2. Acme Manufacturing is a decentralized corporation. Divisions are treated as i
ID: 2538520 • Letter: 2
Question
2. Acme Manufacturing is a decentralized corporation. Divisions are treated as investment centers. In recent years, Acme has been running about 1 1% ROI for the corporation as a whole, which is the minimum target for new investment. One of its most profitable divisions is Walker Products, which last year had ROA of 20% ($1,600,000 operating income on assets of $8,000,000). Walker has an opportunity to expand one of its plants to produce a promising new product. The expansion will cost two million dollars and is expected to increase operating earnings to $1,900,000. Required: What factors should Walker's manager and her supervisor, the VP of operations, consider in deciding whether to go forward with the expansion? 22 pointsExplanation / Answer
Solution:
Existing ROI of Walker divison = 20%
If expansion of plant is done then total assets after expansion = $8,000,000 + $2,000,000 = $10,000,000
Operating earning after expansion of walker division = $1,900,000
New ROI after expansion = $1,900,000 / $10,000,000 =19%
Hence after expansion ROI of walker division will be reduced from 20% to 19% though same still will be higher than ROI of acme as a whole.
However walker manager's and her supervisor should consider following factors while deciding to go forward with the expansion:
1. If Walker's division manager and her supervisor is getting incentive on the basis of ROI of division then this expansion will result in decrease in ROI of the division, hence reduction in incentive amount. Therefore they should not go for expansion.
2. If walker's division manager and her supervisor is getting incentive on the basis of residual income then this expansion will result in Residual income of the division, hence increase in incentive amount. Therefore they should go for expansion.
Residual income without expansion = $1,600,000 - ($8,000,000*11%) = $720,000
Residual income with expansion = $1,900,000 - ($10,000,000*11%) = $800,000
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