The following information applies to the questions displayed below.j Wyalusing

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[The following information applies to the questions displayed below.j Wyalusing Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers' lots. Wyalusing expanded into the precut housing market when it acquired Fairmont Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers' lots for assembly. Wyalusing designated the Fairmont Division as an investment center. Wyalusing uses return on investment (ROI) as a performance measure with investment defined as average productive assets. Management bonuses are based in part on ROl. All investments are expected to earn a minimum return of 15 percent before income taxes. Fairmont's ROI has ranged from 24.6 to 27.8 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an estimated ROl of 23 percent. Fairmont's management decided against the investment because it believed the investment would decrease the division's overall ROI. The 20x1 income statement for Fairmont Division follows. The division's productive assets were $29,400,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year FAIRMONT DIVISION Income Statement For the Year Ended December 31, 20x1 (in thousands) Sales revenue Cost of goods sold $63,350 34,100 $29,250 Gross margin Operating expenses: Administrative Selling 4,530 17,545 22,075 Income from operations before income taxes $ 7,175 Required: 1-a. Calculate the return on investment (ROI) for 20x1 for the Fairmont Division 1-b. Calculate residual income for 20x1 for the Fairmont Division.

Explanation / Answer

Solution:

Part 1-a –

Return on Investment (ROI) = Operating Income / Average Assets x 100

Average Assets = (Beginning Balance + Ending Balance)/2

It is given in the question that ending assets are 5% higher than balance at the beginning of the year. It means ending assets value is 105% of the Beginning Assets.

Hence, Beginning Assets = Ending Assets $29,400,000 / 105%

= $28,000,000

Average Assets = (28,000,000 + 29,400,000) / 2 = 28,700,000

Return on Investment (ROI) = Operating Income $7,175,000 / Average Assets 28,700,000 x 100

= 25%

Part 1-b

It is given in the question that Fairmount division had an investment opportunity in 20X1 that had an estimated ROI of 23%. So we can also assumed that the company’s desired income for 20X1 is 23% on Average Assets or Investment.

Residual Income = Income from Operation - Desired Income on Investment

Desired Income on Investment = Average Assets x 23% = 28,700,000*23% = $6,601,000

Residual Income = Income from Operation 7,175,000 - Desired Income on Investment 6,601,000

= $574,000

Or if we use 15% minimum return on average assets then the Residual Income will be as follows:

Desired Income on Investment = Average Assets x 15% = 28,700,000*15% = $4,305,000

Residual Income = Income from Operation 7,175,000 - Desired Income on Investment 4,305,000

= $2,870,000

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