Problem 12-17 Sarah Jones, the manager of the Teen division of Eve Clothing Comp
ID: 2476457 • Letter: P
Question
Problem 12-17
Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $5,070,000 with total assets of $32,500,000 and noninterest-bearing current liabilities of $1,400,000. The proposed investment would add $1,027,000 to operating income and would require an additional investment of $5,266,000. The targeted rate of return for the Teen division is 13.80 percent. (Ignore taxes in this problem.)
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Compute the residual income of the Teen division if the embroidery machine is purchased.
Problem 12-17
Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $5,070,000 with total assets of $32,500,000 and noninterest-bearing current liabilities of $1,400,000. The proposed investment would add $1,027,000 to operating income and would require an additional investment of $5,266,000. The targeted rate of return for the Teen division is 13.80 percent. (Ignore taxes in this problem.)
Explanation / Answer
ROI of Teen Division if embroidery machine is not purchased:
ROI = Operating income / Total Assets = $ 5,070,000 / $ 31,100,000 x 100 = 16.30 %
ROI of the Teen Division if the embroidery machine is purchased = $ ( 5,070,000 + 1, 027,000) / $ ( 31,100,000 + 5,266,000) = $ 6,097,000 / $ 36,366,000 x 100 = 16.77%
Residual income of Teen Division if the embroidery machine is not purchased = Net operating income - ( Total assets x minimum required rate of return) = $ 5,070,000 - ( $ 31,100,000 x 13.80% ) = $ 778,200
Residual income of Teen Division if embroidery machine is purchased = $ 6,097,000 - ( $ 36,366,000 x 13.80%) = $ 1,078,492
Yes, Sarah will decide to invest in the embroidery machine.