The Mustang Division of Detroit Motors had an operating income of $900,000 and n

Question

The Mustang Division of Detroit Motors had an operating income of $900,000 and net assets of $5,000,000. Detroit Motors has a target rate of return of 16 percent.

(a) Compute the return on investment. (Round your answer to three decimal places.)

(b) Compute the residual income.

(c) The Mustang Division has an opportunity to increase operating income by $200,000 with an $850,000 investment in assets.

1. Compute the Mustang Division's return on investment if the project is undertaken. (Round your answer to three decimal places.)

2. Compute the Mustang Division's residual income if the project is undertaken.

Explanation / Answer

QUESTION - 1

(a) Return on investment (ROI) = Operating income / Net assets

= $900,000 / $5,000,000 = 0.18, or 18.000%

(b) Residual income (RI) = Operating income - (Net asset x Rate of return)

= $900,000 - ($5,000,000 x 16%) = $(900,000 - 800,000) = $100,000

QUESTION - 2

New operating income = $(900,000 + 200,000) = $1,100,000

New net assets = $(5,000,000 + 850,000) = $5,850,000

(1) ROI = $1,100,000 / $5,850,000 = 0.18803, or 18.803%

(2) RI = $1,100,000 - ($5,850,000 x 16%) = $(1,100,000 - 936,000) = $164,000

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