Question 3 (9 Marks)

The manager of K&K Ltd is considering a new investment opportunity at the end of December 2020. The company has two independent divisions: Division A and Division B. Any of these divisions can take responsibility for this investment opportunity. The companys cost of capital is 12%, which is the required rate of return for the company. The company has a required pay-back period of maximum 3.0 years.

The total investment of Division A is $840,000 and Division B is $980,000. The estimated divisional margin for 2021 (without considering the investment opportunity) of Division A is $102,000 and for Division B is $160,000.

The required investment to take this opportunity is $200,000, useful life is 4 years and residual value at the end of the useful life is $20,000. The net cash flows estimated from this investment are as follows (assume depreciation is the only non-cash expense):

Net cash flows year 2021 70,000

Net cash flows year 2022 110,000

Net cash flows year 2023 40,000

Net cash flows year 2024 30,000

Required:

1. Based on the Accounting Rate of Return (ARR) method, what would be the decision of the company regarding the investment (round to two decimal places)?

Average Profit =

Average investment =

ARR =

Recommendation? Why?

Based on the Payback Period method, what would be the decision of the company regarding this opportunity of investment (calculate the Pay Back Period in years rounding to two decimal places)?

Recommendation? Why?

If the performance of the divisional managers is based on the Return on Investment (ROI) of their divisions based on their divisional margin, and, therefore, their main objective is to maximise their performance in 2021, will they accept this investment (justify your answer calculating the difference in their ROI)?

Assume depreciation is calculated using the straight-line method.

ROI Division A 2021 (without additional investment) =

ROI Division B 2021 (without additional investment) =

ROI additional investment 2021 =

Decision of each Division? Why?

If the performance of the divisional managers is based on the Residual Income (RI) of their divisions, based on a charge of capital of 18%, and, therefore the main objective of the managers is to maximise their residual income in 2021, will they accept this investment (justify your answer calculating the RI of the additional investment)?

RI additional investment 2021 =

Decision of each Division? Why?