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

1. 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?