Question

Debbie's Department income totals $200,000, investment in the department is $2,000,000, and the company's cost of capital is 8%.

Calculate the return on investment (ROI).

Calculate Residual Income (RI).

Assume there is a potential capital project available to managers that requires a $200,000 investment and will return $18,000. What happens to the ROI for Debbie’s Department? What happens to the Residual Income for Debbie’s Department? Would the department manager be more likely to accept the project if department performance was evaluated using ROI or economic value added? Why?

Problem 2: Jonah and the Whale

Jonah, Inc. has two operating divisions in a decentralized structure. Division X is located in the US and produces the Xwater, which is an input to Division Y’s WhaleY. Division Y is located in the South of France. Division X uses idle capacity to produce Xwater. Xwater has a US domestic market price of $60. Its variable costs are $25 per unit. Jonah’s US tax rate is 40% of income. In addition to the transfer price for each Xwater received from Division X, Division Y also pays a shipping fee of $15 per unit ofXwater to get the Xwater from the US to France. The WhaleY costs an additional $10 to produce and sells for an equivalent of $115. Division Y could purchase Xwater from a Paris supplier for $50 per unit with no shipping cost. The company’s French tax rate is 70% of income. Assume French tax laws permit transferring at either variable cost or market price.

Assuming you have two choices – Variable and Market Price – what transfer price is economically optimal for Jonah, Inc.?

Answer 1

Return on investment is 10% (200,000/2,000,000)

Residual income is 40,000.

ROI for the fresh project will be 9% (18,000/200,000). By accepting this project, the overall ROI will reduce, as initial ROI is 10% and the ROI for new project is lower than 10%.

Calculation of residual income

Therefore, overall residual income will increase by 2,000.

Therefore, if evaluation is made as per ROI, the project will be rejected. If evalaution is made as per residual income, the project will be accepted.

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