Question

The manager of a division that produces computer hardware is considering the opportunity to invest in two independent projects. The first is a monitor and the second is a CPU. Without the investments, the division will have total assets for the coming year of $14.5 million and after-tax income of $1.58 million. The invested capital required for each investment and the expected operating incomes are as follows:

Monitor CPU

After-tax operating income         $33,750                                    $44,850

Invested capital                         375,000                                    345,000

Corporate headquarters will obtain its financing for the computer hardware division’s further investments from long term debt and shares and the weighted average cost of capital is estimated to be 9%

Required:

1. Compute ROI for each investment project   
2. Compute the budgeted divisional ROI for each of the following alternatives:
   a. The monitor investment is made
   b. The CPU investment is made
   c. Both investments are made
   d. Neither investment is made

Assuming that divisional managers are evaluated and rewarded on the basis of ROI performance, which alternative do you think the divisional manager will choose?

Answer 1

In the given case cost of capital is 9% and ROI of Moniter is 9% and ROI of CPU is 13%

Therefore manager should invest in CPU because of its higher ROI i.e 13%