Question

ROI and Residual Income:
Impact of a New Investment
The Mustang Division of Detroit Motors had an operating income of $700,000 and net assets of $4,000,000. Detroit Motors has a target rate of return of 16 percent.

(a) Compute the return on investment. (Round your answer to three decimal places.)

(b) Compute the residual income.

(c) The Mustang Division has an opportunity to increase operating income by $200,000 with an $950,000 investment in assets.

1. Compute the Mustang Division's return on investment if the project is undertaken. (Round your answer to three decimal places.)

2. Compute the Mustang Division's residual income if the project is undertaken.

Answer 1

.(a) Return on investment (ROI)=Operating Income/Net asset

Return on investment (ROI)=$700,000/$4,000,000= 0.175

Return on investment (ROI)=17.50%

(b) Residual Income:

Residual Income = Net Operating Income? (Target Rate of Return-Net Assets)

Residual Income= $700,000-(0.16*4,000,000)=$60,000 .(c) 1.Return on Income , if the project is undertaken : Net Asset after investment=(4,000,000+950,000)=$4,950,000 Operating Income after investment=(700000+200000)=$900,000 Return on Income=900,000/4,950,000=0.182 Return on Income=18.2% 2.Residual Income, if project is undertaken: Residual Income=$900,000-(0.16*4,950,000)=$108,000