You are provided with the below-selected data from Pure Corporation, a company w
ID: 2595924 • Letter: Y
Question
You are provided with the below-selected data from Pure Corporation, a company with
several divisions. Division managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, Pure Corporation as a whole, produced a 14 percent return on its investment(ROI).
Just recently, the management of Pure's Western Division was approached about the possibility
of acquiring a competitor. If the competitor is acquired, the investment required would be the
competitor’s net operating assets. The data that follow relate to recent performance of
Pure's Western Division and the competitor company:
Western Division management has determined that merging the competitor company with
Pure's operating systems would require an additional $100,000 investment in operating assets,
that is, an additional $100,000 in invested capital would be needed.
Show All Work
1. Compute the current ROI of the Western Division.
2. What would Western Division’s ROI be if the competitor company were acquired?
3. What is the likely reaction of Western Division’s management toward this acquisition and
why?
4. What would the likely reaction of Pure's top management be toward this acquisition
and why?
5. Suppose that Pure uses residual income to evaluate performance and desires a 14% minimum return on invested capital. Compute the current residual income of the Western Division.
6. Compute Western Division’s residual income if the competitor company were acquired.
7. If Residual Income is used as the performance measure for divisions by Pure, what is
the likely reaction of Western Division’s management toward this acquisition and why?
Explanation / Answer
1) Current ROI of the Western Division = Current net Income/Net operating assets
Current net income = Sales - variable cost - Fixed cost = 4,400,000-(4,400,000*65%)-1,100,000
= $440,000
Net operating assets = $1,200,000
Current ROI = $440,000/$1,200,000 = 36.67%
2) ROI if the competitor's company acquired = Total Net income/Total Operating assets
Net Income of competitor's company = 2,600,000-(2,600,000*70%)-950,000 = -$170,000
Total Net Income = $440,000-$170,000 = $270,000
Total Operating Assets = $1,200,000+$100,000 = $1,300,000
New ROI = $270,000/$1,300,000 = 20.77%
3) The Management of western division likely to be against the acquisition beacause ROI will decrease from 36.67% to 20.77%. Since bonus are awarded on the basis of ROI, the acquisition will result in less compensation.
4) The Pure's top management would likely be against the acquisition because there is a net operating loss of $170,000 which can be seen from the income statement of competitor.
5) Current Residual Income = Current Net Income - (Operating Assets*minimum return)
= $440,000-(1,200,000*14%) = $272,000
6) Residual Income after acquiring competitor company = $270,000-($1,300,000*14%) = $88,000
7) The western division's management is likely against this acquisition because the residual income has decreased from $272,000 to $88,000 after the acquisition of competitor company.
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