(ROI and suboptimization) Northstar Offroad Company (NOC), a subsidiary of Allston Automotive, manufactures go-carts and other recreational vehicles. Fam¬ ily recreational centers that feature go-cart tracks, miniature golf, batting cages, and arcade games have increased in popularity. As a result, NOC has been re¬ ceiving some pressure from Allston Automotive top management to diversify into some of these other recreational areas. Recreational Leasing Inc. (RLI), one of the largest firms that leases arcade games to family recreation centers, is looking for a friendly buyer. Allston Automotive management believes that RLI’s assets could be acquired for an investment of $3.2 million and has strongly urged Bill Grieco, division manager of NOC, to consider acquiring RLI.

Grieco has reviewed RLI’s financial statements with his controller, Marie Donnelly, and they believe that the acquisition may not be in the best interest of NOC. “If we decide not to do this, the Allston Automotive people are not going to be happy,” said Grieco. “If we could convince them to base our bonuses on something other than return on investment, maybe this acquisition would look more attractive. How would we do if the bonuses were based on residual income using the company’s 15 percent cost of capital?”

Allston Automotive has traditionally evaluated all its divisions on the basis of return on investment, which is defined as the ratio of operating income to total assets; the desired rate of return for each division is 20 percent. The man¬ agement team of any division reporting an annual increase in the return on investment is automatically eligible for a bonus. The management of divisions reporting a decline in the return on investment must provide convincing expla¬ nations for the decline to be eligible for a bonus, and this bonus is limited to 50 percent of the bonus paid to divisions reporting an increase.

Following are condensed financial statements for both NOC and RLI for the fiscal year ended May 31, 1997.

a. Under the present bonus system, how would the acquisition of RLI affect Mr. Grieco’s bonus expectations?

b. If Mr. Grieco’s suggestion to use residual income as the evaluation criterion is accepted, how would acquisition of RLI affect Mr. Grieco’s bonus expectations?

c. Given the present bonus arrangement, is it fair for Allston Automotive man¬ agement to expect Mr. Grieco to acquire RLI? Explain.

d. Is the present bonus system consistent with Allston Automotive’s goal of expansion of NOC into new recreational products? Why or why not?
(CMA)

Transcribed Image Text:

NOC RLI Sales revenue Leasing revenue Variable expenses Fixed expenses Operating income Current assets Long-term assets Total assets Current liabilities Long-term liabilities Shareholders' equity Total liabilities and shareholders' equity $10,500,000 (7,000,000) (1,500,000) $ 2,000,000 $ 2,300,000 5,700,000 $ 8,000,000 $ 1,400,000 3,800,000 2,800,000 $ 8,000,000 $2,800,000 (1,000,000) (1,200,000) $ 600,000 $1,900,000 1,100,000 $3,000,000 $ 850,000 1,200,000 950,000 $3,000,000