Selected sales and operating data for three divisions of different structural en

Question

Selected sales and operating data for three divisions of different structural engineering firms are
given as follows:

Division A

Division B

Division C

  Sales

$

7,300,000

$

11,300,000

$

10,400,000

  Average operating assets

$

1,460,000

$

5,650,000

$

2,080,000

  Net operating income

$

467,200

$

1,175,200

$

379,600

  Minimum required rate of return

27.00

%

20.80

%

24.00

%

Required:

1.

Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover. (Round your Turnover answers to 2 decimal places. Round your Margin and ROI percentage answers to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

2.

Compute the residual income (loss) for each division. (Loss amounts should be indicated by a minus sign. Round your Required Rate of Return percentage answers to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

3.

Assume that each division is presented with an investment opportunity that would yield a 29% rate of return.

  

a.

If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?

b.

If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Selected sales and operating data for three divisions of different structural engineering firms are
given as follows:

Explanation / Answer

Part 1)

The formula for calculating margin, asset turnover and ROI are given below:

Margin = Net Income/Net Sales*100

Asset Turnover Ratio = Net Sales/Average Operating Assets

ROI = Margin*Asset Turnover Ratio

____________

Using the values provided in the question, we get,

Division A:

Margin = 467,200/7,300,000*100 = 6.40%

Asset Turnover Ratio = 7,300,000/1,460,000 = 5

ROI = 6.40%*5 = 32%

____________

Division B:

Margin = 1,175,200/11,300,000*100 = 10.40%

Asset Turnover Ratio = 11,300,000/5,650,000 = 2

ROI = 10.40%*2 = 20.80%

____________

Division C:

Margin = 379,600/10,400,000*100 = 3.65%

Asset Turnover = 10,400,000/2,080,000 = 5

ROI = 3.65%*5 = 18.25%

_____________

Part 2)

_____________

Part 3)

a) Based on ROI, Division B and C would accept the investment opportunity expected to provide 29% returns. It is so, because the current ROI (20.80% and 18.25%) of these divisions is less than 29% and accepting an investment with a return greater than the current ROI would result in an overall increase in the division's rate of return. Division A's ROI is greater than 29% and therefore, it is not beneficial for the division to accept the investment opportunity as it would result in reduction in the overall rate of return.

Tabular Representation:

____________

b) To determine the acceptance/rejection based on Residual Income, we will have to compare the minimum required rate of return and the return on the new investment opportunity. In the given case, all the divisions would accept the investment opportunity, as the return provided by the new investment opportunity (29%) is greater than the minimum required rate (27%, 20.80% and 24%) of all return in case of all the divisions. Acceptance of such an investment would result in an increase in the residual income for the divisions.

Tabular Representation:

Division A Division B Division C Avg Operating Assets (A) 1460000 5650000 2080000 Required Rate of Return (B) 27% 20.80% 24% Required Operating Income (A*B) 394,200 1,175,200 499,200 Actual Operating Income 467,200 1,175,200 379,600 Required Operating Income (above) 394,200 1,175,200 499,200 Residual Income (Loss) $73,000 0 ($119,600)

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