Derrick Iverson is a divisional manager for Holston Company. His annual pay raises are largely determined by his division’s return on investment (ROI), which has been above 25% each of the last three years.

Derrick Iverson is a divisional manager for Holston Company. His annual pay raises are largely determined by his division’s return on investment (ROI), which has been above 25% each of the last three years. Derrick is considering a capital budgeting project that would require a $5,160,000 investment in equipment with a useful life of five years and no salvage value. Holston Company’s discount rate is 18%. The project would provide net operating income each year for five years as follows:

Sales			$	4,400,000
Variable expenses				1,950,000
Contribution margin				2,450,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	790,000
Depreciation		1,032,000
Total fixed expenses				1,822,000
Net operating income			$	628,000

Required:

1. Compute the project's net present value.

2. Compute the project's simple rate of return.

3a. Would the company want Derrick to pursue this investment opportunity?

3b. Would Derrick be inclined to pursue this investment opportunity?

Explanation

1.

The net present value is computed as follows:

		Now			Years 1-5
Purchase of equipment	$	(5,160,000	)
Sales				$	4,400,000
Variable expenses					(1,950,000	)
Out-of-pocket costs					(790,000	)
Total cash flows (a)	$	(5,160,000	)	$	1,660,000
Discount factor (18%)(b)		1.000			3.127
Present value (a) × (b)	$	(5,160,000	)	$	5,190,820
Net present value	$	30,820

2.

The simple rate of return would be:

Simple rate of return	=	Annual incremental net income
		Initial investment
	=	$628,000	=	12.2%
		$5,160,000

3.

The company would want Derrick to pursue the investment opportunity because it has a positive net present value of $30,820. However, Derrick might be inclined to reject the opportunity because its simple rate of return of 12.2% is well below his historical return on investment (ROI) of 25%. Derrick may be justifiably concerned that implementing this project would lower his ROI and his next pay raise.

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Exercise 11-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income

Exercise 11-12 Evaluating New Investments Using Return on Investment (ROI) and Residual Income [LO11-1, LO11-2]

Selected sales and operating data for three divisions of different structural engineering firms are given as follows:

	Division A			Division B			Division C
Sales	$	12,560,000		$	35,700,000		$	20,560,000
Average operating assets	$	3,140,000		$	7,140,000		$	5,140,000
Net operating income	$	577,760		$	428,400		$	555,120
Minimum required rate of return		7.00	%		7.50	%		10.80	%

Required:

1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover.

 

 

2. Compute the residual income (loss) for each division.

3. Assume that each division is presented with an investment opportunity that would yield a 8% rate of return.

a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?

b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Explanation

1.

ROI computations:

ROI =	Net operating income	×	Sales
	Sales		Average operating assets

Division A:

ROI =	$577,760	×	$12,560,000	= 4.60% × 4.00 = 18.40%
	$12,560,000		$3,140,000

Division B:

ROI =	$428,400	×	$35,700,000	= 1.20% × 5.00 = 6.00%
	$35,700,000		$7,140,000

Division C:

ROI =	$555,120	×	$20,560,000	= 2.70% × 4.00 = 10.80%
	$20,560,000		$5,140,000

2.

	Division A			Division B			Division C
Average operating assets	$	3,140,000		$	7,140,000		$	5,140,000
Required rate of return	×	7.00	%	×	7.50	%	×	10.80	%
Minimum required return	$	219,800		$	535,500		$	555,120
Actual operating income	$	577,760		$	428,400		$	555,120
Minimum required return (above)		219,800			535,500			555,120
Residual income	$	357,960		$	(107,100	)	$	0

3.

a. & b.

	Division A	Division B	Division C
Return on investment (ROI)	18.40%	6.00%	10.80%
Therefore, if the division is presented with an investment opportunity yielding 8%, it probably would	Reject	Accept	Reject
Minimum required return for computing residual income	7.00%	7.50%	10.80%
Therefore, if the division is presented with an investment opportunity yielding 8%, it probably would	Accept	Accept	Reject

If performance is being measured by ROI, both Division A and Division C probably would reject the 8% investment opportunity. These divisions’ ROIs currently exceed 8%; accepting a new investment with a 8% rate of return would reduce their overall ROIs. Division B probably would accept the 8% investment opportunity because accepting it would increase the division’s overall rate of return.

If performance is measured by residual income, both Division A and Division B probably would accept the 8% investment opportunity. The 8% rate of return promised by the new investment is greater than their required rates of return of 7% and 8%, respectively, and would therefore add to the total amount of their residual income. Division C would reject the opportunity because the 8% return on the new investment is less than its 11% required rate of return.
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