Question

O’Brien Vineyards reports the following:
Net Operating Income
205,000
Average Operating Assets
1,985,000
Sales
2,575,000
Operating Expenses
2,320,000
Minimum Required Rate of Return is 12.25%
1. What is O’Brien Vineyard’s ROI?
2. What is O’Brien Vineyard’s Residual Income?
3. If Vineyard manager, Brant O’Brien, is compensated based on ROI, will he want to make an investment of $400,000 that would generate additional net operating income of $75,000 per year? Why or why not. Please show your calculations.
4. If Vineyard manager, Brant O’Brien, is compensated based on residual income, will he want to make an investment of $400,000 that would generate additional net operating income of $75,000 per year? Why or why not. Please show your calculations.

Answer 1

1.ROI = Net Operating Income/Average Operating Assets

= 205,000/1,985,000

= 10.33%

2.Residual Income:

Net Operating Income	205,000
Required Return 1,985,000*12.25%	243,162.5
Residual Income	(38,162.5)

3. Revised ROI = (205,000+75,000)/(1,985,000+400,000)

= 280,000/2,385,000

= 11.74%

ROI has increased from previous level of 10.33%, hence manager should make this investment.

4.Residual Income from New Investment:

Net Operating Income	75,000
Less: Desired Return 400,000*12.25%	49,000
Residual Income	26,000

Since the investment provides positive residual income, the manager should make this investment.