Question 1 (performance evaluation: RI, ROI) Generic Motors Corporation has two

Question

Question 1 (performance evaluation: RI, ROI)

Generic Motors Corporation has two divisions, Kadillack and Chevrolay. Their performance for last year is as follows.

The required rate of return (cost of capital) for Generic Motors is 10% a year.

Required:

a) What is the return on investment (ROI) for each division?
Kadillack ROI = ______% (enter say 9.5% as 9.5, not as 0.095 and not as 9.5%)
Chevrolay ROI = ______%
Which division performs better, based on ROI? (1=Kadillack, 2=Chevrolay) 3

b) What is the residual income (RI) for each division?
Kadillack RI = $_______million (enter say $3.52 million as 3.52, not as 3,520,000)
Chevrolay RI = $_______million
Which division performs better, based on RI? (1=Kadillack, 2=Chevrolay) 6

c) Which of the two measures (ROI or RI) would you use to decide which division performs better? Briefly explain your reasons.

***PLEASE SHOW STEPS!!!

Kadillack Chevrolay Investment (operating assets) $400 million $1,600 million Profit $80 million $240 million

Explanation / Answer

Solution:

(a) Calculation of Return on Investment (ROI) for each division

Return on Investment (ROI) = Operating Profit / Average Invested Assets x 100

ROI of Division Kadillack = $80 / $400 x 100 = 20% or 20

ROI of Division Chevrolay = $240 / $1,600 x 100 = 15% or 15

Based on ROI, Kadillack division performance is better than Chevrolay.

(b) Calculation of Residual Income (RI) for each division

Residual Income = Operating Profit – Cost of Capital/Investment

Cost of Capital/Investment = Operating Assets / Investment x Required Rate of Return

RI of Kadillack division = $80 million – ($400 Million x 10%) = $80 Million - $40 Million = $40 Million

RI of Chevrolay division = $240 Million – ($1600 million x 10%) = $240 Million – $160 million = $80 Million

Based on RI, Chevrolay division performs better.

(C) ROI measures the performance of business in common. It is a financial accounting measure which is understandable by managers for analysis and comparison across corporate divisions for companies of similar size and sectors. It measures Return in terms of percentage.

Residual Income is a absolute measure and considered a better overall performance measure. It measures performance in terms of money rather than as a percentage.

Hence, Better measure for overall business performance is Residual Income.

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