Question

Lisa Simpson, president of the Kwik-E Mart Corporation, has mandated a minimum 12% return on investment for any project undertaken by the company. Given the company’s decentralization, Lisa leaves all investment decisions to the divisional managers as long as they anticipate a minimum rate of return of at least 12%. The Flavored Water Division, under the direction of manager Ralph Wiggum, has achieved a 14% return on investment for the past three years. This year in not expected to be different from the past three. Wiggum has just received a proposal to invest $1,700,000 in a new line of flavored water that is expected to generate $221,000 in operating income and sales of $1,450,000.

Required

1. Calculate the residual income for the proposed new line of flavored water.
2. If Ralph Wiggum is evaluated based on residual income, will he choose to invest in the new line of flavored water? Why or why not?

Answer 1

Residual Income = Net ooperating income - [Operating assets *minimum required rate of return]

                    = 221000 - [1700000*12%]

                    = 221000 - 204000

                   = 17000

b)As the residual income is positive ,Investment in new line should be made.