PA10-2 Calculating Unknowns, Predicting Relationship among Retun on Investment,
ID: 2521353 • Letter: P
Question
PA10-2 Calculating Unknowns, Predicting Relationship among Retun on Investment, Residual Income, Hurdle Rates LO 10-4, 10-5 The following is partial Information for Charleston Company's most recent year of operation. t manufactures lawn mowers and categorizes is operations into two divisions: Bermud Midiron. ? 600,000 160,000 $ 150,000 0.16 40,000 30,000) Sales revenue $2,500,000 Average invested assets Net Operating income Profit margin nvestment turnover Retum on investment Residual income 20% Required: 1. Wilthout making any calculations, determine whether each division's return on investment is above or below Charleston's hurdie rae The Bermuda Division's rehum on investment is The Midiron Division's retum on investment is Charleston's hundle Charleston's hurdle rate 2. Determine the missing amounts in the proceding table. (Round turnover to 2 decimal places answers to 1 your ROI percentage answers to 1 decimal place, (Le, 0.123 should be entered as 12.3%). Round investmentExplanation / Answer
Answer:
1
The Bermuda Division’s return on investment isaboveCharleston’s hurdle rate
The Midiron Division’s return on investment isbelowCharleston’s hurdle rate
Explanation to the answer:
The Bermuda Division’s return on investment must be above the hurdle rate, because the division has a positive residual income. The Midiron Division’s return on investment is less than the hurdle rate because the residual income is negative
2
Midiron Division
Bermuda Division
Sales revenue
$800,000
$600,000
Average invested assets
$2,500,000
$3,750,000
Net operating income
$160,000
$150,000
Profit margin
20
%
25
%
Investment turnover
0.32
0.16
Return on investment
6.4
%
4
%
Residual income
$40,000
($30,000)
Working notes for the above answer is as under
Bermuda Division:
Sales Revenue = ($160,000 / 20%)
= $800,000
Investment Turnover = ($800,000 / $2,500,000)
= 0.32
Return on Investment (ROI) = (20% × 0.32) or ($160,000 / $2,500,000)
= 6.4%
Midiron Division:
Average Invested Assets = ($600,000 / .16)
= $3,750,000
Profit Margin = ($150,000 / $600,000)
= 25%
Return on Investment (ROI) = (25% × .16) or ($150,000 / $3,750,000)
= 4%
_________________________________________
3
Bermuda Division
Charleston’s Hurdle Rate
4.8
%
Working
Bermuda Division:
Residual Income = Operating Income – (Average Invested Assets × Hurdle Rate)
$40,000 = $160,000 – ($2,500,000 × Hurdle Rate)
$2,500,000 × Hurdle Rate = $160,000 – $40,000
$2,500,000 × Hurdle Rate = $120,000
Hurdle Rate = $120,000 / $2,500,000 = 4.8%
Midiron Division:
Residual Income = Net Operating Income – (Average Invested Assets × Hurdle Rate)
($30,000) = $150,000 – ($3,750,000 × Hurdle Rate)
3,750,000 × Hurdle Rate = $150,000 + $30,000
3,750,000 × Hurdle Rate = $180,000
Hurdle Rate = $180,000 / $3,750,000 = 4.8%
________________________________________________
4
Return on Investment
5
%
4-b
From Charleston’s perspective, is this a viable investment?
Yes
Explanation
The return on investment for this project is 5% ($140,000 income / $2,800,000 investment). Since the expected return is greater than the hurdle rate of 4.8%, it is a viable project.
_________________________________________________
5
The Midiron Division
will favor
of the investment.
The Bermuda Division
will not favor
of the investment.
Explanation
The Midiron Division will be in favor of the investment because its 5% return on investment is greater than the division’s current ROI of 4%. However, the Bermuda Division will be opposed since its 5% return is less than its current ROI of 6.4%.
Midiron Division
Bermuda Division
Sales revenue
$800,000
$600,000
Average invested assets
$2,500,000
$3,750,000
Net operating income
$160,000
$150,000
Profit margin
20
%
25
%
Investment turnover
0.32
0.16
Return on investment
6.4
%
4
%
Residual income
$40,000
($30,000)
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