Westerville Company reported the following results from last year’s operations:

Question

Westerville Company reported the following results from last year’s operations:

Sales $ 1,000,000

Variable expenses 300,000

Contribution margin 700,000

Fixed expenses 500,000

Net operating income $ 200,000

Average operating assets $ 625,000

This year, the company has a $120,000 investment opportunity with the following cost and revenue characteristics:

Sales $ 200,000

Contribution margin ratio 60 % of sales

Fixed expenses $ 90,000

The company’s minimum required rate of return is 15%.

Required:

If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

Explanation / Answer

Calculation of net operating income from Normal operations plus incestment opportunity As per last year Investment oppourtunity Total Sales $10,00,000 $2,00,000 $12,00,000 Contribution Margin $7,00,000 $1,20,000 $8,20,000 Less : Fixed expense $5,00,000 $90,000 $5,90,000 Net operating Income $2,00,000 $30,000 $2,30,000 Minimum required rate of return expected = 15% Total investment in assets = $625000 + $120000 = $745000 Expected return in dollar = 15% * $745000 = $111750 Residual Income = Net operating income - Expected return = $230000 - $111750 = $118250

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