13.38 ROI versus residual income, incentives, bonus schemes: manufacturer

13.38 \"3.38 PO! versus residual income: incentives; bonus schemes: manufacturer L 013 1 Fun Time Company (FTC). a subsidiary of New Age lndustries. manufactures go-carts. water skis and ' motorised scooters. With the increasing popularity of electronic arcade games, New Age has been 13'2 encouraging FTC to diversify into some of these other recreational areas. Arcade Unlimited Ltd (AUL) is 13-3 a large manufacturer of arcade games and it is looking for a Friendly buyer. New Age's top management 13.4 believes that AUL's assets could be acquired For an investment of only 14.8 million and has strongly urged 13." Will Kelly, the divisional manager of FTC. to consider acquiring AUL. Keliy has reviewed the financial statement of AUL and he believes that the acquisition may not be in the best interests of FTC. However. he knows that if he does not acquire AUL. New Age's management is not going to be pleased! Kelly exclaims to his divisional management team: 'lt only we could convince them to base our bonuses on something other than ROI. this acquisition would look more attractive. If only our bonuses were based on residual income, using the company's weighted average cost of capital of 15 per centl'. New Age has always evaluated the divisions on the basis of R01, and the target ROI for each division is 20 per cent. The management team of any division that reports an annual increase in their ROI is given a bonus. but the managers of divisions where the ROI declines must provide a very convincing explanation as to why they should get a bonus. Where ROI has declined. the bonus is limited to only 50 per cent of the bonus that is paid to the divisions that report an increase in ROI. The following data relate to the most recent financial year: mi. m: I Sales revenue $4 650 000 $14 250 000 Less: Variable expenses 1 950 000 9 000 000 Fixed expenses 1 800 000 2 250 000 Operatingprot M M Current assets $2 850 000 5 3 450 000 Longterm assets M09. m Masses em w Current liabilities $1 275 000 5 2 100 000 Longterm liability 1 800 000 5 700 000 Shareholders'equiry . w M Total liabilities andequiw M M Required: 1 Explain why FTC may be reluctant to acquire AUL. Provide calculations. 2 It New Age were to use residual income to measure divisional performance and evaluate managers. would FTC be more motivated to acquire AUL? Provide calculations. 3 Comment on the current bonus scheme and outline two other schemes that New Age could use to deliver bonuses to divisional managers