Question

Exercise 15-17 Comparing return on investment with residual income LO 15-6, 15-7

The Monarch Division of Allgood Corporation has a current ROI of 15 percent. The company target ROI is 11 percent. The Monarch Division has an opportunity to invest $3,900,000 at 13 percent but is reluctant to do so because its ROI will fall to 14.40 percent. The present investment base for the division is $9,100,000.

Required

A. Calculate the current residual income and the residual income with the new investment opportunity being included

B. Based on your answers to requirement a, should Monarch Division make the investment?

C. Should Monarch Division make the investment?

Answer 1

A. Residual Income = Operating Income - ( Operating Assets x Target ROI )

Current residual income = $ 9,100,000 x 15 % - ( $ 9,100,000 x 11 % ) = $ 364,000.

Residual income with the new investment = ( 3,900,000 + 9,100,000) x 14.40 % - (9,100,000 x 11 %) - ( $ 3,900,000 x 13 %) = 1,872,000 - 1,001,000 - 507,000 = $ 364,000.

B. Yes, the Monarch Division should make the investment because though the ROI of the division falls from 15 % to 14.40 %, the residual income remains unchanged. Therefore, if the demand for the product is very high, the investment should be made.