Provide the missing items in the worksheet below! 2. Division A Division B Divis

Question

Provide the missing items in the worksheet below!

2.

Division A

Division B

Division C

Average operating assets...........

$1,500,000

$5,000,000

$2,000,000

Required rate of return...........

×      15%

×      18%

×      12%

Minimum required return...........

________

________

________

Actual net operating income.........

________

_________

________

Minimum required return (above)

Residual income

$   75,000

$           0

$   (60,000)

Part three below builds on parts 1 & 2. It is asking you what the managers of the divisions will do

3.

If judged by ROI

Division A

Division B

Division C

(ROI) from above

20%

18%

9%

Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would...

____

______

______

Judged by Residual income if

Minimum required return for computing residual income...

15%

18%

12%

Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would...

Write your answer to the questions:

Please provide explanation of the managers’ behavior.

What are the potential problems of only using performance measures that are based on accounting such as ROI & Residual Income?

2.

Division A

Division B

Division C

Average operating assets...........

$1,500,000

$5,000,000

$2,000,000

Required rate of return...........

×      15%

×      18%

×      12%

Minimum required return...........

________

________

________

Actual net operating income.........

________

_________

________

Minimum required return (above)

Residual income

$   75,000

$           0

$   (60,000)

Explanation / Answer

2 Division A Division B Division C Average Operating assets $1,500,000 $5,000,000 $2,000,000 Required rate of return 15% 18% 12% Minimum Required return (Avg Operating assets*Required rate of return) $225,000 $900,000 $240,000 Actual net Operating income (Minimum Required return + Residual Income) $300,000 $900,000 $180,000 Minimum required return 225000 900000 240000 Residual Income $75,000 0 ($60,000) 3 If Judged by ROI Division A Division B Division C ROI from above 20% 18% 9% Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would Reject Reject Accept Judged by Residual income if Minimum required return for computing residual income… 15% 18% 12% Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would.. Accept Reject Accept Explanation of the manager's behavior If judged on ROI, division A and Division B would reject the opportunity as it is already earning interest of more than 17% whereas Division C would accept this investment as this would lead to overall increase in its ROI If Judged on Residual Income, Division A and Division C should accept the investement as this would increase overall the residual return for the divisions whereas division B would reject it as it would decrease the overall residual income What are the potential problems of only using performance measures that are based on accounting such as ROI & Residual Income? 1 These performance measures are not useful for long term analysis of the divisions as they are considering only the current details of revenue 2 The calculation of ROI and RI is subject to manipulation, there can be manipulation done by the managers to earn higher bonus 3 Also if the net operating assets are shown at book value, than the ROI and RI may not reflect correct values as the values might be higher or lower based on fair value 4 Identification of costs and investments would be diffficult task for the managers

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