Exercise 11-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO11-1, LO11-2]
Selected sales and operating data for three divisions of different structural engineering firms are given as follows:
| Division A | Division B | Division C | |||||||
| Sales | $ | 16,100,000 | $ | 28,880,000 | $ | 20,880,000 | |||
| Average operating assets | $ | 3,220,000 | $ | 7,220,000 | $ | 5,220,000 | |||
| Net operating income | $ | 644,000 | $ | 519,840 | $ | 626,400 | |||
| Minimum required rate of return | 8.00 | % | 8.50 | % | 12.00 | % | |||
Required:
1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover.
2. Compute the residual income (loss) for each division.
3. Assume that each division is presented with an investment opportunity that would yield a 9% rate of return.
a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?
b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?
1) ROI
| Division A | Division B | Division C | |
| Margin | 644000/16100000 = 4% | 519840/28880000 = 1.8% | 626400/20880000 = 3% |
| Turnover | 16100000/3220000= 5 | 4 | 4 |
| ROI | 20% | 7.2% | 12% |
2) Residual income
| Division A | Division B | Division C | |
| Net income | 644000 | 519840 | 626400 |
| Minimum income | -257600 | -613700 | -626400 |
| Residual income | 386400 | -93860 | 0 |
3a) Analysis : ROI
| Division A | Accept |
| Division B | Reject |
| Division C | Accept |
3b) Analysis : Residual income
| Division A | Accept |
| Division B | Reject |
| Division C | Accept/Reject |
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