Problem 13-42 ROl and Residual Income; Investment Evaluation (LO 13-2,13-3, 13-4
ID: 2582136 • Letter: P
Question
Problem 13-42 ROl and Residual Income; Investment Evaluation (LO 13-2,13-3, 13-4,13-8) Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 15 percent return on its investment. During the past week, management of the company's Northeast Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Northeast Division and the competitor: Competitor Northeast Division $4, 340,000 Sales Variable costs Fixed costs Invested capital $2,740,000 75% of sales 70% of sales $ 896,000 $1,050,000 $ 756,000 $ 300,000 Management has determined that in order to upgrade the competitor to Megatronics' standards, an additional $140,000 of invested capital would be needed Required: 1. Compute the current ROI of the Northeast Division and the division's ROl if the competitor is acquired 2. If divisional management is being evaluated on the basis of ROl, will the Northeast Division likely pursue acquisition of the competitor? 3-a. Compute the ROl of the competitor as it is now and after the intended upgrade 3-b. If ROl is used as the basis for evaluation, would Megatronics Corporation likely be in favor of the acquisition of the competitor? 4. Calculate the Northeast Division's ROl after acquisition of competitor but before upgradingg 5-a. Assume that Megatronics uses residual income to evaluate performance and desires a 12 percent minimum return on invested capital. Compute the current residual income of the Northeast Division and the division's residual income if the competitor is acquired 5-b. If divisional management is being evaluated on the basis of residual income, will the Northeast Division likely pursue acquisition of the competitor?Explanation / Answer
1. a. Computation of Current ROI of Northeast division
ROI = Net operating profits / Invested Capital
Net operating Profts = Sales - Variable Cost - Fixed Cost
= 4,340,000 - (75% x 4,340,000) - 896,000 = 189,000
Invested Capital = 1,050,000
ROI = 189,000 / 1,050,000 = 18%
b. Computation of new roi after acquisition
Total Sales = $7,080,000
Variable Cost = (4340000 x 75%) + (2740000 x 70%) = $5,173,000
Fixed Cost = 896,000 + 756,000 = $1,652,000
Net Operating Profits = $255,000
Invested Capital = $1,050,000 + 300,000 + 140,000 = $1,490,000
ROI after acquisition = 255,000 / 1,490,000 = 17.11%
2. On the basis of ROI- After the acquisition overall ROI of Northeast division has declined from 18% to 17.11% and therefore, acquisition will not be accepted.
3. Current ROI of competitor:
Operating profits = 2,740,000 - (2,740,000 x 70%) - 756,000
= 66,000
Invested Capital = 300,000
ROI = 66,000 / 300,000 = 22%
ROI after upgrade = 66,000 / (300,000 + 140,000) = 15%
3-B. No, since the Overall ROI of the company will decrease due to acquisition.
4. Northeast ROI before Upgrade = $255,000 / (300,000 + 1,050,000) = 18.88%