Question

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Westerville Company reported the following results from last year’s operations:

Sales	$	2,200,000
Variable expenses		660,000
Contribution margin		1,540,000
Fixed expenses		1,100,000
Net operating income	$	440,000
Average operating assets	$	1,375,000

At the beginning of this year, the company has a $275,000 investment opportunity with the following cost and revenue characteristics:

Sales	$	440,000
Contribution margin ratio		60	% of sales
Fixed expenses	$	220,000

The company’s minimum required rate of return is 15%.

14. If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?

• Yes

• No

15-a. Assume that the contribution margin ratio of the investment opportunity was 55% instead of 60%. If Westerville’s Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?

• Yes

• No

15-b. Would the owners of the company want her to pursue the investment opportunity?

• Yes

• No

Answer 1

Solution 14:

Residual income from new investment opportunity = Net operating income - Minimum required income

= ($440,000*60% - $220,000) - ($275,000*15%) = $2,750

Accepting investment opportunity will increase residual income, therefore CEO should pursue the investment opportunity.

Solution 15a:

Residual income from new investment opportunity = Net operating income - Minimum required income

= ($440,000*55% - $220,000) - ($275,000*15%) = ($19,250)

Accepting investment opportunity will decrease residual income, therefore CEO should not pursue the investment opportunity.

Solution 15b:

No, owner's do not want to pursue beacuse ROI provided by investment opportunity is less than minimum required rate of return.