The Empire Hotel is a full-service hotel in a large city. Empire is organized in
ID: 2370004 • Letter: T
Question
The Empire Hotel is a full-service hotel in a large city. Empire is organized into three departments
that are treated as investment centers. Budget information for the coming year for these three departments
is shown below. The managers of each of the departments are evaluated and bonuses are awarded each year based on ROI.
Empire Hotel
Hotel Rooms Restaurants Health Club--Spa
Average invevestment $8,000,000.00 $5,000,000.00 $1,000,000.00
Sales revenue $10,000,000.00 $2,000,000.00 $600,000.00
Operating expenses $8,500,000.00 $1,250,000.00 $450,000.00
Operating earnings $1,500,000.00 $750,000.00 $150,000.0
Instructions
a. Compute the ROI for each department. Use the DuPont method to analyze the return on sales and capital turnover.
b. Assume the Health Club--Spa is considering installing new exercise equipment. Upon investigating, the manager of thedivision fins that the equipment would cost $50,000 and that sales revenue would increase by $8,000 per year as a resultof the new equipment. What is the ROI of the investment in the new exercise equipment? What impact does the investment in the exercise equipment have on the Health Club--Spa's ROI? Would the manager of the Health Club--Spa be motivated to undertake such an investment?
c. Compute the residual income for each department if the minimum required return for the Empire Hotel is 17 percent. What would be the impact of the investment in (b) on the Health Club--Spa's residual income?
Explanation / Answer
Return on investment (ROI) measures the gain or loss generated on an investment relative to the amount of money invested. ROI is usually expressed as a percentage and is typically used for personal financial decisions, to compare a company's profitability or to compare the efficiency of different investments.
The return on investment formula is:
ROI = (Net Profit / Cost of Investment) x 100
The ROI calculation is flexible and can be manipulated for different uses. A company may use the calculation to compare the ROI on different potential investments, while an investor could use it to calculate a return on a stock.
For example, an investor buys $1,000 worth of stocks and sells the shares two years later for $1,200. The net profit from the investment would be $200 and the ROI would be calculated as follows:
ROI = (200 / 1,000) x 100 = 20%
The ROI in the example above would be 20%. The calculation can be altered by deducting taxes and fees to get a more accurate picture of the total ROI.
The same calculation can be used to calculate an investment made by a company. However, the calculation is more complex because there are more inputs. For example, to figure out the net profit of an investment, a company would need to track exactly how much cash went into the project and the time spent by employees working on it.
ROI is one of the most used profitability ratios because of its flexibility. That being said, one of the downsides of the ROI calculation is that it can be manipulated, so results may vary between users. When using ROI to compare investments, it's important to use the same inputs to get an accurate comparison.
Also, it's important to note that the basic ROI calculation does not take time into consideration. Obviously, it's more desirable to get a +15% reuturn over one year than it is over two years.
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