Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evalu

Question

Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $4,800,000 with total assets of $32,900,000 and noninterest-bearing current liabilities of $1,400,000. The proposed investment would add $1,049,000 to operating income and would require an additional investment of $5,274,000. The targeted rate of return for the Teen division is 13.60 percent. (Ignore taxes in this problem.) Compute the ROI of the Teen division if the embroidery machine is not purchased. (Round answers to 2 decimal places, e.g. 15.32%.) ROI Compute the ROI of the Teen division if the embroidery machine is purchased. (Round answers to 2 decimal places, e.g. 15.32%.) Compute the residual income of the Teen division if the embroidery machine is not purchased. Residual income Compute the residual income of the Teen division if the embroidery machine is purchased. Residual income Will Sarah decide to invest in the embroidery machine if her performance is evaluated in terms of ROI? Sarah decide to invest in the embroidery machine.

Explanation / Answer

ROI is a profitability measure that evaluates the performance of a business by dividing net profit by network. There are many formulas to calculate ROI depending on the purpose for which it is calculated. But the most commonly used is

ROI = Net Profit/total assets.

Here we have Budgeted Operating income and total assets.

If the embroidery machine is not purchased, budgeted Operating income is $ 4,800,000 and total assets are $32,900,000. So ROI is

($4,800,000/$32,900,000)*100 = 14.59% (Rounded off to 2 decimals)

Hence ROI is 14.59%

If the embroidery machine is purchased, then there will be addition to the budgeted operating income and total assets. The additional budgeted operating income is $1,049,000. So total budgeted operation income will be $4,800,000 + $1,049,000 = $5,849,000. Additional investment required to purchase the embroidery machine is $5,274,000. So total assets are $32,900,000 + $5,274,000 = $38,174,000. Now ROI will be ($5,849,000/$38,174,000)*100 = 15.32% (Rounded off to 2 decimals)

Hence ROI is 15.32%

It is given the current liabilities are non-interest bearing. That means there is no interest to be paid on the current liabilities. So it does not affect the operating income and we have taken operating income without any adjustments. Also it is assumed the total assets are same as operating assets.

Residual Income is the income above the minimum target return. This means it is the excess of income earned over minimum income earned based upon targeted rate of return. It is calculated using the formula

Residual income = Operating income – (Operating assets * Target Rate of Return)

If the embroidery machine is not purchased, Operating income is $4,800,000, Operating assets are $32,900,000 and target rate of return is 13.60%

Residual income = $4,800,000 – ($32,900,000 *13.60%) = $4,800,000 - $4,474,400 = $325,600

Hence Residual income is $325,600

If the embroidery machine is purchased, Operating income is $5,849,000, Operating assets are $38,174,000 and target rate of return is 13.60%

Residual income = $5,849,000 – ($38,174,000 *13.60%) = $5,849,000 - $5,191,664 = $657,336

Hence Residual income is $657,336

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