Question

Bombard Division has operating income of $200,000 for the year ending December 31, 2011. Average invested capital is $1,000,000 and the weighted-average cost of capital is 10%. The division is considering a new investment that would cost $500,000 and earn 15% annually. If residual income  is the performance metric, should the manager of the Bombard Division accept the new investment?

		No, because the return on investment of the division decreases with the new investment.
		No, because the return on investment of the division increases with the new investment.
		Yes, because the residual income of the division increases with the new investment.
		Yes, because the return on investment of the division increases with the new investment

Answer 1

BOMBARD DIVISION

OPERATING INCOME - $200,000

AVERAGE INVESTED CAPITAL IS 1,000,000

WACC =10%

RESIDUAL INCOME IS = NET OPERATING INCOME - ( AVERAGE OPERATING ASSETS * MINIMUM REQUIRED RATE OF RETURN )

= $200,000 - ( 100,0000 * 10%)

=$100,000

CONSIDERING NEW INVESTMENT THAT WOULD COST $500,000

EARN = $500,000 * 15% = $75,000

RESIDUAL INCOME

= $2750,000 -(1,500,000 *10%)

= $125,000

SO THE CORRECT ANSWER IS -

Yes, because the residual income of the division increases with the new investment