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ROI and Residual Income Final Exam Corporation is organized in three separate divisions and currently uses ROI as the divisional performance metric

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ROI and Residual Income

Final Exam Corporation is organized in three separate divisions and currently uses ROI as the divisional performance metric.  The company uses the following definition of ROI:

 

Operating income

            ROI =  .

 

Operating assets at the beginning of the period

 

  Suppose today is the first day of fiscal 2009. Vikas, the manager of Innovative Product division, is evaluating a new investment opportunity.  The investment project would require an immediate cash outlay of $30,000 for purchasing a new plant. The project would yield contribution margins (revenues less variable expenses) of $12,800 in each of the next three years. Assume that all revenues and variable expenses associated with the new project are on cash basis, and are collected/paid at the end of each fiscal year. Also assume that depreciation is the only fixed cost incurred in this project. The plant has a useful life of three years with no salvage value at the end of its useful life.  

 

  Suppose the company’s cost of capital (COC) is 11%. At 11%, the new investment project has a NPV of $1,152.75.

 

  If the Innovative Product division does not undertake the new investment opportunity, it expects to earn an operating income of $9,600 in fiscal 2009. At the beginning of the current fiscal year (i..e., 2009), the net book value of its operating assets is $60,000. The company uses the straight-line method for depreciating its plant assets.

 

  Suppose Vikas has a short planning horizon as he is planning to quit at the end of current fiscal year. In making his investment decision, his sole objective is to maximize his bonus during the current fiscal year.

 

              

             Required:

 

1. If Vikas’s bonus is based on divisional ROI, would he undertake the new investment project? Support your answer with necessary calculations.

 

2. For this part , assume that the company uses residual income to determine annual bonuses of its divisional managers. Residual income is measured as:

             

            RI = Operating income – COC x Operating assets at the beginning of the period.

 

Would Vikas undertake the new investment project? Support your answer with necessary calculations.