Homestead Farming Company’s last year sales were $6,200,000, operating income wa

ID: 2454241 • Letter: H

Question

Homestead Farming Company’s last year sales were $6,200,000, operating income was $320,000, and the investment was $1,600,000. The cost of capital is 12%.

2.1 Calculate the company’s ROI efficiency.

2.2 Calculate the company’s ROI productivity.

2.3 Calculate the company’s ROI.

Homestead Farming has the opportunity to buy adjoining land for $1,000,000 that will increase sales by 4,000,000 and net income by $130,000. Homestead Farming is a division of Dole Fresh Foods and Homestead’s management is evaluated on ROI.

2.4 Would management make the investment?

2.5 Suppose management is evaluated on residual income. Would management make the investment?

2.6 Which decision benefits Dole Fresh Foods?

Explanation / Answer

(‘2.1) ROI Efficiency-

ROI efficiency is the measure of profit derived from sales generated.

ROI Efficiency (Return on sales ) = Operating Income / Sales

= 320,000/6200,000

ROI Effieciency = 5.16 %

(‘2.2) ROI Productivity

ROI productivity is the measure of sales derived from investment made. It disclosed the productivity of assets employed.

ROI Productivity ( Turnover Ratio) = Sales / Investment

= 6200,000/1600,000

ROI Productivity = 3.88 Times

(2.3) ROI

ROI = Return on sales x Turn over ratio

ROI = (Operating Income / Sales ) x (Sales / Investment)

ROI = (320000/6200000) x (6200000 / 1600000)

ROI = 20 %

(2.4) Evaluation of new investment

Particular

Before Investment

Increase in figures due to new investment

Figures after investment

Investment

1600,000

1000,000

2600,000

Sales

6200,000

400,000

6600,000

Operating Income

320,000

130,000

450,000

ROI after Investment = Operating Income / Investment

ROI = 450,000/2600,000

ROI = 17.31 %

Conclusion – As ROI is decrased from 20 % to 17.31 % so based on ROI investment should not be made.

(2.5) Residual Income

RI = Operating Income – ( Cost of capital x Investment)

RI (before Investment) = 320,000 - ( 0.12 x 1600,000)

RI (before Investment) = 128,000

RI (after Investment) = 138,000

As RI is increased after investment hence Homestead Company should make new investment

(2.6) Residual Income gives better measure of performance of division compare to ROI.

Hence Homestead Company should be evaluated based on RI.