/00-23:77% 27-28 Last year a division of a major corporation had total sales of
ID: 2567167 • Letter: #
Question
/00-23:77% 27-28 Last year a division of a major corporation had total sales of $26,110,000, net operating income of $1,801,590, and average operating assets of $7,000,000. The company's minimum required rate of return is 18%. An investment in new equipment of $1,000,000 will result in a 15% increase in NOI. 27. What is the division's residual income before the new investment? 1,801,590-L7ooo.ooxos?5Yl59D 28. If the division manager is evaluated based on residual income, would he make the investment in new equipment? Why or why not?Explanation / Answer
Solution:
Residual Income is a method of measuring performance of investment centers. Residual Income measures the amount a division adds to shareholder value of the parent company.
Residual Income = Net Operating Profit After Tax – Required Profit to cover the cost of financing
27)
Net Operating Profit After tax = $1,801,590
Minimum Required Rate of Return before the new investment = Average Operating Assets x Minimum Required Rate of Return
= $7,000,000 x 18%
= $1,260,000
Residual Income = Net Operating Profit after tax $1,801,590 – Minimum Required Return 1,260,000
= $541,590
28)
Average Operating Assets after new investment = 7,000,000 + 1,000,000 = $8,000,000
Minimum Required Return on Investment = 8,000,000*18% = $1,440,000
Net Operating Income after increase of 15% = 1,801,590 + 15%*1801590 = $2,071,828.50
Residual Income = 2,071,828.50 – 1,440,000 = $631,828.50
On the basis of Residual Income the investment should be made in new equipment, since the overall residual income is higher than the required minimum rate of return.
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