Viola Holloway is the division manager of the Instruments Division of Forrow Aer
ID: 2801210 • Letter: V
Question
Viola Holloway is the division manager of the Instruments Division of Forrow Aerodynamic Company. Viola Holloway is evaluating whether to acquire a new product for the Instruments Division. The Budgeted Income (Net Operating Income) for next year for the Instruments Division is presently $750,000 with Average Operating Assets of $3,000,000. The proposed investment in the new product would add projected Net Income (Net Operating Income) of $360,000 and would require an additional investment in Equipment (Average Operating Assets) of $2,000,000. Forrow Aerodynamic Company requires a Minimum Required Rate Of Return on its investment of twelve percent (12%).
Required
Compute the Return On Investment (ROI) for the Instruments Division of Forrow Aerodynamic Company under the following scenarios:
a. If the new product is not acquired.
b. Of the new product only (assuming it is acquired).
c. If the new product is acquired.
Compute the Residual Income for the Instruments Division of Forrow Aerodynamic Company under the following scenarios:
a. If the new product is not acquired.
b. Of the new product only (assuming it is acquired).
c. If the new product is acquired.
Will Viola Holloway acquire or not acquire the new product if Forrow Aerodynamic Company evaluates performance of its Investments Centers under the:
Return On Investment (ROI) Formula.
Residual Income Approach.
.
1.
Net
Operating Income
/
Average Operating Assets
=
ROI
a.
ROI of Division without New Product
$
$
%
b.
ROI of New Product
$
$
%
c.
ROI of Division with New Product
$
$
%
2.
Net
Operating Income
(
Minimum Rate of Return
×
Average Operating Assets
) =
Residual Income
a.
Residual Income without New Product
$
%
$
$
b.
Residual Income of New Product
$
%
$
$
c.
Residual Income with New Product
$
%
$
$
1.
Net
Operating Income
/
Average Operating Assets
=
ROI
a.
ROI of Division without New Product
$
$
%
b.
ROI of New Product
$
$
%
c.
ROI of Division with New Product
$
$
%
2.
Net
Operating Income
(
Minimum Rate of Return
×
Average Operating Assets
) =
Residual Income
a.
Residual Income without New Product
$
%
$
$
b.
Residual Income of New Product
$
%
$
$
c.
Residual Income with New Product
$
%
$
$
Explanation / Answer
1 Net Opg. Income/ Average Opg. Assets= ROI a. ROI of Division without New Product 750000 3000000 25% b. ROI of New Product 360000 2000000 18% c. ROI of Division with New Product 1110000 5000000 22.2% 2 Net Opg. Income- (Min.reqd.Return*Av. Opg.assets)= Residual Income a. Residual Income without New Product 750000 (12%*3000000) 390000 b. Residual Income of New Product 360000 (12%*2000000) 120000 c. Residual Income with New Product 1110000 (12%*5000000) 510000 3 As per ROI approach,,adding new product, contributes additional $ 18 for every $ 100 invested to the company. As per the residual income approach,the addition of the new product ,adds $ 120000 to the shareholder value of the company. Thus ,under both methods of evaluation, Viola will acquire the new product.
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