Residual Income and Investment Decisions Jarriot, Inc., presented two years of data for its Furniture Division and its Houseware Division Furniture Division: Sales Operating income Average operating assets Year 1 $35,800,000 1,430,000 2,480,000 Year 2 $38,000,000 1,590,000 2,480,000 Houseware Division: Year 1 Year 2 Sales $11,800,000 $12,600,000 Operating income 630,000 590,000 Average operating assets 5,550,000 5,550,000 At the end of Year 2, the manager of the Houseware 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 called the Espresso-Pro; it is an in-home espresso maker that can brew regular coffee as well as make espresso and latte drinks. While the market for espresso drinkers is small initially, he believes this market can grow, especially around gift-giving occasions. The second is the Mini-Prep appliance that can be used to do small chopping and dicing chores that do not require a full-sized food processor. 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: Espresso-Pro Mini-Prep Operating income $28,000 515,100 Outlay 160,000 110,000 Jarrot's corporate headquarters has made available up to $550,000 of capital for this division Any funds not invested by the division will be retained by headauarters 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) Espresso-Pro residual income $ 16,800 V Mini-Prep residual come 57,400 2 Carnitine 1. Compute the residual income for each of the opportunities. (Round to the nearest dollar.) Espresso-Pro residual income $ 16,800 7,400 Mini-Prep residual income 2. Compute the divisional residual income for each of the following four alternatives: (Round to the nearest dollar.) a. The Espresso-Pro is added. 178,300 X b. The Mini-Prep is added. $ 162,600 X c. Both investments are added. 185,700 x d. Neither investment is made; the status quo is maintained. 161,500 X Assuming that divisional managers are evaluated and rewarded on the basis of residual income, which alternative do you think the divisional manager will choose? Both projects 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 43,100 X Was the correct decision made? Yes Check My Work 1. Residual income Operating income - (Minimum rate of return x Operating assets). Residual income is the difference between operating income and the minimum dollar return required on a company's operating assets. 2. Use the formula in Requirement 1. Then discuss the choices of the division managers. 3. Compute profit or loss and discuss whether or not the correct decision was made
