Lady Luck Wines Ltd. expects its divisions to earn a minimum rate of return of 12%. One of its divisions, Red Wines, is an investment centre that harvests, ferments and bottles various types of red wine.

An investment opportunity is available to Red Wines that would require an investment of $500,000 in new operating assets and earn net operating income of $80,000.

Required:

a) Would the management of Red Wines likely accept the investment opportunity if they are evaluated based on return on investment of the division? Show calculations and conclude. (2 marks)

b) Would the management of the Red Wines division likely accept the investment opportunity if they are evaluated based on residual income? Show calculations and conclude. (3 marks)