Sarah Jones, the manager of the Teen division of the Pearl City Clothing Company

Question

Sarah Jones, the manager of the Teen division of the Pearl City Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $4,934,500 with total assets of $32,021,000 and noninterest-bearing current liabilities of $1,580,800. The proposed investment would add $1,012,800 to operating income and would require an additional investment of $5,219,900. The targeted rate of return for the Teen division is 15 percent. (Ignore taxes in this problem.)

1. Compute the ROI of the Teen division if the embroidery machine is not purchased. (Round answer to 2 decimal places, e.g. 15.32%.)

2. Compute the ROI of the Teen division if the embroidery machine is purchased.  (Round answer to 2 decimal places, e.g. 15.32%.)

3. Compute the residual income of the Teen division if the embroidery machine is not purchased.

4. Compute the residual income of the Teen division if the embroidery machine is purchased.

Explanation / Answer

1. Compute the ROI of the Teen division if the embroidery machine is not purchased.

ROI = Operating Income / (Total Assets - Non interest bearing current liabilities)

.......= $4,934,500 / ($32,021,000 - $1,580,800)

.......= $4,934,500 / $30,440,200

.......= 16.21%

2. Compute the ROI of the Teen division if the embroidery machine is purchased

ROI = Operating Income / (Total Assets - Non interest bearing current liabilities)

........= ($4,934,500 + $1,012,800) / ($32,021,000 + $5,219,900 - $1,580,800)

........= $5,947,300 / $35,660,100

........= 16.68%

3. Compute the residual income of the Teen division if the embroidery machine is not purchased.

Residual Income = Operating Profit - (Cost of Capital x Invested Capital)

............................= $4,934,500 - (15% x  $30,440,200)

............................= $368,470

4. Compute the residual income of the Teen division if the embroidery machine is purchased.

Residual Income = Operating Profit - (Cost of Capital x Invested Capital)

............................= $5,947,300 - (15% x $35,660,100)

............................= $598,285

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