Daun, is a subsidiary of Rimba Berhad, manufactures go-carts and other recreational vehicles. Family recreational centers that feature not only go-cart tracks but miniature golf batting cages and arcade games as well, have increased in popularity. Consequently, Daun has been receiving pressure from Rimbas management to diversify into some of these other recreational areas. Ranting, one of the largest firms that leases arcade games to family recreational centers, is looking for a buyer. Rimbas top management believes that Rantings assets could be acquired for an investment of RM1.6 million and has strongly urged Bakar, division manager of Daun, to consider acquiring Rnaring. Bakar has reviewed Rantings financial statements with his accountant, Maggie, and they believe the acquisition may not be in the best interest of Daun. If we decide not to do this, the Rimba people are not going to be happy, said Bakar. If we could convince them to base our bonuses on something other than return on investment (ROI), maybe this acquisition would look more attractive. What would we do if the bonuses were based on residual income, using the companys 15 percent cost of capital? Rimba traditionally has evaluated all of its divisions on the basis of return on investment. The desired rate of return for each division is 20 percent. The management team of any division reporting an annual increase in the ROI is automatically eligible for a bonus. The management of divisions reporting a decline in the ROI must provide convincing explanations for the decline in order to be eligible for a bonus. Moreover, this bonus is limited to 50 percent of the bonus paid to divisions reporting an increase in ROI.

1. Explain why Daun would be reluctant to acquire Ranting if Rimba continues to use ROI as the sole measure of divisional performance. - 5 marks
2. Explain why Daun would be more willing to acquire Rnating if Rimba could be persuaded to use residual income to measure the performance of Daun. - 4 marks
3. Discuss how the behavior of division managers is likely to be affected by the use of the following performance measures: i. Return of investment and ii. Residual income. - 2 marks

The following table is the financial statements for both Daun and Ranting for the most recent year