Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evalu
ID: 2476053 • Letter: S
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 $4,820,000 with total assets of $32,700,000 and noninterest-bearing current liabilities of $1,500,000. The proposed investment would add $1,042,000 to operating income and would require an additional investment of $5,283,000. The targeted rate of return for the Teen division is 13.50 percent. (Ignore taxes in this problem.)
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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 $4,820,000 with total assets of $32,700,000 and noninterest-bearing current liabilities of $1,500,000. The proposed investment would add $1,042,000 to operating income and would require an additional investment of $5,283,000. The targeted rate of return for the Teen division is 13.50 percent. (Ignore taxes in this problem.)
Explanation / Answer
1. ROI of the Teen Division if the embroidery machine is not purchased:
Operating Income = $4,820,000
Total Assets = $32,700,000
Current Liabilities = $1,500,000
ROI = Operating Income / (Total assets - Current Liabilities)
ROI = 4,820,000 / (32,700,000 - 1,500,000) = 15.45%
2. ROI of the Teen Division if the embroidery machine is purchased:
Operating Income = $4,820,000 + 1,042,000 = $5,862,000
Total Assets = $32,700,000 + 5,283,000 = $37,983,000
Current Liabilities = $1,500,000
ROI = Operating Income / (Total assets - Current Liabilities)
ROI = 5,862,000 / (37,983,000 - 1,500,000) = 16.07%
3. Residual Income if the machine is not purchased:
Required return = (32,700,000 - 1,500,000) x 13.5% = $4,212,000
Operating Income = $4,820,000
Residual Income = 4,820,000 - 4,212,000 = $608,000.
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