You are provided with the below-selected data from Pure Corporation, a company w

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.

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1. What would Western Division’s ROI be if the competitor company were acquired?

2. 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.

3. Compute Western Division’s residual income if the competitor company were acquired.

4. 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?

Pure Western Division Competitor Company Sales $4,400,000 $2,600,000 Variable Costs 65% of sales 70% of sales Fixed Costs $1,100,000 $950,00 Net Operating Assets $1,200,000 $100,000

Explanation / Answer

1. Western Division's ROI if the competitor company were acquired = 86.53%

2. Current residual income of the Western Division = $272,000

3. Western Division's residual income if the competitor company were acquired = $943,000

4. If residual income is used as the performance measure for divisions by Pure, Western Division's management would most likely go ahead with the acquisition as it leads to an increase in residual income. Also it increases the ROI of the division.

DETAILS PURE WESTERN DIVISION COMPETITOR COMPANY DIVISION (COMPETITOR IS ACQUIRED) Sales $4,400,000 $2,600,000 $7,000,000 Variable cost (2,860,000) (1,820,000) (4,680,000) Contribution margin 1,540,000 780,000 2,320,000 Fixed cost (1,100,000) (95,000) (1,195,000) Operating Income 440,000 685,000 1,125,000 Net operating assets 1,200,000 100,000 1,300,000 ROI = Net operating income / Net operating assets 36.67% 685% 86.53% Cost of capital 14% 14% 14% Residual income = Operating income - (Operating assets * cost of capital) 440,000 - (1,200,000 * 14%) = $272,000 685,000 - (100,000 * 14%) = $671,000 1,125,000 - (1,300,000 * 14%) = $943,000

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