The Clipper Corporation had net operating income of $380,000 and average operati
ID: 2501055 • Letter: T
Question
The Clipper Corporation had net operating income of $380,000 and average operating assets of $2,000,000. The corporation requires a return on investment of 18%.
Required ( support your answers with explanations):
a.Calculate the company's return on investment (ROI) and residual income (RI).
b.Clipper Corporation is considering an investment of $70,000 in a project that will generate annual net operating income of $12,950. If the division planning to make the investment currently has a return on investment of 20% and its manager is evaluated based on the division's ROI, will the division manager be inclined to request funds to make this investment?(Note: the decision model for the division manager is self-interested i.e. centers on the decision's effect on his evaluation criteria)
c.Clipper Corporation is considering an investment of $70,000 in a project that will generate annual net operating income of $12,950. If the division planning to make the investment currently has a residual income of $50,000 and its manager is evaluated based on the division's residual income, will the division manager be inclined to request funds to make this investment?(Note: the decision model for the division manager is self-interested i.e. centers on the effect on his evaluation criteria)
Explanation / Answer
a)
Company's return on investment (ROI) = net operating income/average operating assets
Company's return on investment (ROI) = 380000/2000000
Company's return on investment (ROI) = 19%
Residual income = Net operating income- return on investment *average operating assets
Residual income = 380000 - 18%*2000000
Residual income = $ 20000
b)
ROI of new investment = net operating income/investment
ROI of new investment = 12950/70000
ROI of new investment = 18.50%
ROI of overall company if investment taken place = Total net operating income/ Total average operating assets
ROI of overall company if investment taken place = (380000+12950)/(2000000+70000)
ROI of overall company if investment taken place = 18.98%
Division manager will not be inclined to request funds to make this investment as this investment would return 18.5%which is below than division planning to make the investment currently has a return on investment of 20% and as manager is evaluated based on the division's ROI , so he would not recommend as the ROI of overall would decline.
c)
Residual Income would increase from this investment = Net operating income- return on investment *average operating assets
Residual Income would increase from this investment = 12950 - 18%*70000
Residual Income would increase from this investment = $ 350
Division manager will be inclined to request funds to make this investment as it would improve the residual income from 20000 to $ 20350