You are a consultant for the Gybson Guitar Company. The Company currently has a
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Question
You are a consultant for the Gybson Guitar Company. The Company currently has a target rate of return of 10%. The company awards bonuses are based upon ROl increases. If ROI decreases, no bonus is earned. Bonuses are a key part of executive compensation. The Company has four Divisions: The Oldies, Rock, Jazz and Classic. Current results for each division of Gybson Company are as follows Total Assets Oldies $1,000,000 $1,500,000 $1,300,000 Classic$1,200,000 Income $160,000 $190,000 $190,000 $210,000 Rock Jazz Respond to the following in a Microsoft Word document and submit. Give complete and clear answers . Compute the ROI & Residual Income for each division and for Gybson as a whole (round to 6 points after the decimal) An opportunity comes along for the Classic Division to purchase a small guitar company. The purchase will require an investment of $250,000 and will increase income by $27,000 o What is new ROI for the Classic department if they make the investment? Round to 6 points after the decimal o What is new ROl for the Gybson if the Classic department makes the investment? o Will the head of the Classic Division make the investment if bonuses are only based upon increasing ROI? Explain o Does the president of Gybson want the head of Classic Division to make the investment? Explain. o What happens to the Residual income of Classic if they make the investment? Would the head of Classic Division make the investment if bonuses were based upon increasing Residual Income?Explanation / Answer
Computation of ROI and residual Income for each division and for Gybson
Opportunity comes for Classic division for investment
Investment amount = $250,000
Income from investment = $27,000
i) If the investment is done new ROI of classic division will be = (Total income / Total Assets) * 100 = [(210,000+27,000) / (1,200,000+250,000)]*100 = 16.344828%
ii) New ROI of Gybson if the investment is done = (Total income / Total Assets) * 100 = [(750,000+27,000) / (5,000,000+250,000)*100 = 14.8%
iii) If the investment is done then the ROI of Classic will fall from 17.50% to 16.344828%. A falling ROI may create a negative impression of Classic division to Gybson. So, as a head of Classic division the investment is not to be done.
iv) If the organisation takes decision based on ROI then the President of Gybson wouldn't want to make the division. If this investment would be granted then the ROI of Gybson will fall from 15% to 14.8%, which means that no bonus will be given to the investors of Gybson. This may make the investors of Gybson unhappy. No president will want that. So does the President of Gybson will not want Classic to make that investment.
v) New total asset of Classic division = 1,200,000+250,000 = $ 1,450,000
Total new income of Classic = 210000+27000 = $237000
New target income of Classic = 1450000*10% = $145000
New Residual Income of Classic = 237000-145000 = $92,000
If the new investment is done then the residual income of Classic will go up by (92000-90000) = $2,000. from the previous one.
vi) If the new investment is done
New total asset of Gybson = 5000000+250000 = $5250000
New total income of Gybson = 750000+27000 = $777000
New target income of Gybson = 5250000*10% = $525000
Residual Income of Gybson = 777000-525000 = $252000
If the new investment is undertaken then the residual income Gybson will rise by (252000-250000) = $2,000. So the new residual income of Gybson will be higher than before. If the decision of investing and bonuses were based upon residual income then this should be undertaken and the head of Gybson would want Classic division to make the investment.
Oldies Rock Jazz Classic Gybson A. Total Assets ($) 1,000,000 1,500,000 1,300,000 1,200,000 5,000,000 B. Income ($) 160,000 190,000 190,000 210,000 750,000 C. Target rate of return (%) 10 10 10 10 10 D. Target income ($) (AxC) 100,000 150,000 130,000 120,000 500,000 E. ROI (%) [(B/A)*100] 16 12.666667 14.615385 17.50 15 F. Residual Income ($) (B-D) 60,000 40,000 60,000 90,000 250,000Related Questions
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