Section C: Three optional problems - answer any TWO problems from this section (

Question

Section C: Three optional problems - answer any TWO problems from this section (2 x 28 pts each- 56 pts). Problem #1 (28 points) During 2015, Heady Company (HC) reported operating income of $30,000,000 on operating assets of the company's Speaker Division (SD) reported income cf $6,000,000 on operating assets of $30,000,000. Heady has offered the SD division $7,500,000 of additional operating assets to invest in new projects. The m generate additional income of $1,200,000 from these new assets. Heady Company has a desired/target return on investment (ROI) of 12 percent. Required: a. Provide ROI calculations for each of the following: i. The Heady company ii. The SD Division anager of the SD's division thinks she could ii. The additional investment opportunity b. Provide residual income (RI) calculations for each of the following: i. The Heady company ii. The SD Division ii. The additional investment opportunity c. Use supporting calculations to explain whether the SD division's manager would decide to undertake the additional investment opportunity assuming that:: i. She is paid a bonus based upon her division's total ROI. ii. She is paid a bonus based upon her division's total RI

Explanation / Answer

Solution:

Requirement a – ROI calculation : Operating income / Average Total Assets *100

Heady Company = 30,000,000/200,000,000*100 = 15%

SD Division = 6,000,000/30,000,000*100 = 20%

Additional investment opportunity = 1200000/7500000*100 = 16%

Requirement b – Residual income = Invested capital * (ROI – WACC)

Heady Company = 200,000,000 * (15% - 12%) =$6,000,000

SD Division = 30,000,000 * (20% - 12%) = $2,400,000

Additional investment opportunity = 7,500,000 (16% - 12%) = $300,000

Requirement c –

Revised operating income for SD division if additional investment opportunity is undertaken:

= 6,000,000 + 1,200,000 = $7,200,000

Revised average total assets = 30,000,000 + 7,500,000 = $37,500,000

Consolidated ROI for SD division = 72,00,000 / 37,500,000*100 = 19.20%

Consolidated RI = 37,500,000 * (19.20% - 12%) = $2,700,000

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