Question

Q2. Gideon Corp. is a reinsurance and financial services company. Gideon strongly believes in evaluating the performance of its stand-alone divisions using financial metrics such as ROI and residual income. For the year ended December 31, 2019, Gideon’s CFO received the following information about the performance of the property/casualty division:

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Sales Revenues	$   900,000
Operating Income	$ 225,000
Total Assets	$1,500.000

Current Liabilities	$   300,000
Debt (Interest Rate 5%)	$ 400,000
Common Equity (Book Value)	$   500,000

For the purposes of divisional performance evaluation, Gideon defines investment as total assets, and income as operating income (that is, income before interest and taxes). The firm

pays a flat rate of 25% in taxes on its income.

Required:

1. What was the net income after taxes of the property/casualty division? showing working

2. What was the division’s ROI for the year? showing working

3. Based on Gideon’s required rate of return of 8%, what was the property/casualty division’s residual income for 2019? showing working

Answer 1

Answer 1: Calculation net income after taxes of the property/casualty division

	Amount ($)
Operating Income	$ 225000
Less: Interest Expenses ($ 400000 x 5%)	($ 20000)
Operating Income before taxes	$ 205000
Less: Tax ($ 205000 x 25%)	($ 51250)
Net Income	$ 153750

Answer 2: Calculation of ROI for the year

ROI = (Net Income / Captial Employed) x 100

= [$ 153750 / ($ 400000 + $ 500000)] x 100

= ($153750 / $ 900000) x 100

=17.08 %

Answer 3: Calculation of property/casualty division’s residual income for 2019

Residual Income = Net Operating Income - (Minimum required rate of return x total assets)

= $ 153750 - ( 8% x $ 1500000)

= $ 153750 - $ 120000

= $ 33750