Sentinel Industries has manufactured prefabricated houses tor over 20 years. The

Question

Sentinel Industries has manufactured prefabricated houses tor over 20 years. The houses are constructed in sections to be assembled on customers' lots. Sentinel expanded into the precut housing market when it acquired Jensen Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers' lots for assembly. Sentinel designated the Jensen Division as an investment center. Sentinel uses return on investment (ROI) as a performance measure with investment defined as average operating assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum rate of return of 18%. Jensen's ROI has ranged from 20.1% to 23.5% since it was acquired. Jensen had an investment opportunity in 2017 that had an estimated ROI of 19%. Jensen management decided against the investment because it believed the investment would decrease the divisions overall ROI. Selected financial information for Jensen are presented below. The divisions average operating assets were SI2,300,000 for the year 2017. Calculate the following performance measures for 2017 for the Jensen Division.

Explanation / Answer

a) ROI

= 2460000/12300000*100

= 20%

b) Residual Income

12300000*(20-18)/100

= $246000

b) Yes, if in case residual income was used then Sentinental would have accepted for this investment. The investment opportunity will reduce the ROI as the expected return from the investment is 18% which is far below than the historical return of 20.1% to 23.5% and the real ROI is 20%. Main reason for the management to reject the proposal would have been their incentives which may be tied up with the performance and return generated from teh investment. If in case the residual income is being used then management will make use ofthis investment as itwill increase the performance measurement

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