Question

Assume Marsh Company’s Division A has an opportunity to make an investment of $250,000 that would generate a return of 16% on invested assets (i.e., $40,000 per year).

                                                                               New

                                                         Present       Project         Overall

Average operating assets (a) ..    $1,000,000   $250,000    $1,250,000

Net operating income (b) ........       $200,000     $40,000       $240,000

ROI (b) ÷ (a) .........................            20.0%        16.0%            19.2%

Based on ROI analysis, what would you expect Division A management to decide? Why?

Now look at residual income analysis of situation:

Average operating assets (a) ..    $1,000,000   $250,000    $1,250,000

Net operating income (b) ........    $   200,000   $ 40,000    $   240,000

Minimum required return:

12% ´ (a) ..............................         120,000       30,000         150,000

Residual income .....................

Now what would Division A’s management decide? Why?

Use both tools, ROI and RI, to evaluate situations.

Answer 1

Req A:
				Present	New	Overall
					Project
Average Operating Assets				1,000,000	250,000	1,250,000
Net operating income				200,000	40,000	240,000
ROI				20.00%	16%	19.20%
(Net income/ Average Operating assets)
No Management should not take over the investment in new projeect as it will reduce the overall ROI of division
Req B:
				Present	New	Overall
					Project
Average Operating Assets				1,000,000	250,000	1,250,000
Net operating income				200,000	40,000	240,000
Minimum Required return@12%				120,000	30,000	150000
(Average operating assets*12%)
Residual Income				80,000	10,000	90000
As, residual Income has bene rising wth new project. As per this criterion, the project shall be accepted