PROBLEM 11-17 Return on Investment and Residual Income [LO3, LO4 Faced with head
ID: 2556589 • Letter: P
Question
PROBLEM 11-17 Return on Investment and Residual Income [LO3, LO4 Faced with headquarters' desire to add a new product line, Stefan Grenier, manager of Bilti Products' East Division, felt that he had to see the numbers before he made a move. His divi- sions ROI has led the company for three years, and he doesn't want any letdown. Bilti Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROL with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company's East Division for last year are given below: Sales Variable expenses 21,000,000 13,400000 600,000 920,000 1680000 $5250000 R99H494 Fixed expenses Operating income Divisional operating assets The company had an overall ROI of 18% last year (considering all divisions). The new product line that headquarters wants Grenier's East Division to add would require an investment of 3,000,000. The cost and revenue characteristics of the new product line per year would be as follows Variable expenses Fixed expenses 65% of sales 2,520,000 Required 1 Compute the East Division's ROI for last year; also compute the ROl as it would appear if the new product line were added. If you were in Greniers position, would you accept or reject the new product line? Explain Why do you suppose headquarters is anxious for the East Division to add the new product ine Suppose that the company's minimum required rate of return on operating assets is 15% and that performance is evaluated using residual income. 2. 3. 4. a. Compute East Division's residual income for last year; also compute the residual in come as it would appear if the new product line were added. b. Under these circumstances, if you were in Grenier's position, would you accept or reject the new product line? Explain.Explanation / Answer
1)
Present
New Line
Total
Sale
21,000,000
9,000,000
30,000,000
Operating income
1,680,000
630,000
2,310,000
Operating assets
5,250,000
3,000,000
8,250,000
Margin (=Operating income/ Sales)
8%
7%
7.70%
Turnover (=Sales/ Operating asset)
4
3
3.64
ROI (=Margin * Turnover)
32%
21%
28%
Working:
Sales
9,000,000
Variable expenses
5,850,000
Contribution margin
3,150,000
Fixed expenses
2,520,000
Operating income
630,000
?
2) Stefan Grenier will be inclined on the rejection the new product line because accepting it would reduce his division’s overall rate of return
3) The new product line promises an ROI of 21%, and the overall ROI of the company last year was only 18%. Therefore, adding the new line would increase the company’s overall ROI
4)
a)
Present
New Line
Total
Operating assets
5,250,000
3,000,000
8,250,000
Minimum required return
15%
15%
15%
Minimum operating income
787,500
450,000
1,237,500
Actual operating income
1,680,000
630,000
2,310,000
Minimum net operating income
787,500
450,000
1,237,500
Residual income
892,500
180,000
1,072,500
?
b) Under the residual income approach, Stefan Grenier would be inclined for the acceptance of the new product line because an addition of the product line would increase the total amount of the division’s residual income, as computed above
?
?
Present
New Line
Total
Sale
21,000,000
9,000,000
30,000,000
Operating income
1,680,000
630,000
2,310,000
Operating assets
5,250,000
3,000,000
8,250,000
Margin (=Operating income/ Sales)
8%
7%
7.70%
Turnover (=Sales/ Operating asset)
4
3
3.64
ROI (=Margin * Turnover)
32%
21%
28%
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