ROI computations with a capital charge. The following information relates to the
ID: 2472425 • Letter: R
Question
ROI computations with a capital charge. The following information relates to the operating performance of three divisions of Revere, Inc. for last year. Eastern Division Central Division Western Division Operating Profit...................................... $ 400,000 $3,000,000 $ 4,000,000 Investment............................................... 5,000,000 9,000,000 18,000,000 a. Compute the rate of return on investment (ROI) of each division for last year. b. Assume that the rm levies a charge on each division for the use of funds. The charge is 10 percent on investment, and the accounting system deducts it in measuring divisional net income. Recalculate ROI using divisional net income after deduction of the use-offunds charge in the numerator. c. Which of these two measures do you think gives the better indication of operating performance? Explain your reasoning.
Explanation / Answer
a. calculation of ROI:
Calculation of ROI for Eastern Division:
=$400,000/5,000,000 = 8%
Calculation of ROI for Central Division:
=$3,000,000/9,000,000 =33.33%
Calculation of ROI for Western Division:
=$4,000,000/18,000,000 =22.22%
b. Calculation of ROI after charging funds cost @10%:
Calculation of ROI for Eastern Division:
Funds cost=5,000,000x10%= 500,000
Net loss=$400,000 - 500,000 =($100,000)
=($100,000)/5,000,000 =( 2% Loss)
Calculation of ROI for Central Division:
=$2,100,000/9,000,000 =23.33%
Calculation of ROI for Western Division:
=$2,200,000/18,000,000 =12.22%
c. 2nd method is best indicator of operating performance. In the case of eastern Division wecan find that the division is generating $400,000 net income. but after charging for funds invested, it is incurrering loss. Hencethe 2nd method is a better performance measure.
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