Evaluating New Investments Using Return on Investment (ROI)

and Residual Income [LO1, LO2]

Selected sales and operating data for three divisions of three different companies are given below:

Division A Division B Division C Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000,000 $10,000,000 $8,000,000 Average operating assets . . . . . . . . . . . $1,500,000 $5,000,000 $2,000,000 Net operating income . . . . . . . . . . . . . . $300,000 $900,000 $180,000 Minimum required rate of return . . . . . . 15% 18% 12%

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 for each division.

3. Assume that each division is presented with an investment opportunity that would yield a rate of return of 17%.

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

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