Residual Income and Investment Decisions

Allard, Inc., presented two years of data for its Frozen Foods Division and its Canned Foods Division.

Frozen Foods Division: Year 1Year 2Sales$35,800,000$38,000,000Operating income1,360,0001,590,000Average operating assets9,570,0009,570,000

Canned Division: Year 1Year 2Sales$11,800,000$12,800,000Operating income620,000520,000Average operating assets5,600,0005,600,000

At the end of Year 2, the manager of the Canned Division is concerned about the division's performance. As a result, he is considering the opportunity to invest in two independent projects. The first is juice boxes for elementary school children. The second is fruit and veggie pouches for kids on the go. Without the investments, the division expects that Year 2 data will remain unchanged. The expected operating incomes and the outlay required for each investment are as follows:

Juice BoxFruit PouchOperating income$28,000$15,000Outlay150,000100,000

Allard's corporate headquarters has made available up to $530,000 of capital for this division. Any funds not invested by the division will be retained by headquarters and invested to earn the company's minimum required rate of return, 7 percent.

Required:

1. Compute the residual income for each of the opportunities. (Round to the nearest dollar.)

Juice Box residual income$ ___________Fruit Pouch residual income$ ___________

2. Compute the divisional residual income for each of the following four alternatives: (Round to the nearest dollar.)

a. The juice box is added. $ ___________

b. The fruit pouch is added. $ ___________

c. Both investments are added. $ ___________

d. Neither investment is made; the status quo is maintained. $ ___________

Assuming that divisional managers are evaluated and rewarded on the basis of residual income, which alternative do you think the divisional manager will choose?

Juice Box

Fruit Pouch

Both projects

Status quo

3. Assuming that management acts as you recommend in requirement 2, compute the change in profit (loss) from the divisional manager's investment decision.

Profit

Loss

$ ___________

Was the correct decision made? Yes

No