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 = Operating Income/Average Operating assets

= 205,000/1,985,000

= 10.33%

2. residual income is:

Operating Income	2,05,000
Less: Minimum Required return 1,985,000*12.25%	243,162.5
Residual Income	(38,162.5)

3. ROI from New Investment = 75,000/400,000 = 18.75%

Since ROI from new investment is more than present ROI, overall ROI will increase. Hence, new investment should be accepted.

4.

Operating Income	75,000
Less: Minimum required return 400,000*12.25%	49,000
Residual Income	26,000

Since residual income is positive, new investment should be made.