Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evalu

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 $5,200,000 with total assets of $32,700,000 and noninterest-bearing current liabilities of $1,600,000. The proposed investment would add $1,014,000 to operating income and would require an additional investment of $5,279,000. The targeted rate of return for the Teen division is 13.60 percent. (Ignore taxes in this problem.)

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 $5,200,000 with total assets of $32,700,000 and noninterest-bearing current liabilities of $1,600,000. The proposed investment would add $1,014,000 to operating income and would require an additional investment of $5,279,000. The targeted rate of return for the Teen division is 13.60 percent. (Ignore taxes in this problem.)

Explanation / Answer

Part 1)

The ROI can be calculated with the use of following formula:

ROI = Operating Income/Total Assets*100

___________

Using the values provided in the question, we get

ROI if Machine is Not Purchased = 5,200,000/32,700,000*100 = 15.90%

___________

Part B)

Now, we will have to calculated the ROI by including the operating income and investment in additional assets. The ROI if machine is purchased is calculated as follows:

ROI if Machine is Purchased = (5,200,000 + 1,014,000)/(32,700,000 + 5,279,000)*100 = 16.36%

___________

Part C)

The residual income can be calculated with the use of following formula:

Residual Income = Net Operating Income - (Total Assets*Target Rate of Return)

___________

Using the values provided in the question, we get

Residual Income if Machine is Not Purchased = 5,200,000 - (32,700,000*13.60%) = $752,800

___________

Part D)

Now, we will have to calculated the ROI by including the operating income and investment in additional assets. The ROI if machine is purchased is calculated as follows:

Residual Income if Machine is Purchased = (5,200,000 + 1,014,000) - (32,700,000 + 5,279,000)*13.60% = $1,048,856

___________

Part E)

Yes, Sarah will decide to invest in the embroidery machine as the investment will provide a higher ROI.

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