Westerville Company reported the following results from last year’s operations:
ID: 2717035 • Letter: W
Question
Westerville Company reported the following results from last year’s operations: Sales $ 1,500,000 Variable expenses 690,000 Contribution margin 810,000 Fixed expenses 435,000 Net operating income $ 375,000 Average operating assets $ 1,250,000 This year, the company has a $350,000 investment opportunity with the following cost and revenue characteristics: Sales $ 420,000 Contribution margin ratio 70 % of sales Fixed expenses $ 252,000 The company’s minimum required rate of return is 10%.
3. What is last year’s residual income?
What is the residual income of this year’s investment opportunity?
If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?
If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?
-Assume that the contribution margin ratio of the investment opportunity was 65% instead of 70%. If Westerville’s Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?
-Would the owners of the company want her to pursue the investment opportunity?
Explanation / Answer
Last Years Result Details Amt $ Sales 1,500,000 Variable expenses 690,000 Contribution margin 810,000 Fixed expenses 435,000 Net Opearating Income 375,000 ROI 30.0% Average opearing Assets 1,250,000 Minimum Required return@10% 125,000 Residual Income 250,000 Residual Income % 20.0% Investment opportunity Details Amt $ Sales 420,000 Variable expenses 126,000 Contribution margin 294,000 Fixed expenses 252,000 Net Opearating Income 42,000 ROI 12.0% Average opearing Assets 350,000 Minimum Required return@10% 35,000 Residual Income 7,000 Residual Income % 2.0% Investment plus opearions like last year Details Amt $ Sales 1,920,000 Variable expenses 816,000 Contribution margin 1,104,000 Fixed expenses 687,000 Net Opearating Income 417,000 ROI 26.1% Average opearing Assets 1,600,000 Minimum Required return@10% 160,000 Residual Income 257,000 Residual Income % 16.1% 1 As the residual income amt exceeds that of last year the CEO will pursue the same Residual Income if the contribution margin is 65% instead of 70 % in investments Investment plus opearions like last year Details Amt $ Sales 1,920,000 Variable expenses 837,000 Contribution margin 1,083,000 Fixed expenses 687,000 Net Opearating Income 396,000 ROI 25% Average opearing Assets 1,600,000 Minimum Required return@10% 160,000 Residual Income 236,000 Residual Income % 15% 2 In this case the residual Income will be less than previous years residual income So CEO will not pursue 3 The owners will also not want to pursue the investment opportunity if the contribution is 65% as the return will be less than the required rate or return.($14000 against $35000)
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