Question 2 (17 marks) Orange Limited, incorporated in Hong Kong in 1991, is one of the several wholly-owned subsidiaries of Pear Limited. Orange is reputable in manufacturing universal serial bus (USB) which are sold to foreign companies. It has a plant at Tuen Mun. Currently, the sales of Orange are rapidly increasing, and the company is considering a project to expand its production in Tuen Mun plant. Jenny Leung, the CEO of Pear, Cindy Wong, the production manager of Orange, and Lilian Chan, the new management accountant of Pear, had a meeting and discussed the following: Jenny: Due to the increasing trend of sales, we may need to expand our production in Tuen Mun. Or we may lose some of our good customers to other competitors. Cindy: To expand the production in Tuen Mun, we require an additional investment in operating assets of $2,000,000 but we'll have additional sales of $2,500,000. I also estimate that costs for this new project include variable expenses of 65% of sales and fixed expenses of $690,000. I don't think it is worth for us to invest in this project. Lilian: I think I need some time to do the analysis to see if this project is worth investing. I also understand that right now the management of Orange is evaluated based on return on investment (ROI). Jenny: Yes, the management will get the year-end bonus if the ROI is increased. The higher the ROI, the higher the amount of the bonus will be awarded. Lilian: lll suggest that instead of using solely ROI for performance measurement, we may consider using residual income approach, with 9% as the minimum required rate of return. After the meeting, Lilian had prepared the following draft financial data for Orange Limited for last year: Ending Balance Orange Limited Statement of Financial Position Beginning Balance Assets Cash $500,000 Accounts receivable 850,000 Inventory 330,000 Plant and equipment, net* 2,000,000 Shares of Lamon Limited** 600,000 7,000,000 Total assets $11,280,000 $350,000 780,000 420,000 2,500,000 620,000 7,000,000 $11,670,000 Land*** Liabilities and Stockholders' Equity Accounts payable Long-term debt Stockholders' equity Total liabilities and stockholders' equity $650,000 3,500,000 7,130,000 $11,280,000 $800,000 3,500,000 7,370,000 $11,670,000 * Straight line depreciation is used for plant and equipment. ** The shares of Lamon Limited are held for investment purpose. *** The land is held for use for another project to be commenced five years later. The net income of Orange last year was $344,000, after deducting interest expense and tax expense of $70,475 and $30,000 respectively. Dividends of $100,000 was paid last year. Required: (a) Determine the following for Jenny of Pear Limited: (1) Orange Limited's ROI for last year; (ii) The ROI of Orange Limited as it would appear if the new project to expand its production in Tuen Mun is taken; (iii) Orange Limited's residual income for last year; and (iv) The residual income of Orange Limited as it would appear if the new project to expand its production in Tuen Mun is taken. (12 marks) (b) Critically analyse and discuss why Cindy may not want Orange Limited to invest in the new project. Discuss why Lilian suggested Pear Limited should consider using residual income approach to evaluate the management of Orange Limited. (5 marks) (Total for Question 2: 17 marks)